Ether spot ETFs: SEC's Gensler has a legal trick up his sleeve to keep them off the market

By Chris Matthews

Approval of an ether futures ETF doesn't guarantee a spot product will be approved

The cryptocurrency industry has taken an extended victory lap in the 10 weeks since the Securities and Exchange Commission approved the listing of 11 bitcoin (BTCUSD) exchange-traded products, bidding up the world's most popular digital asset by 40% on the way to a series of record highs.

The spectacular run has underscored crypto's inherent volatility and shows why crypto boosters fought so long and hard to win approval for the ETPs. Now investors are turning their attention to what an exchange-traded wrapper could do for ether (ETHUSD), the second-largest digital asset by market capitalization.

Analysts predict the debut of an ether ETP could happen as soon as May and could bring upwards of $45 billion in inflows to the asset within 12 months. Prospective issuers are similarly bullish. The digital asset has already surged in value during the ongoing crypto rally, gaining more than 102% over the past 12 months.

Ether investors are hoping that the same legal playbook that beat the SEC in court and led to its approval of bitcoin ETPs will play out similarly with ether, but SEC Chair Gary Gensler will have better legal arguments in opposing an ether ETP, experts tell MarketWatch.

A spot ether ETP "is a matter of when, not if," Grayscale CEO Michael Sonnenshein said in an interview with CNBC last month, arguing that because the SEC allowed an ether futures exchange-traded fund to trade starting last fall, the SEC will have no leg to stand on if it attempts to thwart an ether spot ETP.

Doubt was cast on this view Wednesday when news broke that the SEC had subpoenaed several companies for information about their dealings with the Ethereum Foundation, the Switzerland-based nonprofit that supports the protocol, with some arguing that this was an opening salvo in a campaign to classify ether as a security and ratchet up regulations on ether trading.

The SEC declined to comment.

Brian Quintenz, global head of policy at the venture-capital fund a16z crypto and a former Commodity Futures Trading Commission commissioner, pointed out in a post on X, the former Twitter, however, that the SEC allowing ether futures ETFs to begin trading last fall is an implicit admission that it doesn't see ether as a security.

Unfortunately for ether boosters, this doesn't necessarily clear the way for an approval of an ether spot ETP anytime soon.

It was the SEC's 2021 approval of a bitcoin futures ETP that opened the door to a lawsuit by Grayscale against the regulator, wherein the courts ruled that it was "arbitrary and capricious" for the agency to allow one and not the other, given that bitcoin futures prices track spot market prices closely.

The situation is different with the ether futures ETF approval, because unlike with bitcoin, the SEC has only approved that fund under the rules laid out by the Investment Company Act of 1940, which governs most investment funds marketed to retail investors, like mutual funds and exchange-traded funds.

Funds approved under the 1940 act are subject to extra scrutiny by the SEC and come with a fiduciary-duty standard and limits on leverage, fees and other harmful practices.

Benjamin Schiffrin, former associate general counsel for the SEC and director of securities policy at the financial-reform group Better Markets, told MarketWatch that it is important that investors understand the difference between exchange-traded products registered under the 1940 act and exchange-traded products that are approved for trade under a different law with more lax oversight standards. The 11 recently approved bitcoin ETPs are technically not ETFs, he said.

"There's a lot of confusion about ETPs versus ETFs," he said. "ETFs are the well-known investment product that many regular investors own that typically track an index" or some other basket of securities.

"We think that the spot bitcoin ETPs are being marketed as ETFs to give investors this small sense of comfort that it's this investment product they're used to, when it's just something different," he said.

Lawmakers are also concerned over claims made by issuers of bitcoin spot ETPs.

Democratic Sens. Jack Reed of Rhode Island and Laphonza Butler of California wrote a letter to Gensler on March 11 asking the SEC to "carefully scrutinize brokers' and advisers' communications regarding bitcoin ETPs" to ensure they are not misleading investors about the nature of these products and to urge the regulator to block any other crypto ETPs from launching.

"Retail investors would face enormous risks from ETPs referencing thinly traded cryptocurrencies or cryptocurrencies whose prices are susceptible to pump-and-dump or other fraudulent schemes," they wrote. "The commission is under no obligation to approve such products, and given the risks, it should not do so."

Indeed, the very success of bitcoin spot ETPs - netting more than $66 billion in inflows in less than three months - underscores why the SEC will give extra scrutiny to an ether spot ETP. Retail traders are much more likely to buy a spot ether ETP than a futures ETF, given their wider distribution and lower costs, Schiffrin said.

"Studies show that cryptocurrencies, including ether, are susceptible to manipulation," he told MarketWatch, adding: "Wash trading is rampant in this space, and regulators can't protect investors against fraudulent and manipulative acts and practices" as the law says they must before approving rule changes.

-Chris Matthews

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03-21-24 1323ET

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