March 10, 2017.
Bats BZX Exchange (“Exchange” or “BZX”) has filed a proposed rule change to list and trade shares of the Winklevoss Bitcoin Trust.
When an Start Printed Page 14077exchange makes such a filing,
the Commission must determine whether the proposed rule change is consistent with the statutory provisions, and the rules and regulations, that apply to national securities exchanges.
The Commission must approve the filing if it finds that the proposed rule change is consistent with these legal requirements, and it must disapprove the filing if it does not make such a finding.
As discussed further below, the Commission is disapproving this proposed rule change because it does not find the proposal to be consistent with Section 6(b)(5) of the Exchange Act, which requires, among other things, that the rules of a national securities exchange be designed to prevent fraudulent and manipulative acts and practices and to protect investors and the public interest.
The Commission believes that, in order to meet this standard, an exchange that lists and trades shares of commodity-trust exchange-traded products (“ETPs”) must, in addition to other applicable requirements, satisfy two requirements that are dispositive in this matter. 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.
I. Description of the Proposal
The Exchange proposes to list and trade shares (“Shares”) of the Winklevoss Bitcoin Trust (“Trust”) as Commodity-Based Trust Shares under BZX Rule 14.11(e)(4).
Details regarding the proposal and the Trust can be found in Amendments No. 1 and 2 to the proposal,
and in the registration statement for the Trust,
but the salient aspects of the proposal are described below.
The Trust would hold only bitcoins as an asset,
and the bitcoins would be in the custody of, and secured by, the Trust's custodian, Gemini Trust Company LLC (“Custodian”), which is a limited-liability trust company chartered by the State of New York and supervised by the New York State Department of Financial Services (“NYSDFS”).
Gemini Trust Company is also an affiliate of Digital Asset Services LLC, the sponsor of the Trust (“Sponsor”).
The Trust would issue and redeem the Shares only in “Baskets” of 100,000 Shares and only to Authorized Participants, and these transactions would be conducted “in-kind” for bitcoin only.
The investment objective of the Trust would be for the Shares to track the price of bitcoins on the Gemini Exchange, which is a digital-asset exchange owned and operated by the Gemini Trust Company.
The Net Asset Value (“NAV”) of the Trust would be calculated each business day, based on the clearing price of that day's 4:00 p.m. ET Gemini Exchange Auction, a two-sided auction open to all Gemini Exchange customers.
The Intraday Indicative Value of the Trust would be calculated and disseminated by the Sponsor, every 15 seconds during the Exchange's regular trading session, based on the most-recent Gemini Exchange Auction price.
The Exchange represents that it has entered into a comprehensive surveillance-sharing agreement with the Gemini Exchange.
II. Summary of Comment Letters
The comment period closed on November 25, 2016. As of March 8, 2017, the Commission had received 59 comment letters on the proposed rule change.
Many of these letters address Start Printed Page 14078the nature and uses of bitcoin; 
the state of development of bitcoin as a digital asset; 
the inherent value of, and risks of investing in, bitcoin; 
the desire of investors to gain access to bitcoin through an ETP; 
the appropriate measures for the Trust to secure its bitcoin holdings against theft or loss; 
whether the Trust should insure its bitcoin holdings against theft or loss; 
the blockchain treatment of positions in the Shares, including short positions or derivative positions; 
the potential conflicts of interest related to the affiliations among the Sponsor, the Custodian, and the Gemini Exchange; 
the proposed valuation method for the Trust's holdings; 
or the legitimacy or enhanced regulatory protection that Commission approval of the proposed ETP might confer upon bitcoin as a digital asset.
Ultimately, however, comments on these topics do not bear on the basis for the Commission's decision to disapprove the proposal. Accordingly, the Commission will summarize and address the comments that relate to the susceptibility of bitcoin or the Shares to fraudulent or manipulative acts and practices, including the need for surveillance-sharing agreements with significant, regulated markets for trading in bitcoin or derivatives on bitcoin.
A. Comments Regarding The Worldwide Market for Bitcoin
Several commenters note that the majority of bitcoin trading occurs on exchanges outside the United States. One commenter claims that most daily trading volume is conducted on poorly capitalized, unregulated exchanges located outside the United States and that these non-U.S. exchanges and their practices significantly influence the price discovery process.
Another commenter states that the biggest and most-influential bitcoin exchange is located outside U.S. jurisdiction.
One commenter states that, since 2013, the price of bitcoin has been defined mostly by the major Chinese exchanges, whose volumes dwarf those of exchanges outside China. According to the commenter, those exchanges are not regulated or audited, and are suspected of engaging in unethical practices like front-running, wash trades, and trading with insufficient funds. The commenter interprets pricing data from these Chinese exchanges to mean that the price of bitcoin is defined entirely by speculation, without any ties to fundamentals.
Another commenter also observes that Chinese markets drive much of the volume in the bitcoin markets and that the bitcoin/Chinese Yuan (BTC/CNY) quote is apt to trade at a significant premium to the bitcoin/U.S. dollar (BTC/USD) quote. The commenter points out that large arbitrage opportunities would not exist for long in efficient markets, but they do persist in bitcoin markets.
