[In]Securities GUEST BLOG: Not the One You Need by Aegis Frumento Esq

September 12, 2019

Not the One You Need

Sometimes a plot is so transparent that you can't help but know what is going to happen next. As many of you know, there've been several attempts over the past two years to have the SEC approve an exchange-traded fund that holds bitcoin. There are at the moment two applications pending before the SEC, one by the Bitwise Bitcoin ETF Trust, and another by the VanEck SolidX Bitcoin Trust. The SEC has promised a decision on both of those in mid-October.

Spoiler alert: Both will be denied.

No, I've not been getting messages from the future. It's just that few days ago SEC Chairman Jay Clayton said on CNBC that there was still "a lot of work" to be done before the SEC would approve ETF's that held bitcoin. He raised the usual issues. "How do we know that we can have custody and have a hold of these crypto assets? That's a key question," he said. "An even harder question given that they trade on largely unregulated exchanges, is how can we be sure that those prices aren't subject to significant manipulation?" https://cryptoslate.com/sec-bitcoin-etfs-vaneck-solidx-btc-disinterest/.

Well, you can never "know" or "be sure" of either. But we're certainly not going to "know" or "be sure of" next month more than we do now, and there's nothing that the applicants can do about it. The custody issue was dramatically illustrated by the collapse of the Canadian coin exchange QuadrigaCX when its founder died with the passwords needed to access most of the cryptocurrency deposits. http://www.brokeandbroker.com/4438/aegis-frumento-quadrigacx/. The risk of manipulation was illustrated by The Attacker of The DAO, and even by Bitwise's somewhat self-immolating "proof" that 81% of all coin exchanges might be fraudulent. See http://www.brokeandbroker.com/4412/aegis-frumento-dao/ and http://www.brokeandbroker.com/4497/aegis-frumento-bitwise/. None of those concerns have anything at all to do with the ability of Bitwise or Van Eck to manage an ETF. They are problems inherent in the infrastructures of cryptocurrencies, and since they haven't been solved and certainly won't be in the next few weeks, it's fairly easy to predict that the SEC won't be approving any ETF applications anytime soon.

Van Eck can read the tea leaves as well as the rest of us, which best explains its recent announcement that it would rebrand its crypto fund as a Rule 144A security. https://www.wsj.com/articles/van-eck-solidx-to-offer-limited-version-of-bitcoin-exchange-traded-fund-11567503003? Rule 144A was the first experiment in creating a trading market for private securities. I know that sounds like an oxymoron. Doesn't a market in private securities make them sort of public? Only sort of. Private securities are simply instruments that have not been registered with the SEC. Rule 144A securities are sold under one of the exemptions from registration contained in the Securities Act of 1933 that define when an offering is not "public." Generally, those being offered a chance to invest in an unregistered security have to be sophisticated, wealthy, and few -- those 1%ers who the SEC feels can fend for themselves.

So the idea of a market in a private security is not so far-fetched.  The 1%ers are few in relation to the rest of us, but they still number in the hundreds of thousands or few millions. There are more than enough of them to sustain a true market. Today, outfits like SharesPost and SecondMarket do a thriving business hosting private markets in late-stage private companies for the benefit of accredited investors waiting for the IPO that will make it all worthwhile.

Rule 144A was somewhat unique because it created the concept of the Qualified Institutional Buyer, or QIB. A QIB is an institutional investor (not a person) with over $100 million in investment assets. The concept behind Rule 144A was that, even more so than rich persons (who despite their wealth (or because of it) might not be so bright ), QIBs really could be left of their own devices. Rule 144A created an unregistered security that QIBs could trade amongst themselves. The SEC expected a private market would arise in 144A securities restricted to a very exclusive club, the QIB Club. If you are a member of the QIB Club, you can trade 144A securities with other QIBs to your heart's content, and the SEC generally leaves you alone. You would expect banks and insurance companies and hedge funds to be QIBs, but there are surprises. Prepaid college tuition plans are in the QIB Club too. https://www.sec.gov/divisions/corpfin/cf-noaction/2016/cspn-011216-501a.htm

