Crypto Wants Some SEC Rules

Crypto rules

wrote last Thursday about a speech that Gary Gensler, the chair of the US Securities and Exchange Commission, gave about securities regulation and crypto. My basic point was that Gensler wants the SEC to have jurisdiction over basically all of crypto, because basically every crypto token is a security, but that he does not seem to have any interest in writing new rules to accommodate the crypto market. Gensler’s approach would put the SEC in charge of crypto, and then more or less ban crypto, and I am not sure that is a winning position for him to take.

Today I want to come back to one bit of Gensler’s speech that I think represents an important philosophical disconnect between the SEC and the crypto world. Gensler said:

I’ve asked the SEC staff to work directly with entrepreneurs to get their tokens registered and regulated, where appropriate, as securities. ...

Given the nature of crypto investments, I recognize that it may be appropriate to be flexible in applying existing disclosure requirements. Tailored disclosures exist elsewhere — for example, asset-backed securities disclosure differs from that for equities.

What I said on Thursday was that the SEC does not seem to have actually been doing any of that tailoring. I wrote:

The SEC has been suing crypto projects for illegally issuing securities for about five years now, but in that time it has not issued any rules, or proposed any rules, or put anything on its rulemaking agenda, about adapting the securities disclosure rules to crypto projects.

But arguably that slightly misrepresents what Gensler said. He didn’t say “I have asked the staff to write rules that will let entrepreneurs register tokens.” He said “I’ve asked the SEC staff to work directly with entrepreneurs to get their tokens registered.” Gensler’s paradigm is not that the SEC will write rules, and you can read them and follow them and register your tokens. The paradigm is that you walk into the SEC’s office and say “here’s a token, can you help me figure out how to register it,” and they do. There was no suggestion of new rules, but of good customer service in adapting, interpreting or perhaps waiving old rules.

Now. One objection to this might be that it’s empirically untrue; certainly lots of crypto entrepreneurs think that the SEC is very unhelpful in helping them figure out how to comply with existing rules. The stereotype is that, if you walk into the SEC to ask about doing a compliant crypto thing, you either get told not to do it at all, or you find a path to doing it legally but you have to pay a big fine first. The incentives are bad.

But here I want to focus on a different objection. The objection that I want to make here is that Gensler’s offer — “come talk to us and maybe we can be flexible to adapt the rules and figure out a way to register your tokens” — is not what crypto people want, even if he really means it.

The ethos of crypto is about decentralization and public code. You can read the Ethereum white paper and related standards and learn about how Ethereum works and then go off and build a decentralized options exchange or a lending platform or a pyramid scheme or whatever else you want on Ethereum. You don’t have to set up a meeting with Vitalik Buterin and get his approval; you just do it. The requirements are open and public, and if you meet them you can do what you want.

This is something that crypto people take seriously. People talk about “permissionless innovation,” and about how easy it is to build new businesses in crypto compared to the legacy financial system. If you are a young person with an idea for a crypto product, you can code it up and make it work with existing blockchains and protocols. Everyone has the same access to the blockchain as everyone else; everything is set up, by default, to work for everybody. If you want to run a stock trading fund, you can spend months negotiating credit terms with a prime broker and getting set up for access to the stock exchanges. If you want to run a crypto trading fund, you can trade on decentralized exchanges and get leveraged from decentralized lending platforms. Everything just sort of plugs in and works, because it is built on a model of trustless blockchains and open access and public code.

In principle securities regulation could be similarly open, and in practice, locally, in most places, it is. There are rules about, for instance, when an activist shareholder has to disclose her position in a company and what information she needs to include; you can read those rules (or hire a lawyer to read them), and follow them, and that’s it. You don’t need to meet with the SEC to negotiate that disclosure; you just follow the publicly available, reasonably clear rules. (Or you don’t if you’re Elon Musk, but that’s another issue.) 

