Some investors in cryptocurrency cheered when Gary Gensler was named by President Joe Biden to be the next chair of the Securities and Exchange Commission (SEC).
As a professor at the Massachusetts Institute of Technology, Gensler taught courses on the blockchain that underpins cryptocurrency and authored research that examined the potential benefits and risks posed to the financial markets by new technology. His understanding of the benefits and risks posed by cryptocurrency seemed deeper than most.
But those same investors might not be feeling so celebratory since Gensler took over at the SEC. The cryptocurrency sector prides itself on its independence from government control and to a lesser extent, the disconnection of value from existing currencies. (One segment of the cryptocurrency market includes stablecoins, which are cryptocurrency tokens linked to the value of established currencies).
Early investors in cryptocurrency would likely prefer Gensler and the SEC leave the sector to function on its own, separate and distinct from traditional financial markets and largely unregulated by any government, American or otherwise.
But that is unlikely to be Gensler’s chosen path, say experts who have parsed his statements on cryptocurrency and examined the SEC’s initial enforcement actions handed down since he took over as chair.
In addition to his academic background, Gensler has an established track record as a strong regulator. As chair of the Commodity Futures Trading Commission, he directed the imposition of strict regulations on the then-largely unregulated security-based swaps market, bringing order to a sector of the market he had called “the wild west.”
Crypto another ‘wild west’ in Gensler’s eyes?
“This asset class is rife with fraud, scams, and abuse in certain applications,” Gensler said about cryptocurrency to the Aspen Security Forum this month. “We need additional congressional authorities to prevent transactions, products, and platforms from falling between regulatory cracks.” He called on Congress to provide regulators with new tools to regulate cryptocurrency.
In an Aug. 5 letter to Sen. Elizabeth Warren (D-Mass.), Gensler laid out his stance on regulating cryptocurrency.
“Right now, I believe investors using these platforms are not adequately protected,” he wrote.
“It doesn’t matter whether it’s a stock token, a stable value token backed by securities, or any other virtual product that provides synthetic exposure to underlying securities. These products are subject to the securities laws and must work within our securities regime,” he added, noting the SEC has prosecuted dozens of cases against “token-related securities.”
“We haven’t yet lost a case,” Gensler wrote.
If crypto is going to be widely adopted, it needs some rules of the road & a cop on the beat to enforce them.— Gary Gensler (@GaryGensler) August 3, 2021
To be clear, I am technology-neutral.
What I'm not neutral about: Investor protection. pic.twitter.com/e6GsSAyXhB
To Ashley Ebersole, a former SEC enforcement attorney and partner at the firm Bryan Cave Leighton Paisner, Gensler sounds like a regulator willing to use every tool at his disposal to regulate cryptocurrency in a more robust manner.
“It sounded like an abrupt turn away from the policy priorities of prior SEC leadership and more of an approach that leads with consumer protection,” Ebersole says. “It was a call for doing everything it can within its jurisdictional bounds.”
Philip Moustakis, counsel at law firm Seward & Kissel and a former senior counsel in the SEC’s Division of Enforcement, says some securities lawyers argue it might not be beneficial to the industry to seek new laws or regulations specifically applicable to digital assets. Others argue the laws are outdated and accuse the SEC of regulation by enforcement.
“Unfortunately, it seems, the latter camp’s voices have been loud enough to prompt action by the new SEC chair to advocate for new crypto-specific rules or regulation which, ultimately, may act to the detriment of digital asset market participants,” he says.
To an extent, robust enforcement of cryptocurrency by the SEC has predated Gensler. Everyone in the cryptocurrency space is watching closely for a decision in the SEC enforcement action and lawsuit against Ripple Labs, filed in December 2020. Ripple stands accused by the SEC of selling 14.6 billion units of the cryptocurrency XRP since 2013 worth $1.3 billion without registering as a security.
At the time of the SEC’s action, XRP was the third most valuable cryptocurrency by market cap, according to the cryptocurrency site Coindesk.
The other side of the crypto-coin
The SEC’s approach to regulating cryptocurrency has been criticized regularly, most notably by Republican Commissioner Hester Peirce.
