Streetwise Professor

September 17, 2022

Gary Gensler Does Crypto. And Clearing (Again). And Climate.

Gary Gensler has long lusted to get his regulatory hooks into cryptocurrency. To do so as head of the SEC, he has to find a way to transform crypto (e.g., Bitcoin, Ether, various tokens) into securities, as defined under laws dating from the 1930s. Although Gensler has stated that crypto regulation is a long way off–presumably because it is no mean feat to jam an innovation of the 2010s into a regulatory framework of the 1930s–he thinks that he may have found a way to get at the second largest crypto, Ether.

Gensler pictured here:

Sorry! Sorry! Understandable mistake! Here’s his actual image:

Crypto Regulation. Excellent!

Ether just switched from a “proof of work” model–the model employed by Bitcoin–to a “proof of stake” model. Gensler recently said that Ether may therefore qualify as a security under the Howey test, established in a 1946 Supreme Court decision–handed down when computers filled large rooms, had no memory, and caused the lights to dim in entire cities when they were powered up.

Per Gensler:

Securities and Exchange Commission Chairman Gary Gensler said Thursday that cryptocurrencies and intermediaries that allow holders to “stake” their coins might pass a key test used by courts to determine whether an asset is a security. Known as the Howey test, it examines whether investors expect to earn a return from the work of third parties. 

“From the coin’s perspective…that’s another indicia that under the Howey test, the investing public is anticipating profits based on the efforts of others,” Mr. Gensler told reporters after a congressional hearing. He said he wasn’t referring to any specific cryptocurrency. 

To call that a stretch is an understatement. A huge one. Because the function of proof of stake is entirely different than the function of a security.

Proof of work and proof of stake are alternative ways of operating an anonymous, trustless crypto currency. As I’ve written in several pieces here and elsewhere, eliminating the need for trusted institutions to guarantee transactions does not come for free. Those tempted to defraud must incur a cost if they do in order to be deterred. A performance bond sacrificed on non-performance or deceit is a common way to do that. Proofs of stake and work both are effectively performance bonds. With proof of work, a “miner” incurs a cost (electricity, computing resources) to get the right to add blocks to the blockchain: if a majority of other miners don’t concur with the proposal, the block is not validated, the proposing miner gets no reward, and sacrifices the expenditure required to make the proposal. Proof of stake is a more traditional sort of bond: you lose your stake if your proposal is rejected.

A security is something totally different, and serves a completely different function. (NB. I favor the “functional model of regulation” proposed by Merton many years ago. Regulation should be based on function, not institution.). The function of a security is to raise capital with a marketable instrument that can be bought and sold by third parties at mutually agreed upon prices.

So with a lot of squinting, you can say that both securities and staking mechanism involve “the efforts of others,” but to effect completely different purposes and functions. The fundamental difference in function/purpose means that even if they have something in common, they are totally different and the regulatory framework for one is totally inappropriate to the regulation of the other.

This illustrates an issue that I often come across in my work on commodities, securities, and antitrust litigation: the common confusion of sufficient and necessary conditions. Arguably profiting from the efforts of others could be a necessary condition to be considered a security. It is not, however, a sufficient condition–as Gensler is essentially advocating.

But what’s logic when there’s a regulatory empire to build, right?

I’m also at a loss to explain how Gensler could think that proof of stake involves the “efforts” (i.e., work) of others, but proof of, you know, work doesn’t.

Gensler’s “logic” would probably even embarrass Sir Bedevere:

“What also floats in water?” “A security!”

Gensler might have more of a leg to stand on when it comes to tokens. But with Bitcoin, Ether, and other similar things, hammering the crypto peg into the securities law hole is idiotic.

But never let logic stand in the way of Gary’s pursuit of his precious:

GiGi is not solely focused on crypto of course. He has many preciouses. This week the SEC released a proposed rule to mandate clearing of many cash Treasury trades.

Clearing of course has always been a mania of Gary’s. His deep affection for me no doubt dates from my extensive writing on his Ahab-like pursuit of clearing mandates in derivatives more than a decade ago. Clearing is Gensler’s hammer, and he sees in every financial problem a nail to be driven.

The problem at issue here is the periodic episodes of large price moves and illiquidity in the Treasury market in recent years, most notably in March 2020 (the subject of a JACF article by me).

