What is a cryptocurrency exchange and what can it offer retail investors? That is the question. The Securities and Exchange Commission says they are clear on that. CoinbaseCOIN begs to differ. Now the SEC is suing them in another stress test for the American crypto market.
The SEC sued Coinbase on June 6, alleging that the company was operating as an unregistered broker. Think of it as the NYSE and E*Trade acting as one. That is Coinbase. No retail investor buys stocks directly from the NYSE.
The SEC said that Coinbase’s brokerage operation and its staking programs all violate securities laws in its complaint. The company “has for years defied the regulatory structures and evaded the disclosure requirements” of U.S. securities law.
“We allege that Coinbase, despite being subject to the securities laws, commingled and unlawfully offered exchange, broker-dealer, and clearinghouse functions,” Gensler said in a statement.
Coinbase instantly battled back.
“The SEC’s reliance on an enforcement-only approach in the absence of clear rules for the digital asset industry is hurting America’s economic competitiveness and companies like Coinbase that have a demonstrated commitment to compliance,” Paul Grewal told CNBC in a statement. “The solution is legislation that allows rules to be developed transparently, not litigation.”
Coinbase CEO Brian Armstrong said at a Bloomberg conference last month that the company had approached the SEC about becoming fully registered for all the services it offers, but received an “icy reception” from Gensler.
The SEC relies on the so-called Howey test to determine whether something is a security or not. An asset is considered a security if it involves three things: investment in a common enterprise, the investment has expectation of returns, and it is dependent on the work of others. This easily matches a number of tokens affiliated with blockchain companies like CardanoADA and Solano, but may be harder to nail down with stablecoins and bitcoin.
Gensler has long said most cryptocurrencies are securities. The President’s Working Group on Financial Markets has also said some cryptocurrencies tethered to fiat currencies may – or may not — be securities. (Gensler said last year that BTC is not a security because of the Howey test.)
The problem highlighted by Coinbase is how exchanges of cryptocurrencies are regulated. If one considers Coinbase the NYSE of crypto, which the SEC clearly does, then it is clear that the SEC does not want the NYSE of crypto to be acting as a broker of those products. Gensler has made this statement as recent as June 8.
“Crypto businesses could take actions that, while not illegal at the time due to lack of specific rules, might be retroactively deemed punishable when new regulations are established,” says Steve Rosenblum, Founder of Libertify.com, a personalized AI risk management solution for crypto fund managers in Paris. “This scenario Coinbase finds itself in is not only detrimental them, but it could undermine investor confidence and destabilize the market.”
It did. BitcoinBTC is still in decline as of late Wednesday.
The SEC needs to establish “clear, comprehensive, and forward-thinking regulations to protect stakeholders, foster fair competition, and promote sustainable growth in the crypto industry,” Rosenblum said. “You need ongoing dialogue and cooperation between regulators, industry players, and the broader community.”
But Coinbase’s Armstrong is not convinced that is happening.
In a Twitter post on May 22, Armstrong eluded to the fact that the reason that most major cryptocurrency exchanges are not in the U.S. was because of unclear rules.
The post linked to a 1.40 second video Armstrong posted on the Coinbase website where he hinted that the lack of clear rules meant exchanges like his would go overseas instead. “Fundamentally, crypto is not a financial product. It can make it cheaper to send money overseas, or for artists to receive money from their fans,” he said.
The SEC will argue that if those products issue coins and those coins can be traded with the expectation of profit, then it is a security.
Coinbase is increasing its investments abroad where they say the rules are more straightforward.
“Most of the world is embracing this technology now to update their financial system and I fear we are going to come back five years from now and say, wow, we need to bring this new technology back on shore,” Armstrong said.
How Unclear Are These Rules, Anyway?
Gensler’s biggest problem with Coinbase is the NYSE/E*Trade approach it has going for it.
“In other parts of our securities markets, the exchange, broker-dealer, and clearing functions are separate. Separation of these core functions helps mitigate the conflicts that can arise with the commingling of such services,” Gensler said earlier this month at the Piper Sandler Global Exchange & Fintech Conference in New York. “Crypto intermediaries may need to separate lines of business.”
This would upend exchanges as they are now. If Coinbase were to just be like the crypto NYSE, hosting cryptocurrencies for trading, then it appears the trading platform it offers to retail clients would have to be splintered off into something else, or owned by someone else. The same goes with operating at custodian of client’s holdings. The NYSE is not the custodian of your RaytheonRTX shares. “The fact that (crypto exchanges) didn’t build their platforms with these things in mind shouldn’t be a free pass to put investors at risk. Registered stock exchanges have done the hard work of registering and putting in place appropriate rulebooks and surveillance, and each is subject to all of our rules. We shouldn’t undermine 90 years of securities laws” for the cryptocurrency exchanges.
Every crypto exchange offers trading and makes money on trading, unlike the NYSE and Nasdaq, which do not offer retail investors a chance to trade on it directly without going through an intermediary. Nasdaq, for example, partners with European firm OptionsPlay to get retail investors to trade options on Nasdaq.
Ladies and gentlemen, we have hit a crossroads. It is unclear if cryptocurrency trading here will be attached to the same exchange the coins trade on if Gensler says the SEC wants those things separated.
This uncertainty stunts growth for companies like Coinbase. Is it the NYSE or is it E*Trade?
Apparently, other countries have “better” rules. (Or are okay with this commingling of operations — exchange, broker, custodian.)
“Emerging economies are the most fertile ground for cryptocurrencies, exchanges and new technologies,” says Alex Reinhardt, a venture capitalist and one of the most powerful 100 people in Dubai, according to Arabian Business.
