Gary Gensler and regulation by probability

Apr 18, 2022

I’m back from some much needed R&R. Hope you missed me as much as I missed you.

Today I want to provide some commentary on a recent speech by SEC Chairman Gary Gensler on the subject of crypto regulation. Before I do that, though, I want to commend to you a comment letter written by Peter Van Valkenburgh, and filed on behalf of Coin Center on Thursday, in the SEC’s rulemaking proceeding to change what counts as an “exchange” subject to registration with the Commission.

SEC’s proposed interpretation of “exchange” is unconstutional

You can read Peter’s summary here, but the entire letter is worth reading. Bottom line, the proposed change would make it so that the trigger for registration would no longer have to be conduct; mere speech would suffice. That is, if you made available decentralized exchange smart contracts, and people used them, you’d be considered an exchange and required to register with the SEC as a National Securities Exchange or ATS. As a result, it would be illegal to publish code unless you first registered with the SEC. But, as Walter said in the Big Lebowski, that is a prior restraint on speech which the Supreme Court has roundly rejected.


Peter’s comment makes it clear that the SEC’s proposed change is unconstitutional and the Commission should scrap it. If it is finalized as drafted, we or someone else in the crypto space will no doubt file a First Amendment challenge in federal court and, as Peter outlines, the current Supreme Court is itching to stand up for commercial free speech rights against regulatory prior restraints.

One thing that is very annoying about this proposed rule is that in its 200 pages it doesn’t once mention crypto or DeFi or decentralized exchange. I can imagine the SEC would say that’s because crypto was not the motivation for this rule change. As several commissioners have stated, who they primarily seek to capture with the change are providers of so-called “communications protocol systems” that facilitate the trading of fixed income and government securities (like certain Bloomberg Terminal services, I imagine). Indeed, in considering the burden of the proposed change (as required by law), the proposal states that “the Commission estimates the total number of Communication Protocol Systems to be 22,” which would only make sense if you were completely ignoring crypto.

But it just doesn’t pass the smell test that folks as smart and steeped in crypto as the leadership and staff of the SEC did not see that the language in the proposal is so broad that it would cover a massive array of systems including decentralized exchange. Indeed, it didn’t escape the attention of Commissioner Peirce, who dissented from the proposal and warned in her statement on the matter:

A final message to those who operate any service that is designed to facilitate any communication between potential buyers and sellers of any type of security: Read this release. Even if you have nothing to do with government securities or even fixed-income, or with traditional securities, read this release. Preferably as soon as it is published on the Commission’s website. It covers a lot of ground, and you should not assume that it has nothing to do with you, because it probably does.

This all suggests an attitude to the regulation of crypto that can only be described as Machiavellian.

Gensler on Crypto Markets Regulation

Which brings me to Chairman Gensler’s speech of April 4 on crypto markets. It is a recapitulation of statements he’s been making in interviews, congressional testimony, and elsewhere for some time, but now collected in on place. The speech addresses three topics: “platforms”, tokens, and stablecoins.

By “platforms” he largely means crypto exchanges, and he draws no distinction between centralized and decentralized systems. I won’t address that distinction beyond what I’ve already said above about the comment letter we just filed and pointing you to this piece on why “decentralized exchange” is a verb and not a noun. Instead I’ll focus on centralized exchanges. Gensler says exchanges should register with the SEC because (emphasis mine):

[T]hese platforms likely are trading securities. A typical trading platform has dozens of tokens on it, at least. In fact, many have well in excess of 100 tokens. As I’ll address later, many of the tokens trading on these platforms may well meet the definition of “securities.” While each token’s legal status depends on its own facts and circumstances, given the Commission’s experience with various tokens that are securities, and with so many tokens trading, the probability is quite remote that any given platform has zero securities.

Saying that some exchange-traded tokens “may well meet” the definition of securities also reminds me of Walter in the Big Lebowski. In particular when he says in eulogizing Donny that, by scattering Donny’s ashes at a beach in La Jolla, he was doing what “may well have been his dying wishes.” That scene is funny because Walter couldn’t know what Donny’s wishes were. Here it’s funny because the SEC won’t say any particular token is a security but nevertheless expects exchanges to submit themselves to comprehensive regulation based solely on an untested likelihood.

