Crypto On Trial: The SEC v. Coinbase
All underlined terms are explained in the footnotes at the end of this article.
TL;DR: In an unexpected twist in the world of cryptocurrency, the U.S. Securities and Exchange Commission (SEC) has turned its scrutinizing gaze towards Coinbase - a highly respected U.S. crypto trading platform - accusing it of functioning as an unregistered securities exchange, broker, and clearing agency. It's a curveball that could have far-reaching implications, not just for cryptocurrencies, but also for the future of blockchain technology in the U.S. At the heart of the issue are questions around whether Coinbase's operations fall within the SEC's traditional definitions and rules, many of which were established in a pre-crypto era. Despite the SEC's accusations, Coinbase CEO Brian Armstrong remains resolute, defending the company's transparency and commitment to regulations while calling into question the applicability of nearly century-old definitions to modern blockchain technology. Dive into this article to explore the complexities of this lawsuit, its potential impact on the global crypto landscape, and why, despite the looming court battle, it's 'business as usual' at Coinbase.
The SEC v. Coinbase.
In the past few weeks, the U.S. Securities & Exchange Commission, colloquially known as "The SEC," has once again directed its incisive gaze towards what seems to be the perpetual thorn in its side: crypto. This time, caught in the crosshairs are the renowned international cryptocurrency exchange, Binance, and—quite unexpectedly—the highly respected U.S.-based cryptocurrency trading platform, Coinbase.
The scrutiny on Binance didn't catch many off guard, given its somewhat tarnished regulatory track record on the international stage, compounded by a pervasive undercurrent of sinophobia within U.S. regulatory circles. This seemingly set a countdown for Binance quite some time ago. However, the focus on Coinbase was a curveball that caught many by surprise. In this article, we'll be honing in on Coinbase, as the implications of the current regulatory actions extend far beyond just the realm of cryptocurrencies. They could significantly impact the development and adoption of blockchain technology across the United States, dethroning us as a global leader in the space.
What did Coinbase do (allegedly)?
The SEC has accused Coinbase of functioning as an unregistered national securities exchange, securities broker, and clearing agency. According to the allegations, Coinbase has jeopardized investors by not delivering the appropriate disclosures or protections. In simple terms, the SEC is asserting that Coinbase has been operating in the financial sector's playground without the required licensing.
Moreover, the SEC has accused Coinbase of neglecting to register its crypto-asset staking-as-a-service program as a security with the regulatory body. Since 2019, Coinbase has been running the program, enabling customers to earn extra income by staking their cryptocurrencies and bolstering various blockchain networks. The SEC argues that Coinbase was fully aware of these laws and deliberately chose to disregard them. As stated by Gurbir S. Grewal, Director of the SEC’s Division of Enforcement:
You simply can’t ignore the rules because you don’t like them or because you’d prefer different ones: the consequences for the investing public are far too great…As alleged in our complaint, Coinbase was fully aware of the applicability of the federal securities laws to its business activities, but deliberately refused to follow them. While Coinbase’s calculated decisions may have allowed it to earn billions, it’s done so at the expense of investors by depriving them of the protections to which they are entitled. Today’s action seeks to hold Coinbase accountable for its choices.
In essence, the SEC is alleging that, since 2019, Coinbase has been enabling the buying and selling of securities, illicitly merging the traditional roles of an exchange, broker, and clearing agency, all without registering these functions with the SEC. To quote SEC Chair Gary Gensler:
We allege that Coinbase, despite being subject to the securities laws, commingled and unlawfully offered exchange, broker-dealer, and clearinghouse functions. In other parts of our securities markets, these functions are separate. Coinbase’s alleged failures deprive investors of critical protections, including rulebooks that prevent fraud and manipulation, proper disclosure, safeguards against conflicts of interest, and routine inspection by the SEC.
In summary, the SEC is arguing that Coinbase consciously sidestepped the rules, consequently depriving investors of the safeguards they are rightfully entitled to.
What does Coinbase have to say about this?
As you might expect, Coinbase's co-founder and CEO, Brian Armstrong, isn't taking these allegations lying down. He fully intends to contest the charges outlined in the SEC's initial release, and has assured that they're prepared to take the battle to court, declaring in his own words that they're “gonna be fine going to the court.”
