Why The Bitcoin ETF Went Down in Flames

SEC Rejects Rule Change to Allow Bitcoin ETF.

Massive Bitcoin Trading on Unregulated Exchanges Was Key Factor.

Bitcoin Price Swings Nearly $400 on Day of SEC Decision.

BTC ETF Might Have Destroyed Bitcoin Ecosystem/Value as Currency.

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Bitcoin ETF Goes Down in Flames

The Securities and Exchange Commission rejected an application to a rule change that would have paved the way for a Bitcoin ETF tradeable on the New York Stock Exchange. Many bitcoin aficionados welcomed the bitcoin ETF as validation of bitcoin and thought it would provide stimulus for further price gains as the ETF would attract large institutional capital.

Bitcoin Holder Reasons to Be Opposed to the Bitcoin ETF

While we may never know what impact the BTC ETF may have had on the price of bitcoin, we speculated that based on the disclosures in the Bitcoin registration statement filed with the Securities Exchange Commission, it may have harmed bitcoin and the bitcoin ecosystem and ultimately its price because:

The proposed Bitcoin ETF had no limit on the amount of Bitcoin it could buy or sell. This would inevitably create greater volatility making Bitcoin use as a currency less attractive and making bitcoin a safe haven asset for institutional investors unlikely.

The Bitcoin ETF would have had to settle its trades on small relatively illiquid unregulated Chinese exchanges and in “dark pools”, creating instances where new trades would not be effectuated, diminishing faith in the ETF and creating even more price volatility. The Bitfinx exchange allows short selling of bitcoin.

If the Bitcoin ETF managed to attract more capital despite the speculative nature of trust, a greater percentage of bitcoin would have been locked up in the trust, meaning fewer bitcoins and entities would be trading bitcoin as a currency but rather buying and selling as a speculative asset.

The Bitcoin ETF may have severely interrupted a naturally developing market that was already troubled by volatility, issues with exchanges and stability concerns with increasing transactions.

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Why the SEC Rejected the Bitcoin ETF

The SEC did not reject the ETF because of the harm it may have caused to the Bitcoin ecosystem or even to bitcoin holders, but rather because the inability of the SEC to monitor the functioning of the trust due to the unregulated nature of the bitcoin trading on the Chinese exchanges, that according to the SEC filing constituted 95% of bitcoin trading.

From the Bitcoin Registration Statement:

“Such an action may also result in the restriction of ownership, holding or trading in the Shares or cause the price of bitcoin to substantially decrease. For example, current estimates suggest that approximately 95% of the global trade volume in bitcoins occur on self-reported, unregulated exchanges located in China. If China were to regulate the bitcoin traded on Chinese Bitcoin Exchanges in a manner that materially restricted liquidity in trading, it could have a significant impact on the price of bitcoin globally. Such regulatory actions or restrictions could adversely affect an investment in the Shares or result in the termination and liquidation of the Trust at a time that is disadvantageous to Shareholders.”

The SEC does not approve or disapprove of securities listed on exchanges. Indeed, companies filing registrations statements for SEC review place this legend on their covers.

Neither the Securities and Exchange Commission nor any state securities commission has approved or disapproved of the securities offered in this prospectus, or determined if this prospectus is truthful or complete. Any representation to the contrary is a criminal offense.

The role of the SEC is not to determine the worthiness of any investment, but rather to ensure that the issuer of such security is disclosing adequately the risks in its registration statement. Many observers thought a double standard was invoked by rejecting the Bitcoin ETF because the SEC has “approved” other risky non profitable stocks. This is an understandable misinterpretation. The SEC was not rejecting Bitcoin as a security,(we will discuss bitcoin’s status as a commodity, currency and security below) like, for example, a share of Snap Chat, but rather the ability of a Bitcoin ETF to be established.

