The SEC and Crypto

“This Framework weighed heavily in our decision to geofence the trading of some assets from U.S. customers of Poloniex” https://t.co/p9YtzrGlcT

— Fred Wilson (@fredwilson) May 24, 2019

I thought this tweetstorm from Fred was pretty good. You ought to read and contemplate the whole thing.

First, you need to understand SEC agency culture. They are very concerned with protecting retail investors.  It is job #1 to make sure they don’t get hurt.  The other thing you need to understand is, in this case, it doesn’t matter who the President is.  Agencies like the SEC are always 3-2 when it comes to political parties.  The party in power names the chairperson.  I don’t think the conservative nature of the SEC as an agency would change if a Democrat were President or even if Democrats ran the Senate.  The decision the agency made transcends politics.

Here is a different way to look at cybercurrency.  If you think that the next war is going to have a large cyber component to it, we want the liquidity and the cyber innovation inside the US borders.  It could be construed as a national security issue.  I have heard many say that we need to subsidize lots of native industries like oil or steel simply because of the component they play in defending our country.  Cybercurrency and the innovation that it develops might be just as important as Henry Ford’s Willow Run plant which built more B-24 bombers than any aircraft plant in the history of man during WW2.  Without it, the air war might have been different.

It is correct for the SEC to make sure consumers don’t get defrauded.  However, crypto innovation is really the first time that early stage innovators have run into an agency like the SEC.  Typically, innovation happens without the interference of a federal agency tasked with protecting the general public with fraud. The amount of fear that they internalize if they fall down in that mission cannot be understated.  Money, commodity, and software are all tied up into one innovative asset.  Is it one, or all three?  This can be hard to decipher.

There has been a fair amount of fraud in the community with all kinds of shenanigans.  You can hardly blame the SEC for going super slowly and being conservative about regulation.  Especially given the culture of the agency.

People might point to startups like Uber/Lyft/Airbnb encountering regulatory hurdles but the things they deal with on a regulatory basis are tiddlywinks compared to cryto and the SEC.  Crypto is a digital asset that can be used in transactions.  Because of the flexibility, it bends the curve.  It reaches around corners and does things that never were possible before.

At the same time having both some experience with SEC regulation and a lot of experience with CFTC regulation, I prefer the CFTC approach.  I wish that the SEC would apply the CFTC culture to the regulation of cryptocurrency.  The SEC is a by the book regulator.  If you have a comma out of place in your application they go bonkers.  The CFTC is a principles-based regulator.  That means there is always some wiggle room but if you hurt the customer look out-unless of course you are Jon Corzine.  Ask my friend James Koutoulas about him.

Poloniex has decided to take action by geo-fencing some crypto assets. 

I am not an attorney and don’t claim to understand the law.  However, I traded for thirty years and I have a really good idea how trading works and how exchanges operate.    I will tell you this.  When a contract gets liquidity, it is winner take most.  It is extremely rare when a contract leaves an exchange once it finds liquidity at that exchange.  When open interest is established in one place with futures contracts, it’s really hard to move it.  Here are a few real live examples.

1.  It happened in the early 1990s when the LIFFE lost all of its German debt contracts to the EUREX.  The move was caused by ethnocentricity more than anything else.  German bureaucrats and bankers decided they were going to trade German debt on a German exchange.
2. In the early 2000s, CME had a real opportunity to take the entire NYMEX down.  NYMEX didn’t have an electronic trading platform and ICE did.  ICE was starting to steal a fair amount of volume from NYMEX.   CME allowed NYMEX to list their contracts on GLOBEX and saved their exchange.  They then bought the NYMEX for $9.2B in a deal which I thought was a terrible deal for CME shareholders at the time.  CME could have competed and taken the contracts given that NYMEX had no electronic system.
3. Over the years, I have watched exchanges try to wrest control of Treasury trading from the CBOT (now CME after their merger).  They offer the contracts for free and the volume doesn’t switch.  Even when it was open outcry vs electronic, the network effects of the contract that had liquidity were so strong nothing could break them.
4. Years ago, CME and CBOT tried to compete in Agency Futures.  Because of the CBOT contract mix at the time, they had the edge.  At CME, I along with a lot of other big market makers went into the Agency contracts and tried to make markets in them.  Initially, we were winning the battle.  CBOT won, but the contracts never did amount to anything.  The problem wasn’t split liquidity, it was that the underlying cash market didn’t embrace the futures market as a go-to place to hedge risk.

Stocks are different because there are listing procedures.  However, check out the volume on certain stocks in dark pools.  The stock market is highly fragmented and while the public understands that the NYSE or NASDAQ is the “reference” price for a stock-the real price is out somewhere on an ATS away from the exchanges.

I wish that the SEC would pay attention to this part about liquidity/volume and open interest.  I know that government moves slowly and sometimes it is really hard to think out of the box but in this case they need to.  It’s not just so venture capitalists and entrepreneurs can put money in their jeans.  It’s really to drive a whole innovative sector forward and create things that we don’t even know needed creating yet.  Some of it might be beneficial to national defense and security.