But there are also a lot of places in securities law where the rules are a little bit vague and you are operating a little bit on the cutting edge and the best practice is to pick up the phone and call the SEC staff and say “hey what do you think about this?” Sometimes this is fairly formalized: The SEC staff issues “no-action letters” (you send them a letter saying “is it okay if we do this,” and they send back a letter saying “if you do that, we probably won’t sue you,” which is almost as good as them saying “yes”) and “telephone interpretations” (you call them up and ask “is it okay if we do this,” they say “sure seems fine” or “no that’s bad,” and then they write down the question and answer so other people with the same question don’t have to ask it again). These are places where the rules are unclear, or they clear but applying them as written would create bad results, so the solution is to ask the SEC “is it okay if we do this” and they just tell you.

Sometimes it’s less formal. Your lawyer calls an SEC lawyer and has an informal chat about the issues raised by whatever you’ve got cooking, and the SEC staff raises some concerns, and you work to address those concerns, and eventually the SEC staffers say “yeah this seems fine now” and you do it. And, as you’d expect, these sorts of informal contacts tend to work better for certain sorts of people. If you are a big firm who can hire good lawyers (perhaps ones who used to work at the SEC), that’s good. If you are a big incumbent who has a reputation for knowing what you’re doing, and a lot to lose if you mess up, that’s good. If you’re a couple of 20-somethings with no track record, it might be hard to get the SEC to take you seriously, and they might be suspicious of what you’re up to.

Many things in crypto are (1) on the cutting edge of securities regulation and (2) done by a couple of 20-somethings with no track record. So the offer of “come in and chat with the SEC” is less appealing to them than it would be to, you know, Goldman Sachs Group Inc.

Crypto people want rules! I don’t mean that they want to be regulated; I mean, specifically, that they want . They want published, objectively specified, open and transparent rules, so that everyone is on a level playing field to do crypto stuff that complies with whatever the rules are. I don’t mean that everyone in crypto wants that: Informal regulation favors the well-capitalized and the incumbent, and if you’re a big crypto firm on good terms with the SEC (which might be an empty set) you might prefer informality and opacity. I just mean that, philosophically, crypto people want open transparent rules for permissionless innovation. That is how the crypto system is designed to work, and they should want the securities laws to work the same way. And in fact COINBASE Global Inc., which is maybe the closest thing the US crypto industry has to a big regulated incumbent, has sent the SEC a petition asking it to make rules for crypto securities. 

Temperamentally I do not think the SEC likes this, and I think that Gensler means what he says about “working directly with entrepreneurs,” and I think that this is a reasoned choice. Look at how crypto often works in practice. People write smart contracts with immutable public code, and then other people hack them to steal their money. That could be the SEC! If you are the SEC, and crypto people say “please write clear transparent rules so we know what is and isn’t allowed,” you might hear that as “please write clear transparent rules so that we can game them.” This would be a reasonable lesson for the SEC to take from (1) the history of crypto’s “code is law” philosophy ending in hacks, (2) the history of crypto firms ignoring the US securities laws, and for that matter (3) the history of traditional finance firms trying to game the SEC’s rules. Crypto is a wholly new area for US securities regulation, and if you try to write all the rules from scratch in one go you will get things wrong. And then people will ruthlessly exploit whatever you get wrong.

For the SEC, having the rules develop informally by a process of collaboration makes sense. Someone comes in and says “can we do X?” You meet them. You ask them questions. You look them in the eye. You look at their backgrounds and their backers and get a sense of whether they are good people. (The fact that they came to you suggests that they to be compliant; people who just read the rules on their own might be dodging your scrutiny.) They tell you what they’re doing and you evaluate it and you say “sure yeah that seems fine, for you.” They go off and do it and you see if it works. If it works out okay, then you are a little bit more generous to the next person who walks into your office looking to do something similar. If it works out terribly, then you walk it back. You proceed incrementally, by trial and error, evaluating each request not just on how well it complies with the specific written rules but on what you think about the project, its promoters and their motivations. If some big regulated public company shows up at your office with a bunch of former SEC lawyers and asks to do a thing, you might let them. If two scruffy 20-somethings show up at your office with no lawyers at all and ask to do the same thing, you might not. These choices might be totally rational as a matter of investor protection and incremental development of the rules in a new area. 

