Digital Asset Regulation
The crypto regulatory war is heating up!
One way to frame the short history of digital assets and crypto is that a lot of money has been chasing a lot of novel ideas. Like any normal distribution of ideas, some are great (Bitcoin), and some are good, and some are fraudulent and have caused significant harm. As a result of these fraudulent ideas, many have posed the question: Why haven’t the regulators stepped in?
It’s a fair question! Lack of regulation has created bad outcomes for consumers and investors. We are only just beginning to sort through the wreckage caused by Voyager Digital, Celsius, Gemini, and, of course, FTX.
The sleeping regulatory bear has been poked in the past year, and long awaited legal actions are finally coming. The government must now flex its enforcement muscles to appease the public’s concern. The cold war is over and the hot war is just starting to heat up.
Last week, two important documents from government officials caused quite a stir. On Tuesday, the White House released their 513 page Economic Report of the President where they devoted 35 pages to the dismantling of the digital asset industry. Calling all value of crypto tokens “perceived” and emphasizing crypto’s failure to replicate state-backed money, the White House has taken a negative stance on the industry writ large. This administration may be posturing to attribute some of the economic instability to crypto speculation and fraud.
The day after the Economic report was released, the Securities and Exchange Commission (SEC) sent Coinbase a Wells Notice centered on the company’s staking business. A Wells notice often precedes legal action but does not necessarily mean legal charges will be brought. Coinbase has promised publicly that it will be arguing its defense in court. This could make for a highly public legal fight that will capture the media’s attention.
What is staking?
Staking is a voluntary service offered on Conibase’s platform (and other platforms) where token holders can lockup their assets and earn yield (a reward) over time. Only tokens that use a consensus mechanism called Proof-of-Stake can be staked. This includes tokens like Ether (Ethereum), Solana, Polygon (MATIC) and others.
Bitcoin is not included in this group because it uses Proof-of-Work to validate the creation of new tokens. This description of staking and consensus mechanisms is lacking, but for the purposes of this blog, staking digital assets with Coinbase represents a risk that the SEC has identified as potentially illegal.
Any time someone is promising yield on an asset it means that the holder of that asset is assuming a few different types of risk including counterparty risk and lockup risk or the risk that you will not be able to move your tokens out of the staking pool.
You do not need a Coinbase account to stake your digital assets, and the staking rewards you receive are not directly tied to the success of Coinbase’s business. You can stake your assets with other services like Lido, for example. Although it requires some effort on your part to set up a crypto wallet and connect it to Lido’s staking pools, this can be done relatively easily and for little cost.
Staking has been in the SEC’s cross hairs recently. On February 9th, the SEC forced crypto exchange Kraken to discontinue its staking services partially due to a lack of disclosures regarding the risks involved and Kraken’s right to retain staking rewards.
Back to the regulatory action…
Coinbase has the resources (over $4 billion in cash) to defend its business and it will do so ferociously because staking represents a significant portion of its revenue. By attacking staking, the SEC is necessarily is also attacking Coinbase’s trading and settlement businesses. Most of Coinbase’s revenue comes from the commissions they charge for trades. If the SEC deems the majority of the assets listed on the exchange securities, then Coinbase’s business would be significantly impacted.
Coinbase is a publicly traded company. They went through the process of listing their stock on a regulated exchange (NASDAQ), and they are obligated to produce audited financials on quarterly and annual bases. Coinbase has attempted to be transparent with the Government about their listing process and they have asked the government for guidance on multiple occasions.
Much of the crypto industry looks toward Coinbase as a vanguard for legal operations in the US. Coinbase has the best chance of defending their business in the courts, and there will be many interested parties in the crypto community spectating to gauge the regulatory climate going forward.
Whose jurisdiction is it anyway?
We have quite a few governing bodies and regulators vying for the right to regulate this industry and the underlying assets. The SEC has been the most litigious. In their view, 99% of the available tokens are securities (basically everything except Bitcoin). They are most likely right, and they have the legal precedent to back this up. The playbook for the SEC over the last 5 years has been to issue enforcement action as regulation.
Many in the crypto community have looked towards the Commodities Futures Trading Commission (CFTC) to regulate the industry because they believe the industry will receive more favorable treatment from the this regulator. The CFTC is responsible for regulating the derivatives market including futures, swaps, and other types of options. Because of Bitcoin’s distributed nature and lack of governance from a small group of holders, I believe Bitcoin qualifies as a commodity and should be regulated as such.