One commenter claims that a sizeable number of traders and owners of bitcoin do not desire to trade in a well-regulated environment for reasons including tax evasion, evading capital controls, and money laundering. This commenter also states that U.S. exchanges do not offer products such as fee-free trading, margin trading, or options, which drive traffic to the top non-U.S. exchanges. The commenter claims that, because trade is now sparse on regulated U.S. exchanges including Gemini, arbitrage will not occur efficiently or proportionally to mitigate manipulation from the dominant unregulated bitcoin exchanges. This commenter also claims that several Chinese exchanges actively engage in bitcoin mining operations, creating a conflict of interest, and notes that these exchanges are unaudited and unaccountable.
Another commenter Start Printed Page 14079also claims that the Chinese exchanges that account for the bulk of trading are subject to little regulatory oversight and that existing know-your-customer or identity-verification measures are lax and can be easily bypassed.
One commenter states that the market for bitcoin, by trade volume, is very shallow. This commenter notes that the majority of bitcoin is hoarded by a few owners or is out of circulation. The commenter also notes that ownership concentration is high, with 50 percent of bitcoin in the hands of fewer than 1,000 people, and that this high ownership concentration creates greater market liquidity risk, as large blocks of bitcoin are difficult to sell in a timely and market efficient manner. This commenter claims that daily trade volume is only a small fraction of total bitcoin mined.
This commenter also states that several fundamental flaws make bitcoin a dangerous asset class to force into an exchange traded structure, including shallow trade volume, extreme hoarding, low liquidity, hyper price volatility, a global web of unregulated bucket-shop exchanges, high bankruptcy risk, and oversized exposure to trading in countries where there is no regulatory oversight.
This commenter believes that lack of regulation and consumer protection also increase the chance and incentives for market price manipulation and states that approving the ETP before structural protections and controls are firmly in place would put investors at undue risk.
The Exchange, in its comment letter, asserts that bitcoin is resistant to manipulation, arguing that the increasing strength and resilience of the global bitcoin marketplace serve to reduce the likelihood of price manipulation and that arbitrage opportunities across globally diverse marketplaces allow market participants to ensure approximately equivalent pricing worldwide.
The Exchange further asserts, in its comment letter, that the Commodity Futures Trading Commission (“CFTC”) has designated bitcoin as a commodity and is “broadly responsible for the integrity” of U.S. bitcoin spot markets.
The Exchange acknowledges that the CFTC has not yet brought any enforcement actions based on the anti-manipulation provisions of the Commodity Exchange Act, but notes that the CFTC has issued orders against U.S. and non-U.S. bitcoin exchanges for engaging in other activity prohibited by the Commodity Exchange Act. The Exchange's comment letter states that a regulatory framework for providing oversight and deterring market manipulation therefore currently exists in the U.S.
Finally, the Commission notes a paper that was submitted with respect to a similar proposed rule change,
arguing that bitcoin is relatively uncorrelated with other assets, enabling investors to construct more efficient portfolios,
and that, as a general matter, the underlying market for bitcoin is inherently resistant to manipulation.
The author of the paper posits that the underlying bitcoin market is not susceptible to manipulation because (a) there is no inside information related to earnings, revenue, corporate actions, or new sources of supply; (b) the asset is not subject to the dissemination of false or misleading information; (c) each bitcoin market is an independent entity, so that a demand for liquidity does not necessarily propagate across other exchanges; (d) a substantial over-the-counter (“OTC”) market provides additional liquidity and absorption of shocks; (e) there is no market-close pricing event to manipulate; (f) the market is not subject to “spoofing” or other high-frequency-trading tactics; (g) order books on exchanges worldwide are publicly visible and available through APIs (application program interfaces); and (h) it is unlikely that any one person could obtain a dominant market share.
The author also asserts that listing the shares on a national securities exchange and a shift from OTC trading to trading on exchanges would make the overall bitcoin market more transparent.
B. Comments Regarding the Gemini Exchange
Several commenters discuss the Gemini Exchange's low trading volumes 
and one commenter claims that of all the exchanges Gemini has the worst pricing.
Another commenter asserts that there is a significant risk that the nominal ETP share price will be manipulated by relatively small trades that manipulate the bitcoin price at that exchange.
This commenter notes that, while U.S.-based bitcoin exchanges are subjected to stricter regulations and auditing for the holding of client accounts, the trading itself seems to occur in a regulatory vacuum and seems impossible to audit effectively.
This commenter expresses concerns regarding the Gemini Exchange Spot Price,
noting that the nominal price of the Shares under the proposal is supposed to be tied to the market price of bitcoins at the Gemini Exchange, which is closely tied to the ETP proponents.
One commenter claims that among U.S.-dollar bitcoin exchanges, Gemini has a 3% share and its liquidity measured by order book depth is significantly lower than several other exchanges. The commenter notes that it is possible that after the launch of an ETP, Gemini's liquidity and volume will increase, but claims that the nature of bitcoin trading that leads to the concentration of volume and liquidity outside of U.S. borders makes any significant future increase unlikely.