Philosophically I sympathize with the crypto industry here: There should be clear rules that are open and available to everyone. Practically I am pretty sympathetic to the SEC. But mostly I just want to point out that there is a disconnect. And if your vision of crypto is about disrupting the traditional financial system, then this might look like the SEC protecting the traditional system from disruption. “Just come in and talk to us,” the SEC says, but you might hear that as “you can’t do anything in crypto without talking to us first.” 

Twitter vote

Twitter Inc.’s shareholders are voting today on whether to sell the company to Elon Musk at $54.20 per share. Twitter closed yesterday at $41.41 per share. There is not much suspense here. If you have stock that is worth $41.41 per share, and someone wants to buy it from you at $54.20, you should let him. Twitter is easily going to get its votes. 1  The Wall Street Journal reports

Early votes show investors approving the deal by a wide margin, the people said, though there is always a chance that the results could change as shareholders can alter their votes through a meeting scheduled for Tuesday at 1 p.m. Eastern time.

I do not actually think there’s much chance that the results could change. If you are a Twitter shareholder, what could possibly happen between now and 1 p.m. that would make you want to cash out at $54.20?

There are a few complications. One is that news is definitely happening about Twitter today. Peiter “Mudge” Zatko, Twitter’s former head of security who has turned whistle-blower, testified in Congress today about how bad Twitter’s security is. But nothing that he says is going to make Twitter shareholders likely to vote for the deal. The worse Twitter is, the more excited you should be about getting $54.20 for your Twitter shares. If Zatko showed up at this hearing and said “actually Twitter’s security is great and they’ve discovered cold fusion” then I guess you should vote to keep your shares; in a world where Twitter is worth much more than $54.20 on its own, the vote will probably fail. But he didn’t say that.

Another complication is that, of course, voting to sell to Musk at $54.20 doesn’t mean it’ll actually happen. Musk has terminated the deal (three times!) because he claims that Twitter has breached some conditions and so he doesn’t have to actually buy it; a Delaware court will decide if he’s right about any of those things. I tend to think that he’s wrong and will have to close, but I don’t have especially huge confidence in that belief, and the market-implied odds aren’t that great, which is why the stock is trading at $41.41. Still, if you are a Twitter shareholder, you have to vote yes on the deal, because if everyone votes no then the deal is definitely dead; if shareholders don’t approve the deal, that gives Musk a fourth and unassailable reason for terminating it. 2  The shareholders voting to close the deal is a necessary but not sufficient condition to the deal closing. Which is why they’ll vote yes.

A third complication is that Twitter’s biggest shareholder is, uh, Elon Musk, 3  and he’s trying to get out of the deal. Could he vote his 9.5% stake in Twitter against the deal, thus preventing it from closing? Well. The merger agreement (section 6.2(d)) says that he has to vote in favor of the deal, but he claims to have terminated the agreement (three times!) so perhaps he no longer feels bound by that, and it is a bit awkward for him to vote yes on a deal that he wants to get out of. What will he do? Eh, it doesn’t really matter; I’m pretty sure that Twitter is going to get a huge majority and won’t actually need Musk’s votes.

