US financial regulation updates
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Last week, Gary Gensler, the chair of the Securities and Exchange Commission, said cryptocurrency trading platforms could not last long outside the US regulatory framework. This week, it became clear that the SEC meant business.
Coinbase, which in April became the first major US cryptocurrency exchange to list publicly, said in a late Tuesday blog post that the SEC had warned it will sue the company if it launches a new digital asset lending product called Lend, and also issued the trading platform with subpoenas for more information.
Lend would enable users to earn interest on certain digital assets on the platform. Paul Grewal, Coinbase’s chief legal officer, said the SEC had told the exchange earlier this year that it considered Lend a security “but wouldn’t say why or how they’d reached that conclusion”.
The SEC’s move highlights a fraught legal debate at the heart of its regulatory approach towards cryptocurrency platforms as US supervisors scramble to keep up with the industry’s ballooning growth.
“At its core, this is a question of SEC jurisdiction,” said Charles Whitehead, professor at Cornell Law School. “The question is whether these loan accounts are securities. And if they aren’t securities, what are they and who regulates them?”
The SEC’s role revolves around whether a product such as Lend is an “investment contract”, making it a security under federal law. Under what is known as the Howey test, the Supreme Court has ruled that an investment contract exists when “a person invests his money in a common enterprise and is led to expect profits solely from the efforts of the promoter or a third party”.
Under a separate test known as Reves, there is also a question of whether an instrument such as Lend is deemed a “note” and in turn a “security”.
David Freeman, head of Arnold & Porter’s financial services practice, said that while he expected the SEC to use those tests, the regulator should also issue rules or guidance via a “formalised process” on how to interpret new crypto instruments.
“A more considered decision can be reached rather than just a fight between the SEC and one company,” Freeman said, adding “rulemaking through enforcement action is not great” as it is not subject to judicial review or public input.
The Coinbase announcement comes as products offering fixed returns for deposits of digital assets have gained in popularity among consumers seeking to benefit from cryptocurrencies, but who may be wary of the volatile crypto markets or attracted by generous interest rates.
“It’s about millions of people who are making their plans around the legal status of these [products],” Freeman said. “And to have the rug pulled out from under them by an enforcement action is not great.”
Gensler has signalled serious concerns over consumer protection in “Wild West” cryptocurrency markets that he said are “rife with fraud, scams and abuse”. While urging Congress to give regulators more explicit authority to monitor crypto exchanges, he had called on the platforms to register with the SEC. In an interview with the FT last week, he expressed his disappointment with the response, saying some crypto platforms are “begging for forgiveness rather than asking for permission”.
The regulator’s warning to Coinbase, and reports it is probing the developers behind the decentralised exchange Uniswap, has been taken by some in the crypto industry as a further sign that the SEC is turning its gaze to yield-generating products and decentralised projects where returns are often generated.
“It’s not uncommon that the ones with the biggest impact get regulated first,” said Philipp Pieper, who began work on DeFi project Swarm Markets in the US and later moved to Germany to seek regulatory approval. He said uncertainty over US regulators’ attitude creates risk for those building new projects and crypto companies.
Coinbase has in recent months made a concerted effort to make friends in Washington. In May, Brian Armstrong, chief executive, spent several days in the city, where he met Jay Powell, the chair of the Federal Reserve, as well as several members of Congress.
Armstrong said on Twitter at the time: “The reactions ranged from very positive (those who see enormous potential) like [the Democratic senator] @SenatorSinema and [the Republican member of the House] @PatrickMcHenry, to admitted sceptics who asked thoughtful questions about illicit activity and I think left with a much more open mind like [the Democratic senator] @MarkWarner, and everyone in between.”
None of those whom Armstrong met responded to requests to comment further.
The company has increased its spending on lobbying, according to figures compiled by the Center for Responsive Politics. In 2015, Coinbase spent $55,000 on lobbying efforts, but last year that rose to $230,000. So far this year it has spent $160,000.
As part of that push, Coinbase recently joined up with three other companies — the investment manager Fidelity, the cryptocurrency investment firm Paradigm and the payments company Square — to set up a new lobbying group, called the Crypto Council for Innovation. The CCI would not comment on the SEC’s action.
A spokesperson for Sherrod Brown, the Democratic chair of the Senate banking committee, told the FT on Wednesday: “The SEC should take all necessary steps to make sure investors are protected and markets are transparent.”
The SEC did not immediately respond to requests for comment.
Additional reporting by Hannah Murphy