The SEC’s crypto conundrum: Approving Ethereum ETFs in a web of regulation

Marie Pupecki Date published: Jun 12, 24

During the last week of May 2024, the SEC approved the exchanges request to list a number of spot Ethereum exchange traded funds (ETFs) for the first time. They will be joining the Bitcoin spot ETFs and the futures trading funds of Ethereum and Bitcoin that are already in the marketplace. These ETFs hold the cryptocurrency for you, thus preventing you from needing to establish a crypto wallet and provide financial information to a marketplace that is far from transparent.

Regulatory challenges and compliance

A week prior, SEC Chairman Gensler had this to say about cryptocurrency: 

“Many market participants in the crypto industry, however, have shown their unwillingness to comply with applicable laws and regulations for more than a decade, variously arguing that the laws do not apply to them or that a new set of rules should be created and retroactively applied to them to excuse their past conduct. Widespread noncompliance has resulted in widespread fraud, bankruptcies, failures and misconduct. As a result of criminal charges and convictions, some of the best-known leaders in the crypto industry are now in prison, awaiting sentencing or subject to extradition back to the United States.” ⁱ

It’s been hard to determine exactly where cryptocurrency and crypto assets fit into our existing market structure. The definition of a security has been litigated for years and will continue for the foreseeable future, particularly with complex crypto-assets. Many platforms cryptocurrencies trade on combine broker dealer, exchange and clearing house and custodial activities and are required to comply with securities laws, register and disclose conflicts of interest.  The SEC has brought enforcement actions against digital asset exchanges (Binance and Coinbase) for operating unregistered securities exchanges on the basis that certain of the digital assets traded on their platforms are securities. ⁱⁱ

Historical context and learning from SEC’s early rejections

Beginning under Chair Jay Clayton in 2018 and through March 2023, the Commission disapproved more than 20 exchange rule filings for spot bitcoin ETPs, even though the SEC had previously approved futures trading for Bitcoin.  One of the filings, in 2021, contemplated the conversion of the Grayscale Bitcoin Trust into an exchange traded product shares (ETF.) ⁱⁱⁱ  The SEC rejected the application, stating that Grayscale did not do enough to ensure that there would not be market manipulation  In January 2024, The U.S. Court of Appeals for the District of Columbia held that the SEC failed to explain its reasoning and vacated the order and remanded it back to the SEC.

The SEC approved the listing and trading of these spot Bitcoin shares. They attempted to limit this applicability, stating that this was only effective for Bitcoin. The SEC claimed that this loss did not signal anything about the commission's views as to other crypto assets under federal security laws or about the outstanding registrations for Etherium ETFs.  Then came the legislators.

U.S. Congress to the rescue

The SEC's SAB 121, issued in 2022, was an attempt to address the custodial risk of safeguarding crypto assets, and required the entity show both an asset and a liability on their books for the fair value of cryptocurrency that it's holding for platform user. This accounting adversely impacts traditional bank's ability to meet regulated capital requirements. With traditional banks locked out of the lucrative custodial market for crypto, Congress started to pay attention. 

The Senate joined the House of Representatives to invalidate SAB121 by approving joint resolution 109.   The Government Accountability Office agreed with Republican lawmakers that the SEC exceeded its authority, and what should have been a rule was issued as non-binding staff guidance. Biden has vowed to veto, stating that letting the rule be removed in this manner would disrupt work to protect investors in crypto asset markets.

Then, last week, the House passed Financial Innovation and Technology for the 21st Century Act (“FIT 21”), a bipartisan effort that seeks to create a regulatory framework for digital assets. The bill would remove blockchain investment contracts from the definition of securities and allow issuers of crypto self-certify as digital commodities not subject to the SEC. SEC Chairman Gensler stated the act would: “would create new regulatory gaps and undermine decades of precedent regarding the oversight of investment contracts, putting investors and capital markets at immeasurable risk.”  ⁱ

Ideagen Audit Analytics 2024 search of comment letters with references to Crypto, Bitcoin and Ethereum

The SEC’s comment letters on crypto-assets

The SEC has had a fair number of comment letters to issuers about crypto-assets.  Some of the concerns that frequently appear in the letters are:

• Risks related to regulatory developments
• Custody of the assets
• Revenue recognition
• Conflicts of interest
• Staking program
• Impairment of Cryptocurrency assets, particularly around measurement of fair value
• Exposure to counterparty risk
• Price declines and volatility
• Litigation claims
• Reputational harm
• Mining pool services

Interested in what else the SEC is asking registrants?  See our recently released comment letter report.