This commenter also observes that while Gemini is a regulated U.S. exchange, it does not operate in a vacuum. The commenter claims that the global landscape of many unregulated bitcoin exchanges exerts huge influence on the Gemini Exchange and consequently on the Winklevoss ETP.
One commenter states that exchanges other than Gemini are not subject to the same level of oversight and that, if the ETP were based on some broad measure of weighted prices across different exchanges, then completely unregulated Start Printed Page 14080actors might be able to exercise undue influence on the ETP valuation price.
One commenter states that the Gemini Exchange Auction could be an improvement over other bitcoin pricing mechanisms, but asserts that the auction has not improved volume. The commenter claims that the Gemini Exchange has the lowest liquidity of the three exchanges in the United States and is one of the least-liquid of all exchanges that trade bitcoin for U.S. dollars.
The commenter observes that the auction data show that traders in the auction are taking advantage of the discounted auction price. The commenter notes that the daily two-sided auction process was designed to maximize price discovery and reduce price volatility that could be the result of momentum pricing, but asks what measures have been put in place to address traders who take advantage of the discounted auction price. The commenter also notes that while other financial products sometimes have auctions to determine price, an auction on a stock exchange does not require money to be deposited in advance with the exchange to be in the auction. The commenter notes that, by contrast, the Gemini Exchange requires dollars or bitcoin to be deposited before participation. The commenter believes that this is a problem because the Gemini auction is limited and “warped” and has failed on at least two occasions.
One commenter claims that there are more robust ways to value the Trust's holdings than using the spot price of a single exchange, such as the Gemini Exchange. The commenter notes that bitcoin trades on a number of exchanges around the world and that most of these exchanges can be considered isolated liquidity pools, which are more vulnerable to manipulation or security breach than the broader market.
The commenter also notes that the Gemini Exchange typically processes less than 10% of the total volume in the bitcoin/U.S. dollar pair and states that an index of the most reliable exchanges should be constructed to value the Trust's holdings. The commenter questions whether using only the Gemini Exchange's spot price could serve to incentivize Authorized Participants and other market participants to direct traffic and flow to Gemini, at the expense of best execution.
Another commenter takes a different view on the merits of single versus multiple price sources. This commenter notes that bitcoin spot prices diverge across exchanges due to various factors and that some exchanges may suffer from lack of oversight and a lack of transparency or fairness. The commenter claims that these facts strengthen the case for an investment product that does not rely on the spot price of less-credible exchanges to value its holdings and instead relies on the spot price on the Gemini Exchange, which is subject to substantive regulation of its exchange activity and custody of assets by the NYSDFS. This commenter also notes that, while leveraged trading on some other exchanges has historically sparked excessive price volatility and instability, Gemini does not offer such products and would be able to serve as a trusted, regulated spot exchange for institutional market participants driving the arbitrage mechanism that ensures efficient pricing between the spot price and the Shares. The commenter claims that the Gemini Exchange has the potential for more-robust price discovery as liquidity is concentrated on that exchange.
One commenter states that there is an inherent trade-off to using one exchange versus an average of several exchanges, some of which may be less scrupulous. The commenter acknowledges that manipulation is a legitimate concern, but notes that it is not uncommon to see a very small number of physical trades determine the base price for a much larger paper market.
Other commenters view the risk of manipulation as more significant. One commenter notes that it would be surprising if illegal and manipulative practices did not occur, since they would be easy to implement, impossible to detect, perfectly legal, and extremely lucrative.
This commenter also states that the Gemini Exchange Auction closing volumes have been low and have shown a slight decreasing trend since the inception of the auction. The commenter notes that, with low volumes, it seems possible to manipulate the NAV by entering suitable bids or asks in the Gemini Exchange Auction.
Another commenter agrees that bitcoin traders can manipulate trading on Gemini Exchange because of its low trading volumes and notes that the Trust's documentation states that momentum pricing of bitcoin has resulted, and may continue to result, in speculation regarding future appreciation in the value of bitcoin, making the price of bitcoin more volatile.
The commenter states that the value of bitcoin may therefore be more likely to fluctuate due to changing investor confidence in future appreciation in the Gemini Exchange Auction price, which could adversely affect an investment in the Shares.
According to another commenter, in this unregulated environment, price manipulation and front-running of large buy or sell orders can happen and well-connected customers can gain preferential treatment in order execution.
The Exchange, in its comment letter, notes that the Gemini Exchange Auction typically already transacts a volume greater than the proposed creation basket size for the Trust, and would likely support the needs of Authorized Participants to engage in basket creation or redemption. The Exchange claims that the global bitcoin marketplace has the potential to provide even more liquidity and to be a source of bitcoin for basket creation and hedging. The Exchange also notes that all intraday order-book and trade information on the Gemini Exchange is publicly available through various electronic formats and is also redistributed by various online aggregators, and that, with the launch of the proposed Trust, the Sponsor must make important pricing data available in real time.