Chairman Gensler has often referred to the SEC as a “cop on the beat.” Imagine if police could stop and arrest you because you “may well” be committing a crime. Perhaps given your demographic profile there’s some probability that you’re likely committing some crime, so maybe you should turn yourself in. That would be ridiculous, of course, and it’s no less ridiculous here. ¡Que ridiculo! as Maude Lebowski would say.


In response to his entreaties, one can imagine an exchange saying to Chairman Gensler, “We certainly want to be in compliance with the law, and it’s not our intention to ever list a security on our platform, so can you please tell us which of the tokens we list is a security so that we may immediately delist it?” A probability doesn’t cut it. Before the Commission can expect an exchange to register it needs to say exactly which listed tokens are the securities. And that brings us to the “tokens” part of Gensler’s speech.

On tokens, Gensler says:

The fact is, most crypto tokens involve a group of entrepreneurs raising money from the public in anticipation of profits — the hallmark of an investment contract or a security under our jurisdiction. Some, probably only a few, are like digital gold; they may not be securities. Even fewer, if any, are actually operating like money.

It’s not so straightforward. That description omits the “common enterprise” and “efforts of others” prongs of the test for an investment contract. There are certainly entrepreneurs who raise money from investors by making promises of efforts they will make to build a token network, and such parties should certainly register their securities offerings with the SEC. But that doesn’t mean that resultant tokens are securities any more than the land sold in the Howey case was ever a security—even if it was part of an unregistered investment contract at some point.

At the very least this has never been decided by a court, and certainly not by the Supreme Court, which is the only way we’re ever going to get certainty about when a token is a security. (I have little confidence we’ll get the answer out of Congress anytime soon.) So, if the SEC is so confident that most tokens are securities, and that as a result exchanges that list them are securities exchanges, then it should bring enforcement actions against token issuers, and not simply settle, but litigate the cases in court so we can all get some actual binding precedent.

To date the SEC has been pretty reluctant to file in court against token issuers. The notable exception is the case against Ripple, brought under the last chairman, and which may not even decide the status of XRP as a security. As a result of that suit, XRP was widely delisted from exchanges, and it’s far from a forgone conclusion that the SEC will win the case.

If the SEC won’t bring cases against a particular token issuers and try them in court, perhaps a prospective token issuer should bring a pre-enforcement challenge against the SEC to get federal courts to opine once and for all about when a token is a security. (If you would be interested in funding such a lawsuit against the SEC, please reach out as I’d like to talk to you.)

Finally, Chairman Gensler addressed stablecoins. He doesn’t really say much of substance as far as the application of the securities law to stablecoins goes, but he notes that they “raise issues for investor protection.” For my part I have little more to say about stablecoins than I already have elsewhere. As I told the President’s Working Group on Financial Markets when it was investigating stablecoins, “To the extent an issuer is not authorized by a prudential regulator or is not backing a stablecoin with dollars and safe assets approved by a regulator, but is instead backing it with riskier assets or a basket of assets, then the securities laws apply.” So then the question is, where has the SEC been? Again, not in court despite the investor protection concerns.

Various and Sundry

On March 30 I spoke on a panel discussion titled “Crypto and National Security: How to Validate American Innovation and Verify U.S. National Security” hosted by the National Security Institute at the Antonin Scalia Law School at George Mason University. Other panelists were Sheila Warren of CCI and Juan Zarate of K2 Integrity and it was moderated by Laura Shin. You can watch the panel discussion here.

Last week I participated in a conversation with Axios reporter Lucinda Shen “on the most consequential trends in cryptocurrency and what’s next for regulation.” Also on the program was a conversation with George Mason University associate professor of law J.W. Verret (who has a great crypto newsletter himself). You can watch the program here.

Nota Bene

If You Use a Bank Account, Don’t Get on the Wrong Side of the Government - Discourse

Arthur Hayes: Energy Cancelled

Crypto picks its battles with Biden - Protocol

👉 Enjoyed this issue of my newsletter? Subscribe today. 👈