Twitter whistle-blower

Surely the highest-variance aspect of the Twitter vs. Musk saga is Zatko’s whistle-blower complaint. If Zatko can make a compelling case that Twitter is horribly bad — that its information security is so bad that it violates the law, that it has fraudulently concealed its problems, etc. — then that is probably Musk’s best argument to get out of the deal: Twitter is doing fraud, it has suffered a material adverse effect, etc. If Zatko is just a run-of-the-mill paranoid security researcher who is aggrieved about being fired and making mountains out of molehills, then his complaint will quickly be kicked out of court and won’t affect the Musk deal. Zatko’s credibility — whether he’s telling the truth, and also whether he is exaggerating or underselling the importance of Twitter’s problems — is a key input into your evaluation of Twitter’s stock value. The more credible he is, the less likely it is that Twitter will get $54.20 per share, and the less Twitter will be worth without Musk’s deal.

So if you are a hedge fund, or an expert-network firm working on behalf of hedge funds, you obviously want to know how credible he is. You might, for instance, want to talk to some of his old coworkers to get a feel for him. You might offer to pay them a lot of money for a one-hour phone call, because you might have a lot of money riding on the Twitter deal, which means specifically that you have a lot of money riding on your evaluation of Zatko’s credibility.

At the New Yorker, Ronan Farrow has a story on “The Search for Dirt on the Twitter Whistle-Blower

The dozens of e-mails and LinkedIn messages received by people in Zatko’s professional orbit appeared to be mostly from research-and-advisory companies, part of a burgeoning industry whose clients include investment firms and individuals jockeying for financial advantage through information. At least six research outfits—Gerson Lehrman Group (G.L.G.), AlphaSights, Mosaic Research Management, Ridgetop Research, Coleman Research Group, and Guidepoint—approached former colleagues of Zatko’s at Stripe, Google, and the Pentagon research agency DARPA. All offered to pay for information, sometimes noting that the compensation would be high or apparently unrestricted. At least two investment firms, Farallon Capital Management L.L.C. and Pentwater Capital Management L.P., also sought information from individuals close to Zatko.

I have to say that Farrow, and Zatko’s former coworkers, seem a lot more shocked by this than I am. Yes, right now, for a series of weird reasons, information about whether Peiter Zatko is or is not a good guy is incredibly valuable to hedge funds, and they will pay “high or apparently unrestricted” amounts of money for some informal chats with his former colleagues about their impressions of the guy. Sometimes that is how financial markets work. You get paid for incorporating information into prices. 

That said I particularly enjoyed this reaction:

Two members of Musk’s team, who asked not to be named, owing to the sensitivity of the ongoing litigation, said that they also had no connection to the inquiries. “There’s a lot of hedge funds currently betting that the deal flows. And so they’re doing everything they possibly can to undermine that not happening,” one of them told me. “It’s obviously wrong. You can’t discredit a witness, as opposed to listening to what he has to say and taking seriously these security threats. . . . That should be the priority, not making a buck.”

Yeah no of course, right, Elon Musk’s priority in evaluating Zatko’s complaint is solely about “taking seriously these security threats”; he has no economic interest at all in Zatko’s credibility and is just dispassionately following the truth wherever it leads.

People are worried about bond market liquidity

This theme is having a nice little comeback

Pacific Investment Management Co. is advocating a radical solution to fix the liquidity woes plaguing the world of bonds: The entire $23.7 trillion Treasury market should move to a model where investors can transact directly with each other -- reducing their unhealthy dependence on balance-sheet-constrained banks.

Among other suggestions, a report from the nearly $2 trillion asset manager urges Janet Yellen’s Treasury Department and other regulators to help create alternative avenues that would allow traders to find buyers and sellers when the primary dealers who normally handle large orders are unable to do so.

“We would like the entire Treasury market to move to all-to-all trading -- a platform where asset managers, dealers, and non-bank liquidity providers are able to trade on a level playing field, with equal access to information,” wrote Pimco’s Libby Cantrill, Tim Crowley, Jerry Woytash, Jerome Schneider and Rick Chan. “The vast majority of the bond market, including most parts of the Treasury market, liquidity remains intermediated, making the market more fragile, less liquid, and more susceptible to shocks.”