Companies like Snap Chat did not have their registration statements “approved” by the SEC, but rather reviewed by the SEC through and iterative process with the issuers to ensure (but not approved or guaranteed by the SEC) that the disclosures about the companies and the risk involved in investing in them are fully disclosed.

The decision by the SEC regarding whether the Bitcoin ETF go forward was based on a requirement that a SEC rule be changed.

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Rule Change

The SEC rejected the request for a rule change that would have allowed the Bitcoin ETF to go forward because:

First, the exchange must have surveillance-sharing agreements with significant markets for trading the underlying commodity or derivatives on that commodity. And second, those markets must be regulated.

Based on the record before it, the Commission believes that the significant markets for bitcoin are unregulated. Therefore, as the Exchange has not entered into, and would currently be unable to enter into, the type of surveillance-sharing agreement that has been in place with respect to all previously approved commodity-trust ETPs—agreements that help address concerns about the potential for fraudulent or manipulative acts and practices in this market—the Commission does not find the proposed rule change to be consistent with the Exchange Act.

The unregulated nature of bitcoin, after all has been many bitcoin proponents’ main argument in favor of the crypto currency. But will it remain that way?

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What is Next for Bitcoin Regulation?

Regulators have been careful not to immediately make definitive pronouncements or impose regulations on bitcoin as it appears they wish to see how it develops.

From the Bitcoin ETF Registration Statement

IRS Says Bitcoin is Property, not a Currency

“On March 25, 2014, the IRS released a notice (the “Notice”) discussing certain aspects of the treatment of virtual currencies, such as bitcoins, for U.S. federal income tax purposes. In the Notice, the IRS stated that, for U.S. federal income tax purposes, (i) bitcoins are “property” that is not currency and (ii) bitcoins may be held as capital assets. However, the Notice is not binding on the IRS, and special tax counsel to the Trust expresses no opinion in respect of, and a court might not uphold, this treatment. In addition, legislation has been introduced that would, if enacted, cause bitcoins to be treated as currency for U.S. federal income tax purposes. If bitcoins were properly treated as currency for U.S. federal income tax purposes, gain recognized on the disposition of bitcoins would constitute ordinary income, and losses recognized on the disposition of bitcoin could be subject to special reporting requirements applicable to “reportable transactions.” The remainder of this discussion assumes that bitcoins are properly treated for U.S. federal income tax purposes as property that is not currency. Special tax counsel to the Trust expresses no opinion regarding these aspects of the U.S. federal income tax treatment of bitcoins.

If bitcoins were properly treated as currency for U.S. federal income tax purposes, gains recognized on the disposition of bitcoins would constitute ordinary income, and losses recognized on the disposition of bitcoins could be subject to special reporting requirements applicable to “reportable transactions.”

The CFTC Says Bitcoin is a Commodity

The CFTC has indicated that it considers bitcoin to be a “commodity” under the CEA, which makes it possible for futures, swaps, and other CFTC-regulated derivatives based on bitcoin to be offered and traded in the United States. The CFTC has not, to date, taken the view that bitcoin is a “commodity interest,” which is defined under the CEA to include futures, swaps, and other derivatives based on commodities. Commodity interests are subject to CFTC regulation and thus, if bitcoin were to be deemed a commodity interest by the CFTC, the Trust and the Sponsor would be subject to additional regulatory and compliance requirements under the CEA and CFTC regulations.”

Is Bitcoin a Security?

Prior to the IRS ruling in March 2014, earlier that month I penned Here comes Bitcoin Regulation with the intent to speculate on how the various US governmental agencies might wish to treat bitcoin. I noted:

Once:

Bitcoin is traded on exchanges, especially ones located in the United States ( e.g. Second Market?);

the identity of Bitcoin users are known;

Bitcoin is traded in an ETF; and

the bulk of Bitcoin changes hands from the large private individual holdings (the few original early Bitcoin adopters who own half the existing Bitcoin) to institutional investors and to the government through confiscation:

taxation and regulation of Bitcoin can easily be imposed.

