SEC rejects bitcoin fund, showing digital currency hurdles as Main Street investment

NEW YORK (Thomson Reuters Regulatory Intelligence) - The U.S. Securities and Exchange Commission on Friday rejected an application for a bitcoin-based exchange-traded-fund, suggesting that the digital currency has far to go before it wins approval as a traded investment on a public securities market, according to the SEC’s ruling on the case and industry sources.

A Bitcoin (virtual currency) paper wallet with QR codes and coins are seen in an illustration picture taken at La Maison du Bitcoin in Paris July 11, 2014.

The SEC’s 38-page ruling (here) listed significant barriers to the approval of trading in bitcoin securities, given a lack of safeguards in the market to prevent fraud and manipulation. While the agency left open the possibility that it could approve a bitcoin fund in the future, the digital currency is at “relatively early stages of its development” to consider turning the digital currency into tradeable shares, the SEC said.

The proposal to approve a Winklevoss Bitcoin Trust would have created a bitcoin-based exchange traded fund offering investors the first chance to acquire shares and trade shares based on a basket made up entirely of bitcoin holdings. Created as an alternative to government currencies, bitcoin are heavily encrypted certificates bought and sold on private exchanges that list daily price fluctuations.


The approval would have been a boon to the digital currency, said its backers, who saw it creating the potential to turn bitcoin into a liquid, highly visible marketplace for the digital currency. The approval would have helped legitimize its use in commercial applications so far hampered by frequent shutdowns and trading irregularities on existing unregulated bitcoin exchanges.

The SEC ruled that the proposed bitcoin ETF would not satisfy the Exchange Act requirement that securities have a “surveillance-sharing agreement with a significant, regulated, bitcoin-related market.” The conditions could potentially be met over time, the agency said, but first the regulator wants to see “regulated bitcoin-related markets of significant size.”

The application drew significant support in the bitcoin industry as its backers argued that SEC approval would have spurred an influx of mainstream investors and lead to greater oversight. The SEC’s response that it could not allow trading in what it saw as an unregulated commodity could doom other pending bitcoin proposals. Bitcoin fell sharply on private markets globally after the application failed.


The SEC knocked down Winklevoss’s contention that New York state already regulates its bitcoin exchange. The New York Department of Financial Services gave a charter to the Winkelvoss operating company, Gemini Trust Co, to run its bitcoin market, Gemini Exchange, last year. The state charter allowed it to handle banking-related operations such as handling payments and processing bitcoin transfers.

But the SEC instead ruled that the bitcoin fund must meet a higher standard to create an exchange-traded security, along the lines of those required of ETFs created from commodities such as gold and other precious metals, which are monitored by various exchanges and regulatory authorities. The SEC holds statutory power to approve the sale of securities or to operate a securities market.


To be sure, the Winklevoss proposal faced objections unique to their own proposal, most notably a potential conflict of interest their bitcoin securities operation pose, which might not be true with other potential ETF sponsors seeking SEC approval. As the largest known owner of bitcoin, the twins, Cameron and Tyler Winklevoss, would be in position to benefit from their role operating an exchange traded fund, putting it in a different from their investors.

Their marketplace could favor the fund’s own transactions in handling bitcoin redemptions or transactions to stay in operation, the SEC said. "It may not be possible to entirely eliminate these conflicts of interest," said the Winklevoss bitcoin ETF prospectus, a 129-page document (here) with a voluminous list of risk disclosures, including their own lack of experience in running investment funds and their uncertain relations with regulators and bitcoin miners, who create certificates, and competing exchanges.

The Winklevoss twins vowed to continue their effort to create a public trading venue for bitcoin. The flat rejection by the SEC, however, suggested there are basic flaws that will not be easily overcome by a simple resubmission.

The Winkleboss twins said, ”We agree with the SEC that regulation and oversight are important to the health of any marketplace and the safety of all investors.” In their plan, they advocated a “pure play” bitcoin fund based entirely on the value of a basket of bitcoin. They said that many of the problems that have surfaced in bitcoin exchanges would disappear if their plan was approved. The newly legitimized bitcoin operation would trigger a flood of liquidity into the marketplace, they said. The price of bitcoin had surged in anticipation their plan might win approval.


But the SEC action suggests that bitcoin-based ETFs that take such a “back door” approach to creating a marketplace are likely to meet the same response. The Winklevoss proposal asserted that its own efforts to provide transparency and oversight, along with the self-policing of the blockchain consortium that certifies the digital signatures, could provide security and integrity to the market and protect the fund’s investors. They argued that they would use their position as the largest known holder of the digital currency to influence bitcoin market compliance.

The SEC pointed out, however, that the Winklevoss group accounts for barely one percent of the global bitcoin market. The rest of bitcoin is spread over multiple exchanges spread around the world, and is thinly traded, illiquid and anonymous. Many bitcoin promoters have backed efforts at regulating the digital currency to broaden its appeal, but other factions prefer that it remain untraceable and unregulatable.


For the foreseeable future, the SEC ruling suggests, the digital currency is likely to encounter regulatory skepticism in efforts to transform the secretive currency once used to fund drug deals and other illicit activities into a Main Street investment product, industry figures said.

The SEC cited the potential for abuses. Andreas Antonopoulos, a widely followed academic and bitcoin industry consultant on regulation, said the SEC decision shows it has not close to overcoming regulators’ concerns.

“The ETF was denied because bitcoin can't be regulated, can't be surveilled. Feature, not bug,” he tweeted on Friday (here).

(Richard Satran is a financial journalist covering daily and emerging issues for Thomson Reuters Regulatory Intelligence.)