Trust in cryptocurrencies declined rapidly following the FTX fallout in June 2022, initiating an extended market downturn without any signs of stabilisation. As 2023 dawned, easing global inflation brought a glimmer of hope as the cryptocurrency market soared by over 50% (YTD). However, recent legal confrontations between the US Securities and Exchange Commission (SEC) and several cryptocurrency exchanges have once again destabilised the crypto market and brought about renewed controversy over how crypto should be regulated. In this article, we delve into the legal implications of the conflict between the SEC and Coinbase and discuss what this may mean for retail investors.
Context – The SEC’s cryptocurrency crackdown
On 6 June 2023, the SEC sued Coinbase, a cryptocurrency exchange, alleging that Coinbase was operating as an unregistered securities exchange and broker. This came one day after the SEC sued Binance, the world’s largest cryptocurrency exchange. The Coinbase stock price plummeted 13.4% on the news of the lawsuit. The Wall Street Journal recently conducted an interview with the CEO of Coinbase, Brian Armstrong, to discuss the impending lawsuit and some of the regulatory challenges for cryptocurrencies in the United States. The full interview can be found here.
Three interesting takeaways from the interview:
Takeaway #1: Definition of a Security
The crux of the suit between the SEC and Coinbase is whether several digital currencies listed on Coinbase’s exchange are considered securities. (The full list can be found here) In the US, the applicable legal test is the Howey test, established in the case of SEC v W.J. Howey Co 328 U.S. 293 (1946). In that case, the Howey Company sold portions of citrus groves to buyers, who would lease the citrus groves back to Howey Company for the company to tend and sell the fruits on behalf of the buyers. The buyers did not tend to the land themselves. The US Supreme Court considered that the investment into the citrus grove was a security.
In the interview, Armstrong lays out the four criteria for an instrument to be considered a security: an investment of money, in a common enterprise, with an expectation of profit, solely from the effort of others.
Takeaway #2: Security vs Commodity
One thing apparent from the interview is the lack of regulatory clarity in the US surrounding cryptocurrencies. It is unclear whether cryptocurrencies are securities or commodities. Armstrong attributes this to the fact that there are separate regulators for securities and commodities in the US. It is also unclear whether something that starts as a security can convert into a commodity at some point. For example, a cryptocurrency may initially be classified as a security because an entity raises money for a crypto-related project, but may also turn into a commodity if it develops utility and decentralises sufficiently.
Interestingly, Armstrong also revealed that Coinbase has a digital asset listing committee and an internal framework which is utilised to determine whether to list an asset on the exchange. The framework looks at various aspects such as a cyber security analysis as well as a legal analysis on whether the asset is a commodity or security. It appears that the SEC was well aware of Coinbase’s framework because it was shared with the SEC before Coinbase became a listed company in April 2021.
Takeaway #3: Adapting archaic rules to fit new novelties
The biggest takeaway from the interview is how the crypto industry has to force fit the novelties of cryptocurrencies into outdated rules. Armstrong brings up the fact that the Howey test has been around since 1946 and applied successfully to all sorts of situations and investment instruments. However, it is clear that despite the flexibility of the Howey test, it has failed to account for the specific needs of cryptocurrencies. One unique characteristic of cryptocurrencies is their decentralisation. One only needs to look at the network of validators on the Ethereum network as an example of decentralisation. Since there is no common enterprise or central governing authority, it is unclear how the SEC would force fit cryptocurrencies into the existing definition of a “security”. It is also difficult to see how regulators can enforce any legal regulations given that there is no central authority.
Conclusion
Although there is a lot of legal uncertainty in the cryptocurrency sphere, what is clear is that the ongoing lawsuit between the SEC and Coinbase will provide much needed clarity on the interpretation of the law.
What seems to be an extreme regulation may actually bode well for the future of digital currencies as more clarity in the law would likely result in an increased adoption of digital currencies. Armstrong raises a strong point that there is great potential for cryptocurrencies to be incorporated into the financial system around capital formation, where people can raise money by issuing crypto securities. It is interesting that Bitcoin, the most widely traded cryptocurrency globally, was not named as a crypto asset in the SEC's lawsuit. This is because Bitcoin is considered a commodity under the Commodity Exchange Act and is regulated by the US Commodity Futures Trading Commission, which doesn't yet have broader regulatory authority over spot trading.
Retail traders can expect that the ongoing lawsuit between Coinbase and the SEC may cause a decrease in the availability or liquidity of the mentioned crypto assets. This could happen if Coinbase, the world's second-largest centralised crypto exchange, is not able to facilitate trades for the named crypto assets. While US investors have other options (such as decentralised platforms and other exchanges), the sudden decrease in liquidity should prompt retail investors to reconsider if they can handle these risks in their portfolios.
In addition, if trading volume for these tokens decreases or an outright ban on trading these tokens is passed, Coinbase’s revenue will likely be impacted negatively. Transaction fees for trades on the Coinbase cryptocurrency platform account for 73% of its total revenue. Therefore, a decrease in trading volume due to the SEC lawsuit may impact Coinbase’s financial performance in the short term.
While this is all currently speculation, Coinbase’s next earnings call may be the canary in the coal mine for the broader crypto industry that retail investors and traders should keep an eye on.
Disclaimer: Anything discussed in this article is the writer’s personal opinion and should not be used or construed as financial advice. Skeptivest.com is not a financial adviser. Information on this website is for educational purposes only.
