On July 26, 2018, the Securities and Exchange Commission issued a 92-page release disapproving of Bats BZX Exchange, Inc.’s (“BZX”) proposed rule change which sought to list and trade shares of the Winklevoss Bitcoin Trust. See generally Bats BZX Exch., Inc. Winklevoss Bitcoin Trust Order, Exchange Act Release No. 34-83723, 2018 WL 3596769 (July 26, 2018) [hereinafter SEC Release]. The Release explains that the Commission disapproved of the proposal because BZX failed to meet its obligations under Exchange Act Section 6(b)(5).
Section 6(b) of the Exchange Act sets forth requirements a proposed exchange must meet to be registered as a national securities exchange. See 15 U.S.C. § 78f(b). Subsection 5 of Section 6(b) requires the exchange to have rules that, among other things, are “designed to prevent fraudulent and manipulative acts and practices.” Id. § 78f(b)(5). The Commission found that BZX failed to demonstrate that its proposed rule change was designed to prevent fraudulent and manipulative acts and, therefore, its fell short of the Section 6(b)(5) requirements. See generally SEC Release. In particular, the Commission explained that BZX failed to demonstrate that bitcoin and bitcoin markets are inherently less susceptible to manipulation and that traditional methods of detecting and deterring fraud and manipulation, such as surveillance-sharing agreements, would be effective. See generally id.
BZX argued that the very nature of bitcoin and bitcoin markets make them less susceptible to manipulation and fraud. See generally id. However, the Commission noted that the record did not include data or analysis to back up BZX’s claim. The Commission was particularly concerned that there was no data or analysis in the record discussing “the actual effectiveness of arbitrage in the bitcoin spot market either in terms of how closely prices are aligned across different bitcoin trading venues or how quickly price disparities are arbitraged away.” Id. at 18.
The Commission also observed that the proposal involved the operation of a single trust that was linked to the Gemini Auction and, therefore, could be affected by manipulation of the Gemini Auction. See id. at 20. The Commission explained that the Gemini Auction was a single market with a single market-close that could potentially be manipulated. See id. The Commission further explained that there was no “comprehensive and accurate regulatory data source reflecting bitcoin pricing or trading,” no reason to find that the trust’s valuation would be an authoritative price since alternate and different spot prices would be available, and the trust and Gemini Auction prices would only differ “if the auction price . . . is determined not to reflect a fair price for bitcoin.” Id. at 21. The Commission also raised concerns about spoofing, deceptive quoting practices, hackers, pre-existing and/or future market domination by individuals or groups, and price manipulation. Thus, the Commission concluded that the proposed exchange failed to demonstrate that it was “uniquely resistant to manipulation.”
The Commission then turned to the use of traditional methods of detecting and deterring fraud and manipulation, such as surveillance-sharing agreements. The Commission noted that BZX did not currently have a have a “surveillance-sharing agreement with a regulated bitcoin market of significant size” and found that “BZX has not demonstrated . . . that the alternative surveillance procedures BZX purport to identify . . . would be sufficient to satisfy . . . Section 6(b)(5).” See id. at 41. The Commission determined that BZX’s proposed rules and surveillance methods would only allow BZX to obtain limited information about the activity and identity of market participants and, therefore, were not sufficient to meet the Section 6(b)(5) requirements. For example, the Commission explained that the public Bitcoin blockchain only identifies parties by pseudonymous public-key addresses. Id. at 44. The Commission was concerned that such limited information would not provide BZX with critical information such as whether a trader had “a dominant ownership position in bitcoin” or was “using or attempting to use a dominant ownership position to manipulate bitcoin pricing.” Id. Without such information, the Commission worried fraudulent and/or manipulative actions could be difficult, if not impossible, to detect.
The Commission also concluded that BZX’s purported surveillance-sharing agreement with the Gemini Exchange was inadequate for the purposes of Section 6(b)(5). Id. at 60. According to the Commission’s Release, “the record d[id] not establish that the Gemini Exchange is a ‘regulated market’ comparable to a national securities exchange or to the futures exchanges that are associated with the underlying assets of the commodity-trust ETPs approved to date.” Id. The Commission also expressed concern that even if it were regulated, the Gemini Exchange may not represent a “‘significant’ bitcoin-related market.” Id. at 60. Additionally, the Commission noted that the majority of the bitcoin exchanges took place outside of the United States and, therefore, may not be subject to sufficient regulation.
The Commission recognized that, even when spot markets are not sufficiently regulated, “a surveillance-sharing agreement with a regulated market of significant size in derivatives related to the underlying asset” could be sufficient for Section 6(b)(5) purposes. Id. at 76. The Commission explained that if a significant market for derivatives of the underlying asset existed “there is a reasonable likelihood that a person attempting to manipulate the ETP by manipulating the underlying spot market would also have to trade in the derivatives market in order to succeed.” Id. However, the Commission did not find that such an agreement existed in BZX’s proposed rule change.
For these reasons, the Commission determined that the BZX proposal failed to demonstrate that its rules were designed to prevent fraudulent and manipulative acts as required by Section 6(b)(5) and, therefore, must be disapproved.
It should be noted that the Commission’s decision was not unanimous. Commissioner Hester M. Pierce registered a dissent, which can be found here.
 BZX initially proposed the rule change on June 30, 2016, and the Commission initially disapproved of the proposal in March 2017. Following BZX’s petition for review, the Commission issued a new Release disapproving of the proposed rule change on July 26, 2018.