“With the right vibes and the right people, it's easy to create something magical.” – Dinah Jane
A simplified way to view the investment universe is to partition it into private and public markets. In the private market, sophisticated investors interact with each other in an ad hoc manner, cutting customized deals where terms can be just as important as price. Private markets are generally restricted to accredited investors—participants whose income or net worth exceeds defined thresholds—and regulatory oversight is light. The opportunity for outsized returns is significant, but transactions are sporadic and tethered to counterparty and liquidity risk. Rare is the private investor who hasn’t been stiffed on a deal, and rarer still is one who has mustered regulators to do something about a deal gone wrong.
In contrast, public markets involve the trading of highly standardized contracts (i.e., securities) between willing investors—sophisticated or otherwise. Exchanges, clearinghouses, and custodians are heavily regulated, and investor protections are high. Supported by the resulting confidence in the system, public markets offer superior trade execution, outstanding liquidity, and far less counterparty risk. People don’t spend much time worrying about the solvency or propriety of Fidelity, for example, and if Fidelity ran into problems, the Securities Investor Protection Corporation (SIPC) would be there to help make things right.
While private investors may envy the liquidity of public markets, moving from the former to the latter comes with a heavy fee. Standing as the gatekeeper between the two investment sectors in the US is the formidable Securities and Exchange Commission (SEC), whose primary mission is to protect individual investors by requiring proper and thorough disclosures from companies looking to tap the public capital markets. Selling securities to non-accredited US investors without first registering with the SEC is to cross one of the brightest of the regulator’s red lines, and those who do so should expect to face an avalanche of enforcement action.
Among the class of investors who should have the clearest understanding of the rules of this particular road are venture capitalists. Venture capital’s very business model is predicated on shepherding startups through private development in the hope of someday cashing in on the liquidity provided by an initial public offering (IPO). The SEC’s registration process is notoriously intrusive, and preparing a startup for that onslaught is a necessary difficulty.
During the apex of the recent crypto mania, many in the venture capital community behaved as though they had the cheat codes to this vexing challenge. By investing in tokens tied to exciting new cryptocurrency startups, getting those tokens listed on legally dubious cryptocurrency exchanges like FTX and Binance, and then publicly pumping the tokens’ prospects, several high-profile venture capitalists unloaded their holdings near the top for windfalls measured in the billions, all while denying the jurisdictional oversight of the SEC.
It seemed too good to be true, and SEC Chair Gary Gensler is out to prove that, indeed, it was.
Over the last several months, Gensler’s SEC has embarked on a historic crackdown on the crypto sector, sending shockwaves across the investment community. While many have settled charges, others have committed to fighting the SEC in court. The entire crux of the matter boils down to one simple question: are crypto tokens securities? If courts rule that they are, a bunch of people—even some high-profile venture capitalists—might find themselves in serious legal jeopardy. Let’s ponder the question ourselves.