Paradoxically, more regulation will also probably mean that Bitcoin will be subject to greater manipulation.

Which U.S. Agency(ies) Will Regulate Bitcoin?

I suggested the SEC would probably throw their hat into the regulatory ring based on the concept that bitcoin could be deemed to be a security:

Bitcoin Regulation by The Securities and Exchange Commission?

If Bitcoin is found to be a security the Securities Exchange Commission (SEC) would claim regulatory jurisdiction.

SEC Chair Mary Jo White wrote in a letter to the Committee on Homeland Security and Governmental Affairs dated August 30th, 2013:

“Whether a virtual currency is a security under the federal securities laws, and therefore subject to our regulation, is dependent on the particular facts and circumstances at issue. Regardless of whether an underlying virtual currency is itself a security, interests issued by entities owning virtual currencies or providing returns based on assets such as virtual currencies likely would be securities and therefore subject to our regulation.”

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The Bitcoin ETF registration statement contained language that indicates the SEC is indeed examining “security” status for bitcoin.:

“To date, the SEC has not asserted regulatory authority over the Bitcoin Network or bitcoin trading or ownership and has not expressed the view that bitcoin should be classified or treated as securities for purposes of
U.S. federal securities laws. However, the SEC has indicated that the subject of bitcoin’s regulatory status is under review. In addition, it has commented on bitcoin and bitcoin-related market developments and has taken action against investment schemes involving bitcoin. If the SEC were to determine that bitcoin is a security, the Trust and the Sponsor would be subject to additional regulatory and compliance requirements under U.S. federal securities laws, including the Investment Company Act and, with respect to the Sponsor, the Investment Advisers Act.

Regulatory changes or interpretations could cause the Trust and the Sponsor to register and comply with new regulations, resulting in potentially extraordinary, nonrecurring expenses to the trust.
Current and future legislation, CFTC and SEC rulemaking and other regulatory developments may impact the manner in which bitcoins are treated for classification and clearing purposes. In particular, bitcoins may be classified by the CFTC as “commodity interests” under the CEA or may be classified by the SEC as “securities” under U.S. federal securities laws. As of the date of this prospectus, the Sponsor is not aware of any rules that have been proposed to regulate bitcoins as a commodity interest or a security. Although several U.S. federal district courts have recently held for certain purposes that bitcoins are currency or a form of money, these rulings are not definitive and the Sponsor and the Trust cannot be certain as to how future regulatory developments will impact the treatment of bitcoins under the law. In the face of such developments, the required registrations and compliance steps may result in extraordinary, nonrecurring expenses to the Trust. If the Sponsor decides to terminate the Trust in response to the changed regulatory circumstances, the Trust may be dissolved or liquidated at a time that is disadvantageous to Shareholders.

To the extent that bitcoins are deemed to fall within the definition of a security under U.S. federal securities laws, the Trust and the Sponsor may be subject to additional requirements under the Investment Company Act and Investment Advisers Act. The Sponsor may be required to register as an investment adviser under the Investment Advisers Act.

Such additional registration may result in extraordinary, recurring and/or non-recurring expenses of the Trust, thereby materially and adversely impacting the Shares. If the Sponsor determines not to comply with such additional regulatory and registration requirements, the Sponsor will terminate the Trust. Any such termination could result in the liquidation of the Trust’s bitcoins at a time that is disadvantageous to Shareholders.”

What do other States and Governments Think Bitcoin is?

“The treatment of virtual currencies such as bitcoins for tax purposes by foreign jurisdictions may differ from the treatment of virtual currencies by the IRS or the New York State Department of Taxation and Finance. If a foreign jurisdiction with a significant share of the market of bitcoin users imposes onerous tax burdens on bitcoin users, or imposes sales or value-added tax on purchases and sales of bitcoins for fiat currency, such actions could result in decreased demand for bitcoins in such jurisdiction, which could affect the price of bitcoins and negatively affect an investment in the Shares.”

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