Is crypto a security, bro?

0:06Pushkin. The U.S. crypto crackdown is in full swing. The U.S. Securities and Exchange Commission is suing the two most important crypto exchanges, Coinbase and Binance, alleging that they're running unregistered securities exchanges. This is a big deal. A lot of different global regulators are grappling with what to do with crypto. Gary Gensler, head of the SEC, has been quite aggressive in saying we don't need more digital currency and it's time for these crypto companies to come into compliance. But there's a question underlying this entire SEC crackdown on crypto, which is, are cryptocurrency securities?

0:41Do these assets even fall under the SEC's purview to begin with? We recently wrote about this in the Unhedged newsletter, and today we'll discuss. This is the Unhedged podcast, the new markets and finance show from the Financial Times and Pushkin. I'm reporter Ethan Wu here in New York, joined by my boss, Robert Armstrong, who has granted me diplomatic immunity to call his views wrong. I think boss is a strong word, Ethan. All writers are equal in the unhedged universe, even if some of us are slightly more equal than others. I wish I bought into that. I really do. We have taken different sides, like I referred to in the newsletter on this issue.

1:19Rob, what's your side? My side is that your side is wrong. Okay, well, that's also my side. My side is that cryptocurrencies are not investment securities and they should not be regulated by financial regulators in the United States or anywhere else. Okay. My side is that cryptocurrencies are plausibly securities. Specifically, they look a lot like stocks. And I think they would slot in, not perfectly, not without any friction, but they would slot into the SEC's broader securities regulation framework. So these are the sides, but we should introduce how these decisions are made. In this discussion, you can't avoid the Howey test.

2:00This is what the Supreme Court in 1946 said should sort of be the standard for defining what counts as an investment contract, what counts as a security. And there are some other ways to do it, but this is the primary one. It's the one relevant here. And the Howey test was based on this lawsuit over a Florida land deal and orange grows, are oranges securities. And it stipulates - They definitely are, by the way. Sure, sure. Not cryptocurrencies, but citrus. Citrus. It's secure. Does that make orange juice a derivative? That's exactly right. That is the question. Yes. The Howey test has three legs.

2:33One leg is a person has to invest. Second is it has to be a common enterprise. The third is it has to be with the expectation of profits based on the efforts of others. All right. So let's walk through those. Certainly, there is the expectation of profits with Bitcoin, Bitcoin or cryptocurrency generally. People aren't out there hoping for losses. So we check that box very nicely. And we're a third of the way there. Well, someone's investing. And I think that's clear enough. Yeah, yeah. Somebody's putting money into this thing. Yeah. So that's happening. Then there's common enterprise. Well, I guess that we can check that box too, right?

3:11There's hella nerds in mother's basements working together to make this ecosystem spin round and round. It's a decentralized enterprise, but you could argue it's an enterprise, sure. Yeah. Armstrong, it seems like you've conceded the argument that I am right and now I will become the boss and I will be more equal than others. The problem with the Howey test is not that cryptocurrencies meet it. It's that everything meets it. Anytime anybody puts up a little money and hopes to turn into a little bit more money, suddenly this becomes a security and the appropriate regulator becomes the SEC. This is just wrong.

3:52Sports betting apps should not be regulated by the SEC. exchanges or websites or conventions or wherever people trade trading cards should not be regulated by the SEC. And it seems to me perfectly clear that cryptocurrency is much closer to one of these things than what we know as securities, bond stocks, whatever else. Specifically because bond stocks, even the bad ones, they have a reasonably legitimate argument that they are backed by productive commercial enterprise, economic activity, right? Whereas that is not true of cryptocurrency. I think one of the things that we have to keep in mind in this discussion is that as a economic innovation, cryptocurrency has fallen flat on its face.

4:55And I don't want to use the word fraud so early in this discussion, but this is three card Monty and that's not the SEC's business. I think one thing we have to keep in mind here is the difference between something like Bitcoin and something like Solana or Cardano or some of these newer cryptocurrencies. And I think the relevant distinction there is the newer cryptocurrencies, you might think the underlying business sucks. I tend to think that, but that's not really the SEC's role to come down on. Is this like a business that makes some amount of sense? These newer cryptocurrency companies, they're doing something that looks a little bit like an IPO.

5:37And I mean, they even used to call it an initial coin offering, an ICO. And the companies have gotten more clever about it, but I think the fundamental economics have not really changed. They say, you buy our tokens. We're going to take that money. We're going to hire developers. We're going to build platforms. We're going to launch seed capital funding arms. The argument you're making right now is that a fraud business is still a business. And if you raise money for a fraud business, you're still selling a security. It's a separate problem. Structurally, you're doing the kind of thing that the SEC is there to regulate, Yeah.

6:10Whatever is back there, because there are these promoters, network operators, etc., standing behind a cryptocurrency launch. I'm saying that fraud is a very strong word. And you can run a business that sucks in an industry that makes not a lot of sense, but that people are still willing to pay for. Yeah. And that's not necessarily fraud. Yeah. On your view, that is what the SEC. I think that's what they see. And you see this in some of the litigation that Gary Gensler has brought. He's not suing about Coinbase trading Bitcoin. He's not suing about Binance trading Ethereum. He's suing about these newer fangled cryptocurrencies that have some amount of economic reality resembling a stock capital race.

6:50Right. So the distinction you're making and which judges, when pressed on this point, have made is that the older cryptocurrencies, if the enterprise that stands behind them were to disappear, the cryptocurrency would march on. This is clearly true of Bitcoin, right? And this makes the coin itself look more like a trading card, right? The bubblegum company goes out of business. The Nolan Ryan rookie card retains its value. And so that doesn't look so much like a security because the common enterprise bit falls away. And people who want to keep operating these exchanges have made that argument.

