In March, the Securities and Exchange Commission (SEC) issued its eagerly awaited ruling on the Winklevoss Bitcoin ETF proposal: denied. Finance and media pundits and immediately declared that Bitcoin wasn’t ready for the mainstream, and Bitcoin's price quickly dropped. But then something strange happened: shortly after the reject, the price of Bitcoin began soaring, from around $1,100 at the time of the ETF decision to $3,430 today.
Along the way, something even stranger happened. A different regulator, the Commodities Futures Trading Commission (CFTC), approved LedgerX’s proposal to launch a regulated Bitcoin futures market.
Who are these regulators, and why are they at odds over Bitcoin’s future?
“Protect investors, maintain fair, orderly and efficient markets and facilitate capital formation.”
The SEC is entrusted with regulating securities, such as stocks, CDs and bonds. They also regulate exchange-traded funds or ETFs. These are a special type of security designed to track an underlying market. In this case, the Winklevoss ETF would have tracked the underlying value of Bitcoin by buying and selling Bitcoin every time ETF shares were bought and sold.
The CFTC was created in 1974 to regulate the booming futures market. Futures are a type of instrument called a "derivative" whose value is derived from that of an underlying asset. When the CFTC was created, most futures trading involved the agricultural industry. Farmers and ranchers have historically relied on futures contracts to protect themselves from market uncertainty.
A farmer might sell a futures contract for one bushel of corn at the price of $3.60. The farmer is now obligated to sell his corn to the holder of the contract at a price of $3.60. If the price of corn goes up between the time the contract is executed and the harvest, the buyer of the future makes money. If the price goes down, the buyer of the future loses money. Either way, the amount the farmer receives for his corn is locked in, allowing him to plan accordingly.
The mission of the CFTC is somewhat different from that of the SEC:
“To foster open, transparent, competitive and financially sound markets...the Commission aims to protect market users and their funds, consumers and the public from fraud, manipulation, and abusive practices related to derivatives and other products.”
The SEC produced a 38-page memorandum explaining its denial of the Winklevoss ETF in March. The SEC’s primary problem with the ETF was the unregulated nature of Bitcoin markets, generally. The SEC wrote:
“The Commission has [previously] emphasized the importance of surveillance-sharing agreements between the national securities exchange listing and trading [the ETF]...and significant markets relating to the underlying asset.”
In other words, because the Bitcoin spot market is generally unregulated, there is no way the SEC could be certain that the ETF was acting in an above-board manner with respect to its investors. The document continues, stating that any ETF must have rules to prevent fraud and market manipulation, in order to protect investors. Since the exchanges that trade Bitcoin are generally unregulated, the SEC did not believe that such rules could be effectively created and enforced.
Given that the SEC’s primary mission is to protect investors, it appears that they erred on the side of caution. The last thing anybody wants to see is a Madoff-esque scandal, and until the Bitcoin markets are better regulated, the SEC didn’t seem interested in approving any Bitcoin ETFs.
On July 24, the CFTC granted LedgerX approval to trade Bitcoin futures. They did this by labeling LedgerX as a “derivatives clearing organization.” The company previously had been unable to trade Bitcoin futures because it was only a “swap execution facility.” The CFTC acknowledges that LedgerX will be trading Bitcoin futures, although the press release states that the CTFC isn’t endorsing Bitcoin itself:
“This authorization to provide clearing services for fully-collateralized digital currency swaps does not constitute or imply a Commission endorsement of the use of digital currency generally, or Bitcoin specifically.”
The CFTC probably had a much easier time approving Bitcoin futures trading than the SEC would have in approving a Bitcoin ETF. The difference lies in their missions: the SEC wants to protect investors, while the CFTC simply aims to have a “fair” futures market.
In an interesting twist, the CFTC’s approval of Bitcoin futures trading could lead to the SEC’s approval of a future Bitcoin ETF. In their denial of the Winklevoss ETF, the SEC wrote:
”When the spot market is unregulated--there must be significant, regulated derivatives markets related to the underlying asset with which the Exchange can enter into a surveillance-sharing agreement.”
Once LedgerX creates its CFTC-approved futures market, the SEC may well have the cover they need to approve a Bitcoin ETF.
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