Peirce has argued the SEC has not provided clear enough guidance to the cryptocurrency industry about what constitutes a security in the space and is now retroactively enforcing rules that, at best, were unclear. She revived her criticism after the SEC announced a $10 million enforcement action on Aug. 9 against Poloniex, which operated a web-based cryptocurrency trading platform from 2017-19.
“Given how slow we have been in determining how regulated entities can interact with crypto, market participants may understandably be surprised to see us … come onto the scene now with our enforcement guns blazing and argue that Poloniex was not registered or operating under an exemption as it should have been,” Peirce wrote in response to the agency’s enforcement action against Poloniex.
A decision in the Ripple Labs case might set some much-needed safe harbors for establishing what a cryptocurrency is outside of the SEC’s jurisdiction, says Nick Morgan, former SEC trial counsel who is now a litigation partner with the firm Paul Hastings.
“It doesn’t matter whether it’s a stock token, a stable value token backed by securities, or any other virtual product that provides synthetic exposure to underlying securities. These products are subject to the securities laws and must work within our securities regime.”
SEC Chair Gary Gensler
“The SEC has never described a digital asset that does not fall within the SEC’s jurisdiction,” Morgan says. “Gensler seems like the perfect person to say where the SEC’s jurisdiction ends.”
In the Ripple Labs case, the SEC looked back to the original offering documents for XRP. While the investment might have changed over time to act like digital currency, as Ripple Labs suggests in its defense, the SEC maintains the initial offering of the XRP token was a security that should have been registered and regulated by the agency.
So, what might constitute a digital investment, a token, that is outside the SEC’s jurisdiction?
’Howey test’ currently guides SEC’s view of cryptocurrencies
For more than 80 years, what constitutes a security was defined by the “Howey test,” based on a Supreme Court decision. The decision establishes an investment is a security if an investment contract exists, and that subsequent investment in that investment comes with the expectation of profits derived from the efforts of others. In 2019, the SEC applied the Howey test to digital assets. Its description of what does and does not qualify cryptocurrencies as securities made it clear the agency views cryptocurrencies as, indeed, securities.
Wild value fluctuations of cryptocurrency—which have become commonplace—would be regarded as an indication by the SEC that cryptocurrency is a security.
“Prospects for appreciation in the value of the digital asset are limited. For example, the design of the digital asset provides that its value will remain constant or even degrade over time, and, therefore, a reasonable purchaser would not be expected to hold the digital asset for extended periods as an investment,” the SEC wrote in its 2019 guidance.
Morgan says the SEC could expand its description of what attributes cryptocurrencies, digital assets, and initial coin offerings could have to place them outside of the SEC’s jurisdiction. For example, if token holders have control of their assets and can vote on managerial decisions that would affect the token’s value, could that place the investment outside of the SEC’s control?
(Morgan says in at least one case, SEC v. Blockchain Credit Partners, the agency said this argument was phony and there cannot be a situation where token holders have sufficient managerial control).
How about if the token self-executes? Its founders create the token, but once it is established, it is wound like a watch and no longer managed by its founders?
“If it self-executes from there, then do the token holders rely on themselves to generate profits, rather than the managerial efforts of others?” Morgan asks.
Ebersole says he is skeptical the SEC would take the steps necessary to create such a safe harbor for certain types of cryptocurrencies.
“There is a fundamental disconnect between the way the SEC sees the Howey test and the way the cryptocurrency and digital assets industries see it,” he says. “They say, ‘How are we supposed to look at an 80-year-old Supreme Court decision and understand what a security is?’”
Ebersole says cryptocurrency founders and investors are not going to get the clarity they seek from the Howey test, and they’re not going to get it from the SEC under Gensler.
It is not a coincidence, several experts point out, that Gensler has used language similar to how he described the security-based swaps market in 2009 to describe the cryptocurrency market today.
“I think that is a good example of the mindset he will apply to regulating cryptocurrency,” Ebersole says. “Why wouldn’t he try to do it again?”