Firstly, Armstrong and his team at Coinbase maintain that they've made consistent efforts to cooperate openly and honestly with the SEC over the years. They’ve responded to queries and willingly provided transparency into their business operations when requested. Yet, they assert that the regulator has frequently responded with silence and indifference. During a discussion at the Bloomberg Invest conference, Armstrong revealed that the SEC's attitude had shifted during discussions last year, prompting Coinbase to increase their level of engagement. Nevertheless, he was taken aback when the lawsuit arrived because, as he put it, "They started to come to us with more questions about the business, so we were very forthcoming. Unfortunately, we were met with silence."
Secondly, despite the SEC's claim that Coinbase traded 13 unregistered securities, Armstrong points out that these represent only a "relatively small percentage of the assets we trade" on their platform, which hosts over 200 different assets. There are still considerable uncertainties surrounding whether the 13 assets in question are even classified as securities—a topic we will delve into later.
Thirdly, Coinbase has been a publicly traded firm since 2021, which means they've undergone a comprehensive review of their business and financial operations by none other than...The SEC. This detail hasn't slipped past Coinbase, who have quickly highlighted that if the SEC had no concerns with their business during their public offering process and has not raised any issues over the past couple of years, then why has their stance suddenly shifted?
Now, you may be wondering whether all this legal wrangling is deterring Coinbase's customers or banking partners, but according to Armstrong, there's no indication of that happening. "I think all of our partners have been very thoughtful working with us," he stated. Despite threats of regulatory action from some states (a common occurrence following SEC action, as state securities authorities vie to assert their relevance), Armstrong remains unyielding. He stated, "We are not going to wind down our staking services. As these court cases play out, it’s really business as usual.”
It seems that Coinbase is prepared for a showdown. With a market cap of over $13 Billion, and more than $3 billion in annual revenues to fund operations and cover legal fees, it's evident that Coinbase isn't going to back down without a fight.
Is Coinbase acting as an Exchange, Broker, and Clearing house?
According to the SEC, Coinbase is operating as an unregistered securities exchange, broker, and clearing agency, and offering an unregistered securities program through its staking-as-a-service. The SEC considers this a problem because it implies that Coinbase isn't providing investors with the protections they are due.
But here's the catch: the realm of crypto operates in mostly stark contrast to traditional securities markets, and a majority of the SEC's regulations are constructed on principles established back in the 1930s. Cryptocurrency exchanges like Coinbase do not operate in the same manner as traditional exchanges such as the New York Stock Exchange or NASDAQ. These traditional exchanges are centralized and require intermediaries for clearing & settling transactions. Crypto exchanges, by contrast, are decentralized and self-clearing, a function enabled by blockchain technology.
So what does this mean? In a conventional exchange like the NYSE, all trading is executed directly by the NYSE. Only NYSE member firms can trade, and each time a stock is traded, the NYSE executes the trade within its own centralized system. In the world of cryptocurrencies, assets are not controlled by a single entity. Firms like Coinbase act more like access providers to a network they don't control, rather than the actual network itself, which is the case with traditional exchanges.
And what about Coinbase serving as a broker? In traditional markets, brokers provide access to the markets, buying securities on your behalf; one can't simply walk onto the floor of the NYSE to place a trade. To a certain extent, the SEC is correct—Coinbase does perform many broker-like actions. However, unlike traditional markets, a significant portion of crypto trading occurs directly peer-to-peer. Although Coinbase facilitates these trades by providing network access, it is less clear that it is actually acting as a true broker (in the context of the SEC’s nearly century-old definition).
As for acting as a clearinghouse, this area becomes even more interesting. In the traditional assets arena, clearinghouses are used to ensure that both parties possess the assets and funds they claim to have, allowing a trade to "clear" without issue—akin to an escrow service. But on a blockchain, clearing and settlement are handled directly by the chain itself. It's a "trustless system", meaning parties can interact directly and don't need to use third-party services to handle transactions. If one party doesn't possess the required assets or funds, the transaction simply won't occur—cryptocurrency assets are therefore "self-clearing." Hence, for the SEC to level this accusation against Coinbase seems both anachronistic and out of touch with the technological reality of blockchain.
Are the 13 assets securities?
I'm just going to cut to the chase—yes, they are; the SEC has a point on this one. The crux of the issue is that, until now, the classification of crypto assets has been shrouded in ambiguity, with various agencies claiming or disclaiming jurisdiction over these assets. Some categorize them as currencies, some as commodities (akin to gold or grain), and others still see them as securities. Even on an international scale, this question remains unresolved, with global agencies and regulators widely differing in their perceptions and regulations of crypto assets.