7:35Right. And some of the newer cryptocurrencies and newer crypto offerings, that's not necessarily true. The case you're referring to, this was a legal decision made earlier this year by an NFT company that they took NBA highlights and they put them on the blockchain. And they were trying to defend their product as, hey, we're baseball cards. We're not securities. And the judge dismissed that. And the reason they dismissed that, to read directly from the case, is the business is called Dapper Labs. If the business shut down, the value of all moments, which is their crypto NFT offering, the value of all moments would drop to zero.

8:10That is the critical causal connection that other collectibles cases lack and which is alleged here. So like you're saying, if the business shuts down, the thing that they have sold investors is worth zero. That's what a stock does, right? That's not what a baseball card does. That's not what a commodity does. That's what a stock does. That's what a security does. It's a bet on the economic reality behind the company. All right. So I'm going to try another argument on you because I don't want to get too tangled up in the nuances of trading cards versus securities versus anything else. Instead, let's go for a historical thought experiment.

8:46Let us suppose that instead of cryptocurrency, another word had been used from the very beginning. Suppose the computer science innovation that gave us Bitcoin was originally called the computer power token generation game. Okay. And people got playing this game and they got really into it and they started trading the tokens. And soon after that, drug dealers and tax evaders noticed they could make their wicked businesses function by using these tokens in this game. But the word currency had never come up. The reason I proposed this experiment is because the word currency never should have come up.

9:29Bitcoin and every other cryptocurrency has failed every test of being a currency. It's not an effective medium of exchange. It's not a store of value. It's not a unit of account. These are just thingies. And so if we'd just gone through and they were just called tokens and the whole thing was called a game, would it be the SEC that was knocking on the door now? No, it would be somebody else. It would be a gambling regulator. It would be the Department of Justice. This would just be a plain old, are people committing fraud on mopes? Yeah. I mean, look, we've been talking about these kind of finer points of U.S.

10:04securities law, and it is important. It's going to be decided in court. But I think the big picture, to me at least, is we live in a kludgeocracy. We cobble together rules and norms and practices a little bit at a time. It's a bit improvised. And the fact of the matter is it's 15 years into the crypto experiment. This is a big-ass industry. It's probably not going to go away, and there needs to be some kind of system for regulating it. And if you think another regulator could do it better, I'm open to that argument. But the fact of the matter is the SEC is there now. They've done the homework on this now.

10:35The people that work there have been engaging with the industry for years now. And I think they're ready to do it. And it fits reasonably well into securities law. And it's way past time that we get this into some kind of regulatory framework. I strongly disagree, and here's why. In the world that you imagine, Ethan, where the SEC rushes into the breach, regulates this large industry in the absence of anybody else, Congress or another regulator doing the job, we're going to wake up in a couple of years, and there are going to be cryptocurrency backers and companies and exchanges swanning around talking about how they are fully SEC regulated and approved.

11:22And the result of that fact will be that a bunch of mopes sitting in their mother's basement are going to think that they are engaged in a real profit making enterprise and they are going to lose their money. And there is actually an alternative out there to using the wrong regulator to regulate this stuff. That alternative is called the market. We are already seeing the market clean the stables, as it were, of the Bitcoin industry. And we just ought to let that keep happening. Let a few mopes lose their money now. They will be disillusioned and Bitcoin will go the way of Beanie Babies and Cabbage Patch Kids.

12:06And that is the outcome we should be hoping for here, not securities regulation of something that's not a security. Well, I, for my part, I think blessed are the moops. We'll be back in a moment with Long Short.

12:34Welcome back. This is Long Short, that part of the show where we go long and short. One company, stock, restaurant, whatever it might be. I've got a particularly weird long today from this week's edition of New York Magazine, which I've got right here. It's about John John, a 23-year-old bone dealer who's shaken up the bone business based out of Brooklyn, New York. He is committed to responsibly sourced human osteology and only buys medical grade pieces, no tribal remains or anything dated before the 1985 Indian bone van, after which the bone industry collapsed. And to be clear, he's not selling this as a cadaver to hospitals or whatever it might be.

13:15He's selling this as an antique, as a collectible to, you know, quote unquote, respectful homes. Good for him. I am long John John and I am long his industry. The bone boom is coming. So the obvious question to ask here is, are bones securities? Well, let me tell you what I'm short, Ethan. I am short home prices. As you and I know, the rapid increase in U.S. interest rates made mortgages too expensive. House prices stalled and then fell. And in the last couple of months, people are excited because house prices in America have started to bubble up again. And this has everyone thinking that the bad days are over and it's good times to come.

13:56I am short home prices. Jay Powell, high interest rates, possibly a recession. All of this is going to grind house prices down at least slowly. Well, I sure hope so. I think anyone under 40, look at where house prices are and you despair. You're never going to own a house. No. Renting for life. Like the Europeans do, you know? Indeed. Maybe the problem is the home ownership society. Best of luck to you, Ethan. Yeah. Thanks for being here, Rob, and thank you for listening. We'll be back next Tuesday with another episode of the Unhedge podcast. Unhedge is produced by Jake Harper and edited by Brian Erstad.

14:35Our executive producer is Jacob Goldstein. We had additional help from Topher Forges. Cheryl Brumley is the FT's global head of audio. And don't forget, Unhedged is also a newsletter written by my colleague Robert Armstrong and me, which is published every weekday. You can sign up for free at ft.com slash unhedged offer. Thanks for joining us here in our first week on the Unhedged podcast. Special thanks goes out to Rula Halaf, Rob Armstrong, Peter Spiegel, Alistair Mackey, Jess Trulia, and Sam Giovinco at the FT. And to Jacob Weisberg, Greta Cohn, and John Schnars at Pushkin. I'm Ethan Wu. Thanks for listening.