Legal Analysis: Lawyer Decodes The Spot Ethereum ETF Approval Process

In a detailed legal analysis shared via X, Davis Polk lawyer Scott Johnsson dissected the complex path that Ethereum (ETH) must traverse to secure a spot Exchange-Traded Fund (ETF) approval. This deep-dive analysis, while drawing parallels to the successful Bitcoin (BTC) spot ETF approval, highlights the unique challenges and potential regulatory shifts necessary for Ethereum’s spot ETF prospects.

Part I: General Roadmap To Spot ETF

Johnsson begins his analysis by emphasizing the importance of understanding the general regulatory path for a digital asset to transition into a spot ETF offering. He points out that BTC pioneered this journey through a 4-step path, with each step building on the prior one. “It took seven years from step 1 to spot ETF for BTC, with disapprovals and regulatory hurdles at almost every turn,” Johnsson notes, highlighting the lengthy and complex process involved.

This is the timeline for BTC. You can see it took 7 years from step 1 to spot ETF, with disapprovals along the entire period. During this time, arguments evolved and matured… resulting in the current regime following the 19b-4 approval order for spot ETFs this past month. pic.twitter.com/KchdpnRZwn

— Scott Johnsson (@SGJohnsson) January 25, 2024

For Ethereum, the timeline appears to be compressing, an observation Johnsson attributes to the maturation of arguments and the refining of regulatory stances, particularly influenced by key litigation events such as the Grayscale case.

Step-by-Step Process For BTC’s Spot Approval:

1. Obtain a DCM Futures Listing: This step is pivotal, primarily establishing the regulatory classification of the asset as a non-security commodity and setting up the necessary futures market for the asset.
2. ’40 Act Futures ETF: This step gains importance as it doesn’t necessitate explicit SEC approval and implicitly ratifies the commodity designation by the SEC.
3. ’33 Act Futures ETF: Integral in the Grayscale ruling, this step requires a formal 19b-4 approval from the SEC, laying the groundwork for logic applicable to spot approval.
4. Spot Approval: The ultimate goal, necessitating another formal 19b-4 approval from the SEC.

Part II: The Threshold Question & Grayscale

In the labyrinth of regulatory frameworks and legal precedents, the journey to spot ETF approval hinges pivotally on navigating the nuances of Section 6(b)(5) of the Exchange Act. Johnsson delves deep into this aspect, identifying it as the linchpin in the process of securing a spot ETF approval. “The essence of the challenge lies in satisfying the stringent demands of Section 6(b)(5), particularly its stipulations concerning the potential for fraud and manipulation in the market,” Johnsson articulates, emphasizing the critical nature of this requirement.

Dissecting the SEC’s Approach: The Three-Pronged Path

The SEC’s approach to addressing these concerns has historically unfolded along three potential pathways, each presenting its unique set of challenges and intricacies:

• Inherent Resistance to Fraud and Manipulation: The first path involves demonstrating that the digital asset (e.g. Ethereum) inherently possesses attributes that make it resistant to fraud and manipulation. Johnsson notes, “This route demands a robust demonstration of the asset’s inherent market mechanisms and structures that inherently guard against fraudulent activities and manipulative schemes.” It’s a path less traveled, primarily due to the high threshold of proof and the complexities involved in substantiating such inherent safeguards.
• Other Means to Prevent Fraud and Manipulation: The second avenue, as Johnsson outlines, “involves identifying and implementing additional measures that effectively mitigate the risks of fraud and manipulation, separate from the asset’s inherent characteristics.” This path necessitates a comprehensive exploration of supplementary safeguards and regulatory mechanisms that can be fortified to protect the integrity of the market.
• A Surveillance Sharing Agreement (SSA): The third and often most scrutinized pathway revolves around establishing a robust Surveillance Sharing Agreement (SSA) with a significant market. “The SSA is pivotal, as it represents a concrete, collaborative effort between the market and regulatory bodies to actively monitor and combat potential fraudulent activities and manipulative practices,” Johnsson explains.

The Grayscale Ruling: A Paradigm Shift

The landscape, however, experienced a seismic shift with the advent of the Grayscale ruling, which brought the SEC’s reliance on the “significant size” test under a glaring spotlight. Johnsson dissects this development, stating, “The Grayscale ruling was a watershed moment, unraveling the SEC’s previously impervious stance and exposing the vulnerabilities and inconsistencies in the ‘significant size’ test.”

This test, which had long been a cornerstone of the SEC’s rationale in denying previous spot ETF applications, was subjected to intense scrutiny. Johnsson illuminates this, saying, “The ‘significant size’ test, once a bastion of the SEC’s defense, was dissected and found lacking in coherence and consistency, marking a critical inflection point in the narrative surrounding spot ETF approvals.”

The ruling underscored two pivotal facts that turned the tide: the close correlation between spot and futures markets, and the identical nature of SSAs with significant markets like the CME. “This correlation and the homogeneity of the SSAs were the fulcrum on which the Grayscale ruling pivoted, compelling a reevaluation of how these factors are weighed in the approval process,” Johnsson observes.