Clearing is a mechanism to mitigate counterparty credit risk. There is no evidence, nor reasonable basis to believe, that counterparty credit risk precipitated these episodes, or that these episodes (whatever their cause) raised the risk of a chain reaction via a counterparty credit risk channel in cash Treasuries.

Moreover, as I have said ad nauseum, clearing and the associated margining mechanism is a major potential source of financial instability.

Indeed, as I point out in the JACF article, clearing and margin in Treasury futures and other fixed income securities markets is what threatened to turn the price (and basis) movement sparked by Covid (and policy responses to Covid) into a systemic event that required Fed intervention to prevent.

I note that as I discussed at the time, margining also contributed greatly to the instability surrounding the GameStop fiasco.

Meaning that in the name of promoting financial market stability Gensler and the SEC (the vote on the proposal was unanimous) are in fact expanding the use of the very mechanism that exacerbated the problem they are allegedly addressing.

Like the Bourbons, Gensler has learned nothing, and forgotten nothing. He has not forgotten his misbegotten notions of the consequences of clearing, and hasn’t learned what the real consequences are.

Of course these two issues do not exhaust the catalog of Gensler’s regulatory imperium. Another big one is his climate change reporting initiative. I’ll turn to that another day, but in the meantime definitely check out John Cochrane’s dismantling of that piece of GiGi’s handiwork.

As Gideon John Tucker said famously 156 years ago: “No man’s life, liberty or property are safe while the Legislature is in session.” Nor are they when Gary Gensler heads a regulatory agency.

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  1. I guess every service provider on Wall Street is actually a securities issuer.

    Comment by Highgamma — September 17, 2022 @ 1:53 pm

  2. @Highgamma. Spot on.

    Comment by cpirrong — September 17, 2022 @ 3:32 pm

  3. LOL.

    Just … beyond belief.

    What else is there that one can say?

    Bouquets for continuing the struggle to bring sweet reason to financial regulation. But you know what they say, ‘Against stupidity, the gods themselves fight in vain’.

    Thanks also for your reply to my comment in a post below, re. Germany. You’re right, the financial markets and banking sector are calm in the face of what is developing, and a bail-out is (highly) likely. My concern is that no amount of ‘printing’ will produce the energy they need to keep their industrial sectors in business: the fiat currency circulating in Germany will, once again, be next to useless for acquiring what is of most value. One’s blood runs cold just at the thought.

    Comment by Ex-Global Super-Regulator on Lunch Break — September 18, 2022 @ 10:22 pm

  4. Oh well they can burn all the broomsticks their army thoughtfully stockpiles.

    Comment by dearieme — September 19, 2022 @ 4:46 am

  5. Ethereum’s move to proof-of-stake combines with another element that opens it to capture by Gensler’s ilk. Unlike Bitcoin mining, Ethereum mining pools have economies of scale. For a mere cryptocurrency, constructing a candidate block is a simple matter of choosing the transactions with the most profitable fees, computing a Merkle tree, and start guessing nonces with your hashpower. The only reason to have pools at all is to smooth out the rate of return, and once a pool gets large enough to win, say, 10 blocks a month, the randomness there (call it “Poisson volatility”) is dwarfed by price volatility.

    Mining a smart contract platform like Ethereum, however, requires complex strategies to choose which scripts to include in your candidate block: at 15-second block intervals you can’t run every script in the pool to know how much gas it consumes (and therefore how much in fees you get) beforehand, so the mining pools have a significant fixed cost of *code analysis*. The pools therefore consolidate, the large ones become entrenched, and so on. Implicit in the crypto parlance for this dynamic, “centralization risk”, is the assumption that technical obstacles to government control is the only protection that matters; it doesn’t matter what the law is.

    Proof-of-stake aggravates the problem because seizing staked Ether is much more profitable than hunting down GPU cards. Do you think it is a coincidence that the take-down of E-gold in 2009 resulted in the government getting all the gold? Some staking pools operate in a custodial manner, or offer a token in exchange for a partial stake in a minimum 32 ETH ($43,000 at current prices) validator, so there is some potential for ICO-like hanky-panky here.

    But hey, the Ethereum world has always run on the run-fast-and-break things model.

    Comment by M. Rad. — September 19, 2022 @ 8:31 pm


    Comment by Jeff Carter (@pointsnfigures1) — September 24, 2022 @ 8:48 am

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