Here is the report. When I was young and naive, I thought that “all-to-all trading” meant that big asset managers like Pimco would want to sell bonds, and big asset managers like BlackRock Inc. would want to buy bonds, and they would meet on some sort of exchange platform and trade bonds with each other. But the stock market is all-to-all, and it’s mostly big asset managers trading stocks with intermediaries: High-frequency traders buy from the sellers and sell to the buyers. I suppose it’s more electronic and competitive — the HFTs are largely “non-bank liquidity providers” — but still, it’s not easy to get rid of middlemen.

How M&A happens

Last week Anthony Scaramucci’s SkyBridge Capital announced that Sam Bankman-Fried’s FTX Ventures would acquire 30% of SkyBridge; the deal apparently also includes an option for FTX to buy 85% of SkyBridge. From the outside it is not hard to guess at the motivations of the principals. Bankman-Fried has lots of money and has been an opportunistic acquirer in a crypto bear market; buying SkyBridge presumably gives him some more mainstream distribution for crypto products. Scaramucci has had a rough year and needs the money; the Financial Times reports

Scaramucci said that the FTX deal was a product of poor performance in a poor market. SkyBridge, which has $2.8bn in assets under management, is down 25 per cent this year, he said.

“Bear markets suck,” he added. “If I was doing super-well right now — our performance is mediocre, lacklustre — who knows if we would be doing the transaction.”

But there was also another motivation. The FT article goes on:

Scaramucci said the transaction was decided over a two-hour lunch at a hotel in the Bahamas, where Bankman-Fried is based. Scaramucci was with his family on a Disney cruise that had docked in the islands.

He said he proposed lunch to discuss the possibility of a partnership, as well as to avoid going to a water park with his children.

What percentage of mergers and acquisitions do you think are driven by people trying to avoid spending time with their children? 

Things happen

Inflation Tops Forecasts, Cementing Odds of Big Fed Hike. Congresspeople just love trading individual stocks. U.S. Banks Lost a Record $370 Billion in Deposits Last Quarter. How Wall Street stormed the music business. Wall Street-Backed Crypto Exchange EDX Markets Is Set for November Debut. KKR Makes Piece of PE Fund Available on Public Blockchain. Fidelity Weighs Bitcoin Trading on Brokerage Platform. SEC Charges with Misleading Investors by Obscuring Financial Performance. Tippee Pleads Guilty In First Ever Cryptocurrency Insider Trading Case. Beware Ryan Cohen, the Meme-Stock King. The Billionaire Hedge Fund Manager Who Wants to Build NFL Rosters

If you'd like to get Money Stuff in handy email form, right in your inbox, please subscribe at this link. Or you can subscribe to Money Stuff and other great Bloomberg newsletters . Thanks!

1. This is different from Digital World Acquisition Corp., the special purpose acquisition company that has a deal to buy Donald Trump’s social media company and can’t get the votes to extend the deadline to complete that deal, for a couple of reasons. The main one is probably that Twitter is owned by index funds, merger arbitrageurs and other institutions, while DWAC is mainly owned by retail Trump enthusiasts, who tend not to vote. But also voting on a merger is slightly more salient than voting on a necessary extension to complete that merger. “Do you want $54.20” is a simple question; “do you want to delay a year to have a good chance of getting $25-ish of value rather than getting $10.20 next week” is more confusing.

2. See section 8.1(b)(iii) of the merger agreement, which unlike some of Musk’s other termination rights is not qualified by the requirement that *he* not be in breach of his obligations.

3. The link in that sentence goes to Twitter’s merger proxy, which lists Vanguard Group as the biggest shareholder, a footnote cites to an April 8 Vanguard filing for Vanguard’s holdings. Bloomberg’s HDS page shows Vanguard disposing of some shares after that filing but before the record date for the Twitter meeting, leaving Musk as the biggest shareholder. Either way it’s close though.

To contact the author of this story:

Matt Levine[email protected]

To contact the editor responsible for this story:

Brooke Sample[email protected]