It's not entirely clear how well the Rule 144A experiment has gone. For a time NASDAQ had sponsored sort of a market for the QIB Club called the Portal. The Portal Market had been in existence in the early 2000s. NASDAQ had plans to make it into a quasi-established trading institution known as the Portal Alliance, to be governed by a group of senior QIB Clubbers. The events of 2007 put an end to all that. NASDAQ abandoned its Portal rules for equities in 2008. https://www.sec.gov/rules/sro/nasdaq/2008/34-58638.pdf. Portal for debt securities lasted just another year. https://www.sec.gov/rules/sro/nasdaq/2009/34-60991.pdf. Since then, broker-dealers maintain or buy lists of known QIBs so they can verify membership in the QIB Club before allowing a 144A trade. That's not to say that 144A securities don't sometimes end up in the hands of someone who's not a QIB, but that's relatively rare.

Meanwhile, Van Eck is trying to pass off its rebranded bitcoin fund as an ETF for the QIB Club. That's even more of an oxymoron than a market in private securities. The point of an ETF is to make complex investments available to the public. By making its bitcoin trust available only to the QIB Club, Van Eck is essentially conceding that bitcoin ETF's ain't happenin', which, of course, is what the SEC has been saying all along.

All this still raises the question, Why would anyone invest in a fund that only holds bitcoin anyway? As if to provide a scratch-off answer, in the week since Van Eck announced its bitcoin 144A fund, it has raised $41,000, the value of just 4 bitcoins. https://cointelegraph.com/news/vanecks-new-bitcoin-trust-assets-total-just-41k-in-first-week. Not resounding show of support. In one of the great understatements, crypto maven Alex Kruger tweeted, "This trust is just a bad launch of a product for which there's not much demand." https://twitter.com/krugermacro/status/1171228055806849026.

Small wonder. No one has yet explained why bitcoin should ever be owned in a fund, especially if, as with Bitwise and Van Eck, that's all the fund owns. It is easier and cheaper to buy and hold bitcoin through a coin exchange. After all, that's what the bitcoin funds would do. Then you'd avoid having to read the fund's PPM, fill out its subscription agreement, pay its fees and expenses and put up with all the other hassles that come with owning a fund. Creating a fund to hold a single asset that is more liquid in its native form than the fund would be seems ludicrous. Whoever invested $40,000 in Van Eck's fund could more easily have just bought 4 bitcoins directly on any coin exchange. The creation of a bitcoin ETF, fund, or what have you is a tale told by an idiot, the sound and fury of securitizing everything, whether it makes sense or not.

Perhaps the public would more gullibility buy into a bitcoin ETF. But the QIB Club is not so dumb. When it comes to buying into a bitcoin fund, the QIB Club is clearly singing, it ain't us, babe.



Aegis J. Frumento
Stern Tannenbaum & Bell
Co-Head, Financial Markets Practice

380 Lexington Avenue
New York, NY 10168

Aegis Frumento is a partner of Stern Tannenbaum & Bell, and co-heads the firm's Financial Markets Practice. Mr. Frumento represents persons and businesses in all aspects of commercial, corporate and securities matters and dispute resolution (including trials and arbitrations); SEC and FINRA regulated firms and persons on regulatory compliance issues and in SEC and FINRA enforcement investigations and proceedings; and senior executives of public corporations personal securities law and corporate governance matters.  Mr. Frumento also represents clients in forming and registering broker-dealers and registered investment advisers, in developing compliance policies, procedures and controls, and in adopting proper disclosure documents. Those now include industry professionals looking to adapt blockchain technologies to finance and financial market enterprises.

Prior to joining the firm, Mr. Frumento was a managing director of Citigroup and Morgan Stanley, a partner and the head of the financial markets group of Duane Morris LLP, and the managing partner of Singer Frumento LLP.

He graduated from Harvard College in 1976 and New York University School of Law in 1979. Mr. Frumento is a frequent author and speaker on securities law issues, and is often quoted in the media on current securities law developments.

NOTE: The views expressed in this Guest Blog are those of the author and do not necessarily reflect those of BrokeAndBroker.com Blog.