The Exchange acknowledges in its comment letter that less-liquid markets, such as the market for bitcoin, may be more easily manipulated, but claims that these concerns are mitigated with respect to the Shares and the trading on the Gemini Exchange. The Exchange notes that the Gemini Exchange Auction price is based on an extremely similar mechanism to the one leveraged for the Exchange's own Opening and Closing Auctions and allows full and transparent participation from all Gemini Exchange participants in the price discovery process. The Exchange states that the auction process leverages mechanics which have proven over the years to be robust and effective on the Exchange and other national listing exchanges in both liquid and illiquid securities alike. The Exchange notes that, because the time of the Gemini Exchange Auction coincides with the Exchange's Closing Auction, efficient real-time arbitrage between the closing price of the Trust and the Gemini Start Printed Page 14081Exchange Auction price will be prevalent and will lead to resilient and effective pricing of both the Trust and the underlying bitcoin asset, leading to convergence between the Trust's closing price and its NAV.
The Exchange states that the Gemini Exchange Auction price typically deviates very little from the prevailing price on other bitcoin exchanges, and the Exchange presents statistics to show that this price is consistent with other pricing sources.
C. Comments on the Derivatives Markets for Bitcoin
One commenter claims that the bitcoin markets are not yet efficient and attributes this inefficiency, in part, to the nascent state of the bitcoin derivatives market. This commenter notes that derivatives provide investors more ways to hedge against bitcoin's potential price movements, introduce more volume and liquidity, and generally give the markets more points of information about bitcoin's future prospects, leading to tighter bid/ask spreads. The commenter claims that most derivatives activity within the bitcoin markets is offered by entities outside of the purview of U.S. regulators.
This commenter notes that, within the United States, one market offers bitcoin forwards, but no one currently offers regulated bitcoin futures. The commenter states that bitcoin options offered by regulated U.S. entities may come next, but that as of now there are none. The commenter observes that the lack of a robust and regulated derivatives market means that market participants do not have a broad basket of tools at their disposal, making hedging difficult and keeping away many market makers that provide significant liquidity to traditional capital markets. The commenter claims that, while derivative products may be in development, a full suite of investor tools that will drive market efficiency and eliminate price disparities is likely at least a couple of years away.
The commenter also notes that without a robust derivatives market for institutional investors to short the underlying asset, or otherwise hedge their positions, there likely would be little counterbalance to the new demand generated by the ETP, and that Authorized Participants could then have trouble sourcing bitcoin and hedging their positions, stalling the creation process.
The commenter concludes that it would be premature to launch a bitcoin ETP because bitcoin markets are not liquid enough to support an open-end fund, and because an ecosystem of institutional-grade infrastructure players is not yet available to support such a product.
One commenter disagrees with assertions linking inefficient bitcoin markets to nascent derivatives markets, stating that no evidence has been provided regarding the would-be effect of derivatives on the bitcoin market. The commenter claims that the assertion assumes that bitcoin pricing is inefficient, which the commenter claims is not the case. The commenter also claims that the assertion assumes that the lack of a derivatives market causes pricing to be inefficient, instead stating that there is direct evidence that many securities trade successfully and efficiently on U.S. and non-U.S. exchanges despite not having a direct derivatives market.
The commenter also disagrees with the claim that, absent a robust derivatives market, there would be little counterbalance to the new demand generated by the ETP, stating that it is impossible to predict the success or failure of the ETP. The commenter notes that Authorized Participants may be able to source bitcoin from China.
Another commenter claims that there are several bitcoin futures markets that have a significant impact on the spot price along with several OTC markets, such as the one recently launched by the Gemini Exchange, that also offer liquidity.
The author of the paper submitted with respect to a similar proposal states that one of the key differences between bitcoin and other commodities is the lack of a liquid and transparent derivatives market and that, although there have been nascent attempts to establish derivatives trading in bitcoin, bitcoin derivatives markets are not at this time sufficiently liquid to be useful to Authorized Participants and market makers who would like to use derivatives to hedge exposures.
The author claims that, for physical commodities that are not traded on exchanges, the presence of a liquid derivatives market is a necessary condition, but claims that for digital assets like bitcoin, derivatives markets are not necessary because price discovery occurs on the OTC market and exchanges instead.
III. Discussion and Commission Findings
Under Section 19(b)(2)(C) of the Exchange Act, the Commission must approve the proposed rule change of a self-regulatory organization (“SRO”) if the Commission finds that the proposed rule change is consistent with the requirements of the Exchange Act and the applicable rules and regulations thereunder.
If it is unable to make such a finding, the Commission must disapprove the proposed rule change.
Additionally, under Rule 700(b)(3) of the Commission's Rules of Practice, the “burden to demonstrate that a proposed rule change is consistent with the Exchange Act and the rules and regulations issued thereunder . . . is on the self-regulatory organization that proposed the rule change.” 