According to a survey by Grayscale, owners of the Bitcoin and EthereumETH Trust ETFs, around 79% of Americans are looking for “clearer regulation” when it comes to crypto. Grayscale is a registered investment advisor and broker/dealer. Their poll did not ask specifically if crypto investors thought “clearer regulation” meant an exchange shouldn’t give retail investors direct access to trades.
Clarity on this doesn’t seem to be happening anywhere.
In the U.K., the recent Financial Services and Market Bill aims to “establish a safe regulatory environment for stablecoins – which may be used for payments.”
Over in Singapore, exchanges and other crypto businesses were brought into the scope of domestic regulation by the Payment Services Act 2019.
The United Arab Emirates recently announced a new regulator for virtual assets.
And the European Union has the Markets in Crypto Assets (also known as MiCA) which aims to bring crypto assets under the scope of securities regulation in the EU.
In Brazil, Congress approved a bill that include digital currencies in their laws regarding payment systems and transactions.
“Each day, more and more countries are bringing cryptocurrencies and exchanges into their regulatory hearth,” Reinhardt says. “This is a trend. I expect it will continue.”
However, none of the above tackles the exchange as broker/dealer issue the SEC seems to dislike.
Enrico Rubboli, CEO of Mintlayer, a blockchain company for financial services, says the lack of regulatory clarity in the U.S. has resulted in some exchanges relocating to Europe and Asia.
“The pressing need for an all-encompassing and flexible regulatory framework in the U.S. is palpable,” he says. “The U.S. is trailing behind in the fast-paced, globally expanding crypto industry, and this is a sector that holds immense promise and potential and has piqued the interest of consumers and businesses alike. U.S. regulations are not just ambiguous; they are outdated, fail to cater to the nuances of the world of crypto technologies. This regulatory fog is driving businesses and exchanges towards jurisdictions that provide a more favorable, clear, and welcoming regulatory environment,” Rubboli says.
Europe, the Middle East, and Asia – led by Japan, South Korea and Hong Kong — are accelerating their crypto initiatives and becoming hubs for financial innovation. The U.S., where bitcoin began and where Silicon Valley venture capitalists thrive in finding future technologies, is getting boxed in and now face stressful legal pressure from the government, as is the case with Coinbase.
Even China, which once maintained a firm ban on cryptocurrencies, is displaying signs of a shift in viewpoint. Rubboli said he thinks Hong Kong could serve as an experimental base for cryptocurrency use and new blockchain technologies before the mainland takes it on.
Japan considers bitcoin legal tender. BitFlyer is registered as an exchange and as a Type I Financial Instruments Business. A Financial Instruments Business is a financial service company that can offer trades in securities for a fee. Coinbase is not registered to receive fees for trading, as BitFlyer is in Japan.
Moreover, Japan’s market regulator considers bitcoin a “crypto asset” that follows the same rules for payment services. They rely on exchange-specific entities that can customize and adapt their rules and regulations to their markets, which can accelerate the decision-making process, unlike here, says Brigham Santos, Chief Operating Officer for Lama, a crypto wallet company in Vilnius, Lithuania that is sort of like Bitpay in Atlanta. “The U.S. way is more centralized by the SEC. This may slow down or even be politicized in its responding to new market developments,” Santos says. “That will end up leaving the U.S. out of the market when it comes to adopting new crypto trend and technologies.”
From a non-US point of view, it’s good that emerging hubs take charge of their own development in a new, fast-moving space, rather than simply follow the U.S.’s lead. For Gensler, the whole thing is either about killing crypto (which is a whole other topic), or forcing cryptocurrency exchanges to act like the NYSE and Nasdaq (which makes one think one of those exchanges will end up buying Coinbase and others some day and Coinbase will stick to providing financial services).
“Armstrong may be worried about the U.S. not having a seat at the table, but for decades the U.S. has chaired most tables. Tensions are obviously rising,” says Ben Caselin, Vice President and Chief Strategy Officer at MaskEX, a the first cryptocurrency exchange to be approved in Dubai under U.A.E.s regulatory framework – the Virtual Asset Regime and Full Market Product licensing laws.
“I think it’s good to see different jurisdictions around the world plotting their own future and setting their own agenda,” Caselin says. “Developed nations and seasoned institutions like the SEC are generally less inclined to radical change, while in emerging markets, where the impact of digital assets is greatest, a desire for change is more apparent.”
It seems the emerging markets are more willing to let exchanges be brokers and clearinghouses without separate rules governing them. The SEC does not seem to be willing to do that. And for the SEC, they can say that they govern the world’s most liquid, most attractive securities market. One could make the case that the SEC would also like to do that for crypto. Time will tell.
The well-known ARK Investment Management firm, made popular by its founder Cathy Woods and her super overweights on Tesla, said it is not afraid of the SEC vs. Coinbase lawsuit.
“Action against Coinbase was inevitable,” said ARK’s director of research, Frank Downing. “Coinbase has been preparing for this day and is ready to challenge the SEC in court. So when we saw the stock trading down…we were ready to be there when it was down 15-20%.”
Coinbase’s share price is down by around $10 a share, closing at $53.90 on Wednesday.
One hopes that the SEC will eventually get this right. If not, the rest of the world will be where the crypto grows.
“I think it is crucial for the U.S. to support the growth of its cryptocurrency ecosystem by encouraging the development of domestic exchanges while maintaining regulatory vigilance,” says Venket Naga, Chief Executive Officer of Serenity Shield, a data privacy solutions provider for blockchains. Naga is based in India.
“I agree with Armstrong’s assertion that the future of finance is intrinsically linked to the evolution of cryptocurrency. This isn’t just about America or any single nation; it’s about the global community coming together to embrace this transformative technology,” he says.
