James Ferguson illustration of a city skyline at night with a securities and exchange commission logo beamed from a spotlight onto the sky above skyscrapers, one featuring a Ripple logo, another Terraform and a third with ‘Leveraged Loans’.
© James Ferguson

For more than a century now, US watchdogs have policed the financial landscape, seeking to protect investors from potential fraud and the consequences of their own blind optimism.

Most of their efforts to ensure that investors get accurate information about what is happening to their money are focused on familiar products, such as stocks and bonds. But every so often an explosion of interest in new investments forces a debate about the regulatory perimeter and whether to expand it. This is one of those moments.

Right now, the US Securities and Exchange is fighting on multiple fronts to bring enforcement cases involving cryptocurrencies, while a completely separate lawsuit is seeking to upend more than 30 years of practice in the leveraged loan market.

The laudable goal is investor protection. The volatility of bitcoin and other tokens and the implosion of the FTX crypto exchange have cost investors billions; and a bankruptcy trustee is seeking to recover money for loan investors left holding the bag when a drug testing firm went belly up after being investigated for fraud.

It’s natural to want to sweep these products into the ambit of the SEC, the US’s best known financial regulator and one charged specifically with investor protection. But the laws around this are far from clear, and the consequences of overreach could be devastating for efforts to keep American markets fair and stable.

Despite the enormous stakes, both fights essentially turn on the arcane question of what is meant by the word “securities”. Prompted by an explosion of speculative investments in the early 20th century, individual states sought to crack down on “schemes which have no more basis than so many feet of blue sky,” as an early case put it. State laws set requirements for investment contracts, and Congress followed up in the 1930s by creating the SEC and set national standards that apply to product sponsors and the brokers and exchanges that sell them.

But there’s a rub: most of these protections, and the SEC’s policing power, only apply when customers are investing in securities. Stocks and bonds are explicitly named in the original 1933 federal law, while commodities, wine and baseball cards clearly do not count. The key standard for more esoteric investment contracts is known as the Howey test for a nearly 80-year Supreme Court case involving Florida citrus groves. It says that a security involves a promise by the promoters to do something specific to generate profits for the investors.

Lawyers have been fighting about the fine points ever since. Usually product sellers seek to evade scrutiny, while buyers look to bring it on. “If it’s a security, it is subject to much more rigorous regulation [and] it’s easier to prove wrongdoing,” explains Ann Lipton of Tulane Law School.

Crypto has scrambled the conversation. SEC officials initially washed their hands of some digital assets, contending they were not securities. But it has more recently taken its customary crackdown role with cases against Binance, Coinbase, Ripple Labs and other crypto exchanges and sponsors. The watchdogs argue that they are failing to provide customers with the safeguards required when trading in securities.

Some crypto proponents warn this is regulatory overreach that will end up leaving investors less protected. Many tokens have become fully detached from their original creators — or, like bitcoin, never had a single sponsor to begin with. They are unlikely to meet the SEC’s requirements for US securities trading. “Treating tokens as securities is effectively prohibition,” says Lewis Cohen of DLx Law. “Trying to tell people not to do what they want to do doesn’t make sense and isn’t effective”.

The leveraged loan case has also muddied the waters. Since a 1992 court case found that packages of loans to risky companies were not securities, a $1.4tn market has sprung up. Buyers knowingly forgo the protections they would get while buying bonds issued by the same borrowers and even sign what are known as “big boy” letters acknowledging what they are giving up.

Expanded investor protection is normally a reason to cheer, but these efforts to push out the regulatory perimeter are fraught with risk, particularly for the SEC. Treasury officials reportedly asked the watchdog not to weigh in on the leverage loan case because they are worried that tightening the rules would destabilise already shaky corporate debt markets.

The SEC’s aggressive crypto enforcement approach was partly rejected by a federal judge in New York last month. It also has some in Congress complaining in legal briefs about an end run around the legislature’s power to write securities laws. The SEC’s appeal could create an opening for the conservative Supreme Court majority, which is already talking about regulatory overreach, to crimp SEC authority on a wider range of issues.

Congress should write new rules that specifically empower the SEC to set crypto standards. Until that happens, the watchdog can help enthusiasts in other ways. Several large asset managers want to offer exchange traded funds that invest in bitcoin. If approved by the SEC, these would without doubt qualify as securities, allowing people to put money into digital assets while still under the agency’s aegis. Trying to shoehorn new asset classes into old definitions is not the wisest course.


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