After careful consideration, and for the reasons discussed in greater detail below, the Commission does not believe that the proposed rule change, as modified by Amendments No. 1 and 2, is consistent with the requirements of the Exchange Act and the applicable rules and regulations thereunder.
Start Printed Page 14082Specifically, the Commission does not find that the proposed rule change is consistent with Section 6(b)(5) of the Exchange Act—which requires that the rules of a national securities exchange be designed, among other things, to prevent fraudulent and manipulative acts and practices and to protect investors and the public interest 
—because the Commission believes that the significant markets for bitcoin are unregulated and that, therefore, the Exchange has not entered into, and would currently be unable to enter into, the type of surveillance-sharing agreement that helps address concerns about the potential for fraudulent or manipulative acts and practices in the market for the Shares. Accordingly, the Commission disapproves the proposed rule change.
1. Commodity-Trust ETPs and Surveillance-Sharing Agreements
The Exchange proposes to list and trade the Shares under BZX Rule 14.11(e)(4), which governs the listing of Commodity-Based Trust Shares.
In this regard, the proposal is similar to many past proposals to list and trade shares of ETPs holding precious metals,
assets that individuals could otherwise obtain directly (for example, in the form of bullion coins), but at the cost of having to secure those holdings.
The Commission analyzes this proposal under the standards it has applied to previous commodity-trust ETPs.
A key consideration for the Commission in determining whether to approve or disapprove a proposal to list and trade shares of a new commodity-trust ETP is the susceptibility of the shares or the underlying asset to manipulation. This consideration flows directly from the requirement in Section 6(b)(5) of the Exchange Act that a national securities exchange's rules must be designed “to prevent fraudulent and manipulative acts and practices” and “to protect investors and the public interest.” 
Since at least 1990, the Commission has expressed the view that the ability of a national securities exchange to enter into surveillance-sharing agreements “furthers the protection of investors and the public interest because it will enable the [e]xchange to conduct prompt investigations into possible trading violations and other regulatory improprieties.” 
The Commission has also long held that surveillance-sharing agreements are important in the context of exchange listing of derivative security products, such as equity options. In 1994, the Commission stated:
As a general matter, the Commission believes that the existence of a surveillance sharing agreement that effectively permits the sharing of information between an exchange proposing to list an equity option and the exchange trading the stock underlying the equity option is necessary to detect and deter market manipulation and other trading abuses. In particular, the Commission notes that surveillance sharing agreements provide an important deterrent to manipulation because they facilitate the availability of information needed to fully investigate a potential manipulation if it were to occur. These agreements are especially important in the context of derivative products based on foreign securities because they facilitate the collection of necessary regulatory, surveillance and other information from foreign jurisdictions.
With respect to ETPs, when approving in 1995 the listing and trading of one of the first commodity-linked ETPs—a commodity-linked exchange-traded note—on a national securities exchange, the Commission continued to emphasize the importance of surveillance-sharing agreements, noting that the listing exchange had entered into surveillance-sharing agreements with each of the futures markets on which pricing of the ETP would be based and stating that “[t]hese agreements should help to ensure the availability of information necessary to detect and deter potential manipulations and other trading abuses, thereby making [the commodity-linked notes] less readily susceptible to manipulation.
Start Printed Page 14083
In 1998, in adopting Exchange Act Rule 19b-4(e) 
to permit the generic listing and trading of certain new derivatives securities products—including ETPs—the Commission again emphasized the importance of the listing exchange's ability to obtain from underlying markets, through surveillance-sharing agreements (called information-sharing agreements in the release), the information necessary to detect and deter manipulative activity. Specifically, in adopting rules governing the generic listing of new derivatives securities products, the Commission stated that the Rule 19b-4(e) procedures would “enable the Commission to continue to effectively protect investors and promote the public interest” and stated that:
It is essential that the SRO have the ability to obtain the information necessary to detect and deter market manipulation, illegal trading and other abuses involving the new derivative securities product. Specifically, there should be a comprehensive ISA [information-sharing agreement] that covers trading in the new derivative securities product and its underlying securities in place between the SRO listing or trading a derivative product and the markets trading the securities underlying the new derivative securities product. Such agreements provide a necessary deterrent to manipulation because they facilitate the availability of information needed to fully investigate a manipulation if it were to occur.
The Commission, in the NDSP Adopting Release, also stressed the importance of these surveillance-sharing agreements comprehensively covering trading in the underlying assets. In the case of a product overlying domestic securities, the Commission said that the exchange listing a derivative securities product should ensure that it was either a common member of the Intermarket Surveillance Group with, or had entered into an information-sharing agreement with, each market trading each underlying security.
Further, the Commission stated that:
For a new derivative securities product overlying an instrument with component securities from several countries, the Commission recognizes that it may not be practical in all instances to secure comprehensive ISAs with all of the relevant foreign markets. Foreign countries' securities or ADRs that are not subject to a comprehensive ISA should not represent a significant percentage of the weight of such an underlying instrument.” 
