Everything's Still a Security
In 1932, the prosecutor and special counsel Frank Pecora spearheaded congressional hearings on the myriad misdeeds of the financial industry.
The damning evidence presented in those hearings led directly to the establishment of the SEC, FTC, FDIC, and the passing of Glass-Steagall — and earned Pecora the moniker "Hellhound of Wall Street."
His interrogation of the country's top financiers, including J.P. Morgan Jr., was so antagonistically reminiscent of the Al Capone trial the year prior that the press coined the phrase "banksters."
Amongst other ethical lapses, the banksters were accused of selling bonds they knew were most likely worthless, duping their customers into investing in the debt of bankrupt South American governments.
Perhaps more damning, they not only stuck customers with the bad junk, they kept the good junk for themselves: In an IPO from the new aerospace sector, the directors of National City Bank were reported to have bought the entire issue for themselves on the rationale that it was too risky for the general public — only to flip it to their retail customers for a 50% profit nine days later.
That sort of behavior is what made the government decide most everything was a security and that they all had to be registered.
The SEC still thinks most everything's a security and still expects them to be registered — including cryptos.
Unfriendly Reminders
We've had several recent reminders of that, starting with Gary Gensler's op-ed in the WSJ the week before last.
His analogy to seatbelts was confusing and he seemed to misleadingly conflate CeFi and DeFi, but his intent was clear: Like my dogs on every walk around the block, the SEC Chair was marking his territory.
The agency seemed to be losing some of that territory: When the Lummis-Gillibrand bill was introduced in June, there were a lot of celebratory hot takes that the CFTC had won the turf battle to regulate crypto.
But that was overly optimistic.
Senator Lummis herself, a notable bitcoin proponent, when asked what she thought of Gensler's stance that most cryptos are securities, responded flatly, "I agree with him."
Regardless, a bill is not a law, so the SEC has continued to act under the assumption that, until told otherwise, crypto is theirs to regulate.
It appears they still intend to exercise that authority: Grayscale noted in a recent filing that it had received a memorandum from the SEC's lawyers questioning "the status…under the federal securities laws" of ZEN, ZEC, and XLM.
I don't know much about these early-vintage cryptos, but at a glance, they certainly seem a lot less like companies and more like currencies or commodities than most DeFi protocols of today.
If anything beyond bitcoin (the only definitely-not-a-security crypto) was going to be regulated by the CFTC, you'd guess it would be something like ZEC.
So it seems the SEC has not ceded any ground in that regulatory turf war.
And if the SEC thinks that older vintage cryptos might be securities, most of the newer vintages must certainly be.
That may be increasingly the case as the narrative in DeFi trends towards "real yield," revenue, and cash flows.
I noticed a crypto commentator this week advising investors to look for projects that "distribute the proceeds to token holders" and that "pay out a real dividend."
Looking for cash flows is always good advice in investing — but that's exactly what the SEC will be looking for, too.
With so much of DeFi now explicitly targeting those cash flows, the industry seems to be putting all of its eggs in the "efforts of others" clause of the Howey test.
But I've yet to see a DeFi protocol that doesn't have a person or group that the SEC wouldn't be happy to identify as the "others" whose efforts we depend on.
Same goes for NFTs.
Lawyers representing ex-OpenSea employee Nathaniel Chastain said in a motion filed last week that their client was being used as a fall guy in an SEC attempt to categorize NFTs as securities.
They argued that NFTs are neither securities nor commodities, stating even that "the government agrees."
I'm not sure I agree with that, and I'm definitely sure Gensler does not: He said in an interview with CNBC this month that if investors anticipate a profit based upon a promoter's efforts, that's a security, NFT or otherwise.
I challenge you to find an NFT project without an easily identifiable "promoter" — let alone one where buyers are not anticipating a profit.
(Not that any of mine have ever turned a profit, but that's a different story.)
If JPEGs are securities, then probably everything else is, too.
Still Top Dog
One thing you cannot accuse the SEC of is inconsistency: In 2016, The DAO, before it nearly sank Ethereum, was meticulously planned to avoid SEC censure, with on-chain governance, a fully decentralized token distribution, and arms-length developers.
And still, the SEC said it was a security.
They've stuck to that hard-line interpretation of Howey ever since. And yet, six years later, protocols seem less cognizant of securities law, not more.
I guess that's because, for all the stern warnings that most everything's a security, the SEC has been mostly bark and not much bite.
And maybe that's how it will continue to be.
But before we go all-in on cash-flow producing DeFi, we should at least be aware that we're creating some big fat targets for the SEC — which could come back to bite us at any time.
The Hellhound of Crypto is still marking its territory.
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