He further elaborates on the intricate dynamics post-Grayscale ruling, “The ruling didn’t just challenge the SEC’s previous denials; it necessitated a profound reconfiguration of the SEC’s approach, paving the way for BTC’s spot approval and setting new precedents for assets like ETH.”

Part III: BTC 19b-4 Approval Order

Johnsson examines the SEC’s tactful navigation around the “significant size” test, a move he perceives as both shrewd and indicative of the agency’s responsive recalibration. “The SEC’s decision to sidestep this contentious test illustrates a deliberate shift, steering the discourse towards uncharted yet potentially more stable grounds,” he articulates. This strategic pivot, while resolving the immediate challenge, subtly reshapes the regulatory landscape for future digital asset considerations.

Embracing The “Other Means” Test: A Paradigm Shift

The SEC’s adoption of the “other means” test under the provisions of 6(b)(5) marked a pivotal shift from its previous stance. Johnsson describes this as “a recalibration of approach, charting a new course in the SEC’s methodology to tackle the concerns of market manipulation and fraud.” This move, characterized by a comprehensive correlation analysis, signified a fresh perspective on assessing the integrity and resilience of digital assets in the market.

The Methodological Refinement: A Rigorous Correlation Analysis

Delving into the SEC’s correlation analysis, Johnsson highlights the meticulousness and foresight embedded in this approach. “The SEC’s methodology is not merely thorough; it’s a testament to their commitment to data-driven and forward-looking regulatory practices,” he asserts. The emphasis on a substantial sample period, intra-day trading data, and, crucially, consistency across the period, underscores a rigorous and methodical approach that sets new precedents in digital asset evaluation.

Johnsson points out the SEC’s directive to exclude references to the Coinbase SSA in the 19b-4 applications. He interprets this as a calculated, strategic maneuver, suggesting, “This deliberate omission opens a subtle yet profound window into the SEC’s broader strategy, hinting at a complex tapestry of considerations and tactical plays at work.”

Part IV: Ethereum Analysis

Johnsson begins with an optimistic perspective, drawing parallels between Ethereum’s journey and the recently paved path by BTC. “The SEC’s approval of a BTC spot ETF, particularly its reliance on the ‘other means’ test and the correlation analysis, lays down a potential blueprint for ETH,” he observes. This precedent, he argues, offers a glimmer of hope, positing that “ETH, much like BTC, stands on the brink of achieving a similar breakthrough, provided it can navigate the intricate web of regulatory nuances.”

The Correlation Conundrum: Ethereum’s Unique Challenges

Despite the optimism, Johnsson delves into the unique challenges Ethereum faces, particularly in establishing a sufficient level of futures-spot market correlation—a cornerstone of the SEC’s recent approval rationale. “ETH’s correlation metrics, while promising, are not a mirror image of BTC’s. This distinction forms the crux of the challenge, necessitating a nuanced understanding and strategic alignment with the SEC’s evolving benchmarks,” he explains.

He further dissects the SEC’s methodological rigor, emphasizing that “Ethereum must not only demonstrate high correlation but also ensure consistency and robustness across a substantial historical sample, aligning with the SEC’s methodical and data-centric approach.”

Strategic Considerations: The SEC’s Balancing Act

Johnsson highlights the broader strategic considerations at play within the SEC, particularly in light of its recent actions and legal stances. “The SEC’s approach, especially its decisions regarding Coinbase and Binance, casts a long shadow over ETH’s prospects. The agency’s actions and the legal precedents they set form a complex tapestry that ETH’s application must deftly navigate,” he points out.

He underscores the significance of ETH’s non-classification as a security in recent SEC actions, suggesting that “This implicit recognition of ETH’s status, while not an outright endorsement, offers a subtle nod to its potential pathway towards spot ETF approval. […] The SEC listed a dozen+ digital assets in each action as alleged securities, […] Notably, ETH is not included in either. Nor has there ever been such an allegation.

The Countdown To The May Deadline For Ethereum

As the May deadline looms, Johnsson presents a multifaceted analysis of the converging factors that could influence the SEC’s decision. “The clock is ticking, and with each passing moment, the SEC’s decision matrix grows more intricate, woven with legal, strategic, and market considerations,” he states.

Also, Johnsson points out the influence of BlackRock with regards to a potential spot Ethereum ETF. “Near undefeated in ETF applications led by highly influential Larry Fink. And there is strong reason to suspect they may have been a stronger catalyst to BTC approval than even the Grayscale ruling.”

The lawyer acknowledges the potential headwinds, especially the SEC’s meticulous correlation methodology and the relatively shorter historical trading data for Ethereum compared to Bitcoin. “Ethereum’s journey is not a straightforward sprint but a marathon laden with strategic hurdles and regulatory checkpoints,” Johnsson remarks, emphasizing the complexity of the path ahead.

In concluding his analysis, Johnsson strikes a note of cautious optimism. “That said, there should be plenty of clues leading up to the deadline which should inform us as to how the SEC is thinking about its decision. And it would certainly not surprise me if the SEC decided to avoid the DC Cir at all costs and simply issue approval,” he reflects.

At press time, the Ethereum (ETH) price stood at $2,223.

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