Consistent with these statements, for the commodity-trust ETPs approved to date for listing and trading, there have been in every case well-established, significant, regulated markets for trading futures on the underlying commodity—gold, silver, platinum, palladium, and copper—and the ETP listing exchange has entered into surveillance-sharing agreements with, or held Intermarket Surveillance Group membership in common with, those markets.
The Exchange represents that its existing surveillance measures, which focus on trading in the Shares, are sufficient to support the proposed rule Start Printed Page 14084change. Specifically, the Exchange represents that its surveillance procedures are adequate to properly monitor the trading of the Shares on the Exchange during all trading sessions and to deter and detect violations of Exchange rules and the applicable federal securities laws.
The Exchange further represents that trading of the Shares through the Exchange will be subject to the Exchange's surveillance procedures for derivative products, including Commodity-Based Trust Shares, and that the Exchange may obtain information regarding trading in the Shares through the Intermarket Surveillance Group, from other members or affiliates of that group, or from exchanges with which the Exchange has a surveillance-sharing agreement.
In addition, the Exchange notes that it has entered into a comprehensive surveillance-sharing agreement with the Gemini Exchange and represents that it may obtain information about bitcoin transactions, trades, and market data from the Gemini Exchange (and from any bitcoin exchanges with which the Exchange enters into a surveillance-sharing agreement in the future), as well as certain additional information that is publicly available through the Blockchain. Moreover, several commenters assert that regulation by the Exchange of activity in the ETP could substitute for a lack of regulation in underlying or derivatives markets.
The Commission views the Exchange's proposed surveillance procedures regarding the Shares themselves as necessary, but not sufficient in light of the discussion below noting that the Exchange has not entered into, and would currently be unable to enter into, surveillance-sharing agreements with significant, regulated markets for trading either bitcoin itself or derivatives on bitcoin.
Moreover, the Commission does not accept the premise, suggested by some commenters, that regulation of trading in the Shares is a sufficient and acceptable substitute for regulation in the spot or derivatives markets related to the underlying asset.
Absent the ability to detect and deter manipulation of the Shares—through surveillance sharing with significant, regulated markets related to the underlying asset—the Commission does not believe that a national securities exchange can meet its Exchange Act obligations when listing shares of a commodity-trust ETP.
The Commission continues to believe that surveillance-sharing agreements between the exchange listing shares of a commodity-trust ETP and significant, regulated markets related to the underlying asset provide a “necessary deterrent to manipulation.” 
To the extent there is some question as to the degree to which bitcoin is subject to manipulation, moreover, surveillance-sharing agreements with significant, regulated markets relating to bitcoin would help answer that question and address instances of such manipulation. Therefore, the Commission's analysis of the Exchange's proposal examines whether regulated markets of significant size exist—in either bitcoin or derivatives on bitcoin—with which the Exchange has, or could enter into, a surveillance-sharing agreement.
2. The Worldwide Spot Market for Bitcoin
With respect to spot bitcoin trading outside the United States, the information in the Exchange's proposal and from commenters demonstrates that the bulk of bitcoin trading occurs in non-U.S. markets where there is little to no regulation governing trading,
and thus no meaningful governmental market oversight designed to detect and deter fraudulent and manipulative activity.
The Exchange notes in its comment letter that only a minority of the global spot bitcoin exchanges are subject to any regulatory regime.
Additionally, the Commission notes that no bitcoin spot market is currently a member of the Intermarket Surveillance Group.
With respect to trading in the United States, the Exchange asserts that the CFTC is broadly responsible for the integrity of bitcoin spot markets and that, therefore, a regulatory framework for providing oversight and deterring market manipulation currently exists in the United States.
The Exchange's conclusion about the state of regulation in the U.S. market for bitcoin, however, is not supported by the facts the Exchange presents.
Although the CFTC can bring enforcement actions against manipulative conduct in spot markets for a commodity, spot markets are not required to register with the CFTC, unless they offer leveraged, margined, or financed trading to retail customers.
In all other cases, including the Gemini Exchange, the CFTC does not set standards for, approve the rules of, examine, or otherwise regulate bitcoin spot markets.
The Exchange notes in its comment letter that the CFTC has brought several bitcoin-related enforcement actions against bitcoin-related entities,
but the actions cited by the Exchange do not demonstrate Start Printed Page 14085that a regulatory framework for providing oversight and deterring market manipulation currently exists for the bitcoin spot market. Rather, the cited enforcement actions have involved either (a) the failure of an entity to register with the CFTC before trading derivatives on bitcoin or offering leveraged, margined, or financed bitcoin trading to retail customers,
or (b) the facilitation of wash trades in bitcoin swaps by a swap execution facility registered with the CFTC.
Some commenters believe that bitcoin markets can be manipulated.
The Exchange agrees, in its comment letter, that “less liquid markets, such as the market for bitcoin, may be more manipulable,” but asserts that the strength and resilience of the global bitcoin market serve to reduce the likelihood of manipulation.
Additionally, the author of the paper submitted with respect to a similar proposal for a bitcoin-based ETP asserts that, for several reasons, the underlying market for bitcoin is not susceptible to manipulation.