But the most accurate response is: "it depends." Some cryptocurrencies behave like commodities (Bitcoin, for example), some function as currencies (like the stable coin USDC), while others can undoubtedly be classified as securities. The determination largely hinges on the inherent activities associated with the token—in other words, its purpose. The purposes of various crypto tokens are as diverse and varied as our economy: some are used to trade or store value, others serve as financial stabilizers, some function as company shares (as seen in Decentralized Autonomous Organizations, "DAOs"), and others operate as outright Ponzi schemes. Many tokens encompass a mix of these uses, adding to the complexity; they're not as straightforward and neat as traditional assets.
The crux of the issue - really old paperwork.
At the heart of the matter, both Coinbase and the SEC possess a measure of truth. The SEC rightfully contends that Coinbase—and the broader crypto industry—is falling short in properly registering assets, services, and systems. Yet Coinbase counters with a valid observation: the SEC appears indifferent to their overtures for dialogue and regulatory adjustments, and therein lies the core issue. Many of the SEC's registration paperwork and processes simply don't align with the distinctive traits of blockchain.
Take, for instance, the quandary of registering a decentralized security. In the conventional world, the issuer registers the security, offering investors regular updates with refreshed data and disclosures. For a centralized entity like Tesla, this process is straightforward—there's a board, a main office, a legal department, and a centralized accounting system. However, such infrastructures often don't exist for many decentralized entities. These entities might be managed by individuals scattered around the world, with no central address, possibly even unaware of each other's identities. Sometimes, the so-called securities aren't even run by humans but are controlled by algorithms, requiring minimal human intervention. In such instances, who registers? Where's the "head office"? Who assumes responsibility?
Now let’s consider the question of brokerage. The SEC mandates that all US brokers register. The fundamental role of a broker is to safeguard their customers' interests and facilitate seamless access to markets. But if you and I can directly trade on a blockchain from wallet to wallet, who is the broker? Is there even a need for one? Moreover, who serves as the exchange? Is an exchange necessary? In the decentralized, digital, and innately international realm of cryptocurrency, who, then, has the authority to regulate such entities?
These profound questions probe the very fabric of our established financial systems, and instead of adapting or even initiating discussions around regulatory modifications to address them, the SEC appears steadfast, relentlessly wielding the same dated 90-year-old rulebook to tackle this contemporary issue.
Is the SEC really to blame?
The brief answer is: yes, but also no, yet also, yes.
As previously discussed, the SEC is compounding an already complex problem by persistently refusing to update regulatory standards to allow crypto companies to easily comply, and this is negatively impacting the U.S. economy. Since 2018, there has been a 26% drop in global crypto development headquartered in the U.S., and this downward trend shows no signs of abating. Most of these issues are tied to regulatory challenges in the U.S., coupled with friendlier regulatory environments abroad—some of which are proactively nurturing crypto development. Kraken's CEO, Jesse Powell, observed, "A lot of companies are looking to domicile outside of the U.S. because they're seeing a lot of benefits from friendlier regulations in these foreign jurisdictions." This stands in stark contrast to the U.S.'s regulatory stance towards the internet during the 1990s, which largely permitted the internet to thrive outside of obsolete regulations, only beginning to retroactively implement thoughtful regulations once a clear understanding of the internet's functioning had been established.
However, the SEC is not entirely at fault. The SEC enforces laws dictated by Congress, and Congress has remained mostly mute on the specific issue of cryptocurrencies. In fact, some analysts speculate that the current surge in seemingly indiscriminate SEC enforcement actions is a desperate attempt by the SEC to create enough commotion to spur Congress into action. But so far, there has been no substantial move in this direction. What's tragic is that, in its blind attempt to gain control over the industry, the SEC has initiated—and will likely continue—regulation by enforcement, given that it has few other options. This approach will likely deter more crypto companies, further diminishing the USA's chances of becoming a leader in the burgeoning blockchain industry.
However, don't be too quick to sympathize with the SEC. Their overall attitude towards the matter has been less than commendable, and they've shown little initiative to understand the technology, despite their crucial role as financial market regulators. While some voices within the SEC—like Commissioner Hester Peirce—have been advocating for a more patient and considered approach to crypto regulation, the majority of SEC board members, especially its chairman Gary Gensler, have been openly and vocally anti-crypto. In a recent CNBC interview, Gensler remarked—in reference to cryptocurrencies in general—“Look, we don’t need more digital currency. We already have digital currency. It’s called the U.S. dollar. It’s called the euro or it’s called the yen; they’re all digital right now. We already have digital investments.”
While some readers might agree with him, I assure you his comment eerily echoes historical remarks such as “we don’t need the internet, we already have libraries,” “We don’t need cars, we already have horses,” or “we don’t need telephones, we already have mail!” Each of these statements represents genuine opinions held by numerous people in history—people who, in retrospect, now appear exceedingly shortsighted.