Of course, the Department of Justice (DOJ) feels the need to step in and pursue legal actions for the crypto crimes that have occurred. High on the DOJ’s list of bad actors are the FTX executive team which will be prosecuted for the many flavors of fraud that they executed, aided, and abetted.
Finally, as we have recently witnessed, the executive branch is now stepping in to dunk on the industry and assign blame. The White House is using the bully pulpit to apply pressure to regulators and congress and shift the public’s attention.
This consortium of officials is disjointed in its ability to offer sweeping standards. Ultimately, Congress needs to provide regulation in the form of law creation. But there exist known difficulties with the law creation process. Two crypto bills proposed last year blew up after competing interests killed the bills.
What laws does the government currently have at its disposal?
The 1946 supreme court case SEC v. W.J. Howey Company set the precedent for determining what is and what isn’t a security. The Howey Company owned large tracts of land in Florida that were used as orange groves and real estate properties. Howey kept half of the groves to finance future property development and sold the other half in the form of real estate contracts. The presiding Judge deemed these contracts securities and thereby created a securities framework that came to be known as the Howey Test.
The Howey Test goes like this: if you are investing money in a common enterprise via an investment contract with the expectation that profits will be derived from the efforts of others then you are investing in a security. The framework is broad and clunky, but it will likely be the central focus of the SEC’s case against Coinbase if one is brought.
Coinbase will argue that its listed assets are not securities because there is no investment contract that is signed by the counterparties at the outset of invesment. Coinbase may also take issue with the assumption that profits for tokens and their networks are derived from the efforts of a governing body. Coinbase will argue that there is no reliance on a centralized board of individuals for each digital asset because of the decentralized nature of each network. Also, Coinbase will complain about the lack of fair notice and the SEC’s methods.
Whether or not the existing securities laws can be appropriately or fairly applied to crypto doesn’t really matter to the regulators. The SEC is going to move forward with prosecuting and will use the Howey Test and relevant case law.
Why worry about the US government if crypto is supposed to be a global project?
The US government is certainly about to make life more difficult for the digital asset space. US regulators have the unique ability to coordinate a global attack on industries by co-opting other countries’ participation.
If the US issues some sort of ban this will create a vacuum in the growing digital asset industry. Non-US crypto entities will continue to iterate and build outside of the US in crypto hubs around the world. Plenty of US talent working in this space will migrate offshore as a result. It’s possible that this is the outcome that US regulators are targeting, but it would represent a large destruction of potential economic activity on US soil.
Takeaways
First they ignore you, then they laugh at you, then they fight you, then you win. - Mahatma Gandhi
We are squarely entering the “then they fight you” phase.
The past year has been filled with bad headlines for the crypto industry. The regulators tacitly allowed the crypto economy to grow rapidly when the prices were going up, but then, as prices moved sharply to the downside and crypto entities failed, investors complained that the proper protections were not in place. The SEC and the government is embarrassed. To enforce existing laws and maintain its reputation as the top cop in the markets, the SEC has to step in and make a show of at least trying to do their job in applying the laws.
More broadly, we have a crisis of distrust in the US. Historically, people have looked towards politicians to right the ship and offer guidance for the use of new tech. In crypto’s case, the regulators and politicians have been unpredictable. They have imposed restrictions, threatened, regulated via legal action, and failed to provide a clear set of rules.
As a result of the inaction from Congress, instances highlighting regulatory dislocation have cropped up in public venues. In a lawsuit between Voyager and the DOJ, a judge went against the government and ruled that Voyager could move forward with rebalancing its assets and executing its bankruptcy plan. The judge said there was no clear evidence of illegal activity, and that the “government could step in at any time” if they could prove otherwise.
I note this recent episode because the lack of a regulatory framework is damaging the government’s ability to prosecute the entities responsible for defrauding consumers. Flimsy legal precedent is not holding up for the government as it pursues lawsuits.
The digital and cellular phone revolutions combined with a low interest rate environment has contributed to an accelerated state of play for fintech (see my blog on the Modern Bank Run). Crypto has captured the public’s attention partially for being famously fast and breaking lots of things but also for the amazing amount of wealth it has created.
Over the next couple of months, we will finally get much needed clarity as Coinbase and the SEC duke it out. Many in the crypto space will be happy to see the cards that the SEC has been holding closely to its chest finally turned over. It will be nothing short of fascinating, so stay tuned!
Matt Levine, Michael Saylor, and Sam Andrew informed my thinking on this topic.
Great read! It'll be interesting to see how crypto regulation will evolve following the arrival of MiCA next year.
A well done assessment with a great amount of research to support! Well done Jack!