In the ever-evolving world of digital assets and law, Grayscale Investments, LLC (Grayscale) found itself at the pinnacle of a major decision by the Court of Appeals for the District of Columbia. On August 29, the court deemed the Securities and Exchange Commission’s (SEC) denial of Grayscale’s October 19, 2021, spot Bitcoin (BTC) exchange-traded fund (ETF) application “arbitrary and capricious” and vacated the agency’s decision. At the heart of the court of appeal’s ruling lies the Administrative Procedure Act (APA), the complex interplay between spot asset pricing and futures asset pricing, and the SEC’s current sentiment towards digital asset-based financial products.

Spot Pricing vs. Futures Contract Pricing

The price of a spot asset (for example, shares of hypothetical stock) refers to the asset’s current market price. If the stock is currently $200.00 per share, that is the current market price of those shares. On the other hand, the price of a futures contract of the hypothetical stock is also based on the current market price, but the parties to the transaction specify that shares of the stock will be bought or sold at a predetermined date and price in the future regardless of the market price at the end date of the futures contract.

The APA’s Importance and the “Arbitrary and Capricious” Standard

The APA delineates the procedures for judicial review of a federal agency’s rulemakings and other actions, such as the SEC’s refusal to allow Grayscale to transform its Grayscale BTC Trust ($GBTC) into a spot-BTC ETF.

It is important to note that the court of appeal’s task was not to decide whether the SEC should greenlight Grayscale’s proposed spot-BTC ETF. Instead, the issue before the court was whether the SEC’s reasoning for denying Grayscale’s application was “arbitrary and capricious” — essentially a polite term for acting without rationale.

When dissecting agency action under this standard, courts cannot play armchair regulators and supplant the agency’s judgment with that of their own. A court’s mandate is to assess if an agency’s decision is grounded in reasonableness and supported by evidence in the record. Typically, a court will presume agency action is legitimate unless it is clearly implausible.

The “Significant Market” Test and Surveillance Sharing Agreements

In support of its decision to deny Grayscale’s application, the SEC offered a straightforward argument: Grayscale’s proposed spot-BTC ETF did not pass the significant market test. Since 2018, the SEC has denied every spot-BTC ETF application it has received by relying solely on the significant market test. One of the main aims of the Exchange Act is to prevent fraud and manipulation in securities markets, and, according to the SEC, the BTC market lacks the liquidity and size necessary to combat fraud. But there is an end-around. Spot-BTC applicants may increase their chances of approval and meet their obligations to deter fraud under Exchange Act § 6(b)(5) by entering surveillance sharing agreements with markets that are: (1) related to the listing exchange (here, Grayscale), (2) regulated, and (3) of significant size. Grayscale chose to enter a surveillance sharing agreement with the Chicago Mercantile Exchange (CME), the world’s largest futures marketplace.

The final prong of the surveillance sharing agreement criteria is the significant market test and it consists of two elements: (1) there must be a reasonable likelihood that a fraudster trying to manipulate the spot-BTC ETF would have to trade on the related market (here, CME) to successfully manipulate the spot-BTC ETF, and (2) it must be unlikely that trading in the spot-BTC ETF would be the predominant influence on prices in the surveilled market (here, the futures market).

And here lies the problem, at least in the eyes of the SEC, which took issue with Grayscale’s surveillance partner. The SEC argued that the CME’s futures market orientation made it ill-suited for tracking potential fraud in the spot market.

Grayscale’s Strong Case

To counter the SEC’s argument, Grayscale highlighted the staggering 99.9% correlation between the spot-BTC market prices and futures-BTC market prices. While the SEC seemed to latch onto the “correlation does not imply causation” argument, it hardly held water against the near-perfect market correlation. As the court of appeals aptly noted, “[w]e recognize the basic principle that mere correlation does not equal causation. But here the correlation was based on the logical and mathematical connection between the spot and futures markets.”

Grayscale also argued that the SEC has been inconsistent in its actions, as shown by its approval of two futures-BTC ETF applications filed by the New York Stock Exchange (NYSE) and the Nasdaq in 2021. Like Grayscale, both the NYSE and the Nasdaq engaged CME to be their surveillance partners. This similarity in surveillance partners and the unmistakable price correlation between the spot and futures BTC markets led the court to conclude that the SEC had acted arbitrarily and capriciously in denying Grayscale’s spot-BTC ETF application.

Looking Ahead

The SEC will likely tread with caution moving forward. With several spot-BTC ETF applications currently pending, the SEC must ensure that its objections (if this is the route it chooses) are not only consistent, but also firmly rooted in sound rationale. Although the SEC has never approved a spot-BTC ETF application under the significant market test, that analytical framework may have met its demise in this action. The SEC’s new deadline to either approve, deny, or delay its decisions on the pending spot-BTC ETF applications is October 19, 2023.