What is going to happen?
The impending legal confrontation between the SEC and Coinbase cannot be brushed aside given the immense stakes involved. Furthermore, the issues are so multifaceted and far-reaching that one single case may not be enough to address them all. What is required is a more extensive timeframe and the involvement of individuals with a higher level of expertise than what is currently available, particularly on the side of the U.S. Government.
Regrettably, if we don't navigate this situation correctly, the U.S. stands to inflict significant damage on the next two decades of innovative progress in a domain that is expected to level the playing field in financial markets and update many outdated financial systems that underpin our current world. While the SEC's concern for investor safety is commendable, and it is justified in demanding that American companies provide a high level of care to American investors and consumers, it needs to understand that it can only demand as much as it is willing to contribute. If regulations are not updated to accommodate new technology standards or if the authorities refuse to even engage in dialogue with the companies in question, then the U.S. crypto industry could find itself in a deadlock. In such a scenario, as it often happens, the American public would be the ultimate losers.
Definitions
The Securities and Exchange Commission (SEC) is a U.S. government oversight agency responsible for regulating the securities industry, which includes stocks and bonds, among other types of investments. The SEC's primary function is to protect investors by ensuring that the securities markets operate in a fair and orderly manner, that investors have access to disclosure of all material information concerning publicly traded securities, and to prevent fraud and malpractice in the market.
A National Securities Exchange is a venue approved by the government, specifically the Securities and Exchange Commission (SEC), where securities such as stocks, bonds, and options can be bought and sold. Think of it as a marketplace like the New York Stock Exchange or the NASDAQ where buyers and sellers meet to trade securities.
A Broker is an individual or firm that acts as an intermediary between buyers and sellers, facilitating transactions of securities. Brokers are licensed professionals who for a fee or commission, execute buy and sell orders submitted by an investor.
A Clearing Agency is an entity that helps in the process of settling a transaction after the trade has been made. It ensures that the buyer has enough money to pay for the securities and that the seller delivers the correct securities. This process involves transferring money from the buyer's to the seller's account and the securities from the seller's to the buyer's account. For crypto, this service is replaced by the actual tokens which are “self-clearing.”
Staking is a process in which crypto owners participate in a proof-of-stake (PoS) blockchain network by holding and "staking" their cryptocurrency in a wallet to support network operations such as transaction validation, security, and governance. In return for staking their coins, participants may receive additional tokens as rewards, effectively earning interest on their holdings. The staking process differs from traditional financial systems as it uses a decentralized network and cryptographic algorithms to secure transactions and generate new blocks.
Securities, as per U.S. SEC regulations refer to financial instruments that represent an ownership position in a specific kind of asset. They typically include stocks, bonds, and debentures, but can also encompass more complex derivatives and investment contracts. The definition of a security is broad under the U.S. securities laws and is based on the "Howey Test". This test determines that a transaction is a security if it is an investment of money in a common enterprise with a reasonable expectation of profits to be derived from the entrepreneurial or managerial efforts of others.
Market Cap or Market Capitalization refers to the total dollar value or worth of a company's outstanding shares of stock. It is calculated by multiplying the company's total number of shares by the current market price of one share. This metric is often used to provide a quick snapshot of a company's size or market value. In the context of cryptocurrency, it represents the value of all tokens of a particular cryptocurrency that have been mined or released, multiplied by the current market price of the cryptocurrency.
Clearing is the process of reconciling purchases and sales of various options, futures, or securities, as well as the direct transfer of funds from one financial institution to another. The process ensures that delivery of securities to the buyer and payment for the securities is made to the seller.
Settlement is the actual exchange of money, or some other value, for the securities. Settlement happens after clearing and completes the transfer of securities ownership from the seller to the buyer, and cash from the buyer to the seller. In traditional securities markets, this process often takes a few days (typically two business days, referred to as T+2), although in the cryptocurrency world, settlement is often nearly instantaneous due to the blockchain technology underpinning these digital assets.
Self-Clearing refers to the process where a firm or an entity handles the clearance of its own trades or transactions without the need for a third-party clearinghouse. This typically involves the entity possessing the necessary infrastructure and capacity to manage the trade confirmation, reconciliation, and settlement processes. In the context of crypto assets, the term "self-clearing" is often used to describe how blockchain technology automatically verifies and records transactions on the network, thereby eliminating the need for a third-party intermediary to confirm and finalize transactions.