The Commission does not believe that the record supports a finding that the unique properties of bitcoin and the underlying bitcoin market are so different from the properties of other commodities and commodity futures markets that they justify a significant departure from the standards applied to previous commodity-trust ETPs. While the Exchange and the author of the paper submit that arbitrage across bitcoin markets will help to keep worldwide bitcoin prices aligned with one another, hindering manipulation,
neither provides data regarding how long pricing disparities may persist before they are arbitraged away, and one commenter specifically noted that large arbitrage opportunities persist in bitcoin markets.
The Commission also believes that the paper's discussion of the possible sources of manipulation is incomplete and does not form a basis to find that bitcoin cannot be manipulated—or to find, by implication, that no surveillance-sharing agreement is necessary between an exchange listing shares of a bitcoin-based ETP and significant markets trading bitcoin or bitcoin derivatives. For example, while there is no inside information related to the earnings or revenue of bitcoin, there may be material non-public information related to the actions of regulators with respect to bitcoin; regarding order flow, such as plans of market participants to significantly increase or decrease their holdings in bitcoin; regarding new sources of demand, such as new ETPs that would hold bitcoin; or regarding the decision of a bitcoin-based ETP with respect to how it would respond to a “fork” in the blockchain, which would create two different, non-interchangeable types of bitcoin.
Moreover, the manipulation of asset prices, as a general matter, can occur simply through trading activity that creates a false impression of supply or demand, whether in the context of a closing auction or in the course of continuous trading, and does not require formal linkages among markets (such as consolidated quotations or routing requirements) or the complex quoting behavior associated with high-frequency trading.
Finally, while it may or may not be possible to acquire a dominant position in the bitcoin market as a whole, it might be quite possible to acquire a position large enough to temporarily move the price on a single, less-liquid bitcoin trading market, even if OTC markets exist that are capable of absorbing liquidity shocks.
3. The Gemini Exchange
The Exchange represents that it has entered into a comprehensive surveillance-sharing agreement with the Gemini Exchange with respect to trading of the bitcoin asset underlying the Trust and that the Gemini Exchange is supervised by the NYSDFS.
Additionally, the Exchange states in its comment letter that it “agrees that less liquid markets, such as the market for bitcoin, may be more manipulable, but believes that . . . such concerns are mitigated as it relates to the Shares of the Trust and trading activity on the Gemini Exchange.” 
As explained below, however, the Commission does not believe this surveillance-sharing agreement to be sufficient, because the Gemini Exchange conducts only a small fraction of the worldwide trading in bitcoin, and because the Gemini Exchange is not 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.
Commenters disagree on whether the Gemini Exchange conducts a significant volume of trading in bitcoin and whether trading on the Gemini Exchange is susceptible to manipulation. The Exchange promotes the Gemini Exchange as one of the top three bitcoin exchanges in the United States,
and some commenters believe that the Gemini Exchange conducts sufficient volume to support the Winklevoss Bitcoin Trust.
Other commenters, however, question these assertions, some noting that the vast majority of bitcoin trading, including trading denominated in U.S. dollars Start Printed Page 14086(“USD”) occurs on unregulated exchanges outside the United States.
The information currently available demonstrates that the Gemini Exchange does not, at this time, trade a significant volume of bitcoin relative to the overall market for the asset.
Instead, bitcoin trading on the Gemini Exchange represents a small percentage of overall bitcoin trading. For example, calculations using statistics from data.bitcoinity.org,
show that, in the six months preceding February 28, 2017, trading on the Gemini Exchange accounted for just 0.07% of all worldwide bitcoin trading, and 5.16% of the much-smaller bitcoin-USD market worldwide.
Moreover, self-reported statistics from the Gemini Exchange show that volume in the Gemini Exchange Auction is small relative to daily trading in bitcoin and to the number of bitcoin in a creation or redemption basket for the Trust. As of February 28, 2017, the average daily volume in the Gemini Exchange Auction, since its inception on September 21, 2016, has been 1195.72 bitcoins, compared to average daily worldwide volume of approximately 3.4 million bitcoins in the six months preceding February 28, 2017. Also, as of February 28, 2017, the median number of bitcoins traded in the Gemini Exchange Auction on a business day (when a creation or redemption request might be submitted to the Trust) has been just 1,061.99 bitcoins,
barely larger than the 1,000 bitcoins in a creation or redemption basket.
Additionally, 88.2% of the business-day auctions were for fewer than 2,000 bitcoins—equivalent to two creation or redemption baskets—suggesting that creation or redemption activity on the Gemini Exchange might dwarf other trading.
Regarding the regulation of the Gemini Exchange, the Exchange notes in its proposed rule change that the Gemini Trust Company is supervised by the NYSDFS, asserting that the Gemini Trust Company is one of only two bitcoin exchange operators in the world subject to substantive regulation. The Commission, however, does not believe that the record supports a finding 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.
The Exchange represents that the Gemini Trust Company is subject to capitalization, anti-money-laundering compliance, consumer protection, and cybersecurity requirements set forth by the NYSDFS.
Commission regulation of the securities markets includes similar elements, but national securities exchanges are also, among other things, required to have rules that are “designed to prevent fraudulent and manipulative acts and practices, to promote just and equitable principles of trade, to foster cooperation and coordination with persons engaged in regulating, clearing, settling, processing information with respect to, and facilitating transactions in securities, to remove impediments to and perfect the mechanism of a free and open market and a national market system, and, in general, to protect investors and the public interest.” 
Moreover, national securities exchanges are subject to Commission oversight of, among other things, their governance, membership qualifications, trading rules, disciplinary procedures, recordkeeping, and fees.
Designated Contract Markets (commonly called “futures markets”) registered with and regulated by the CFTC must comply with, among other things, a similarly comprehensive range of regulatory principles and must file rule changes with the CFTC.
4. The Market for Derivatives on Bitcoin
As noted above,
the commodity-trust ETPs previously approved by the Commission for listing and trading have had—in lieu of significant, regulated spot markets—significant, well-established, and regulated futures markets that were associated with the underlying commodity and with which the listing exchange had entered into a surveillance-sharing agreement.
One commenter states that there are several bitcoin futures markets that have a significant impact on the spot price, but this commenter did not identify any regulated futures market.
Another commenter describes the state of derivatives markets for bitcoin as “nascent.” 
Start Printed Page 14087
The Exchange also describes the current derivative markets for bitcoin as “[n]ascent.” 
The Exchange notes that certain types of options, futures contracts for differences, and other derivative instruments are available in certain jurisdictions, but that many of these are not available in the United States and that they generally are not regulated “to the degree that U.S. investors expect derivatives instruments to be regulated.” 
The Exchange notes that the CFTC has approved the registration of TeraExchange LLC as a swap execution facility (“SEF”) and that, on October 9, 2014, TeraExchange announced that it had hosted the first executed bitcoin swap traded on a CFTC-regulated platform.
Further, the Exchange notes that the CFTC has temporarily registered another SEF that would trade swaps on bitcoin.
The Commission acknowledges that TeraExchange, a market for swaps on bitcoin, has registered with the CFTC, but the Exchange's description of trading activity on that market fails to note that the very activity it cites was the subject of an enforcement action by the CFTC. The CFTC found that TeraExchange had improperly arranged for participants to make prearranged, offsetting “wash” transactions of the same price, notional amount, and tenor and then issued a press release “to create the impression of actual trading in the Bitcoin swap.” 
Neither the Exchange nor any commenter provides evidence of meaningful trading volume in bitcoin derivatives on any regulated marketplace. Thus, the Commission believes that the bitcoin derivatives markets are not significant, regulated markets related to bitcoin with which the Exchange can enter into a surveillance-sharing agreement.
One commenter, and the author of the paper submitted with respect to a similar rule filing, assert that the existence of bitcoin derivative markets is not a necessary condition for a bitcoin ETP.
The key requirement the Commission is applying here, however, is not that a futures or derivatives market is required for every ETP, but that—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.
C. Basis for Disapproval
The Commission has, in past approvals of commodity-trust ETPs, emphasized the importance of surveillance-sharing agreements between the national securities exchange listing and trading the ETP, and significant markets relating to the underlying asset.
Such agreements, which are a necessary tool to enable the ETP-listing exchange to detect and deter manipulative conduct, enable the exchange to meet its obligation under Section 6(b)(5) of the Exchange Act to have rules that are designed to prevent fraudulent and manipulative acts and practices and to protect investors and the public interest.
As described above, the Exchange has not entered into a surveillance-sharing agreement with a significant, regulated, bitcoin-related market. The Commission also does not believe, as discussed above, that the proposal supports a finding that the significant markets for bitcoin or derivatives on bitcoin are regulated markets with which the Exchange can enter into such an agreement. 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, the Commission does not find the proposed rule change to be consistent with the Exchange Act and, accordingly, disapproves the proposed rule change.
The Commission notes that bitcoin is still in the relatively early stages of its development and that, over time, regulated bitcoin-related markets of significant size may develop.
Should such markets develop, the Commission could consider whether a bitcoin ETP would, based on the facts and circumstances then presented, be consistent with the requirements of the Exchange Act.
For the reasons set forth above, the Commission does not find that the proposed rule change, as modified by Amendment Nos. 1 and 2, is consistent with the requirements of the Exchange Act and the rules and regulations thereunder applicable to a national securities exchange, and in particular, with Section 6(b)(5) of the Exchange Act.
It is therefore ordered, pursuant to Section 19(b)(2) of the Exchange Act, that the proposed rule change (SR-BatsBZX-2016-30), as modified by Amendments No. 1 and 2, be, and it hereby is, disapproved.
For the Commission, by the Division of Trading and Markets, pursuant to delegated authority.
Eduardo A. Aleman,
[FR Doc. 2017-05213 Filed 3-15-17; 8:45 am]
BILLING CODE 8011-01-P