Reviewing the grievances between the SEC and Coinbase, will U.S. crypto regulation head towards optimism?

Written by: Michael Nadeau

Compiled by: Luffy, Foresight News

Whether you are an entrepreneur, developer, or investor, understanding the upcoming regulations and policies is essential if you are in the cryptocurrency industry. With regulatory discussions heating up in the U.S. and MiCA becoming law in Europe, it’s time to delve deeper.

Regulation is a broad topic, and for ease of reading and understanding, we will divide the content into two parts. In Part 1, we will discuss the following:

• The role of the U.S. Securities and Exchange Commission (SEC)
• The saga between Coinbase and the SEC
• The divide between the executive and legislative branches
• Crypto users and the 2024 elections

Image source: Times Higher Education

The Role of the SEC

• Protecting investors;
• Maintaining fair, orderly, and efficient markets;
• Enhancing capital efficiency.

The SEC promotes comprehensive public disclosure by companies, protects investors from fraud and market manipulation, and oversees corporate acquisition activities.

The SEC is responsible for maintaining the orderly operation of the world’s largest capital markets. They also have the authority to create new rules as long as they fit within the framework established by Congress in 1933/1934. The SEC enforces this framework to create an environment where bad actors are held accountable and good actors are given opportunities for innovation.

Without thoughtful regulation, the crypto industry cannot mature and realize its true potential. However, the current regulatory framework was created in 1933/1934, and we do not yet have a new set of laws or regulations that apply to the new types of crypto assets.

Crypto assets differ fundamentally from traditional securities in many ways, such as:

• No investment contracts (secondary trading).
• Crypto assets do not represent legal ownership.
• Crypto assets do not grant holders the right to receive interest or dividends.
• Many crypto assets have commodity-like characteristics, where the assets are used for payment or consumption of services.
• Crypto assets are digital bearer instruments that can be self-custodied.
• Crypto assets can be traded in a peer-to-peer manner.
• Crypto assets are traded globally, with near-instant settlement almost around the clock.
• Due to the characteristics of public blockchains, services like custody, bookkeeping/transfer agency, trading, and auditing can be bundled.
• Smart contracts support the automation of new peer-to-peer business models and asset trading markets.
• The transparency of public blockchains and their automatic auditing/verification capabilities create new tools for regulators to comply with investor disclosure in new ways.
• As crypto networks mature, they become more decentralized. This lack of centralization makes it difficult to comply with current traditional securities disclosure requirements.

The SEC's desire to place cryptocurrencies under the same regulatory framework as traditional securities is unworkable. However, we should not abandon the goal of protecting investors while enhancing capital efficiency. We just need to adjust the rules or create new ones. This work will fall to Congress, not the SEC.

Of course, cryptocurrencies have not escaped the complexities of politics.

Enforcement Regulation

Unfortunately, the SEC's current approach—regulating through enforcement—has not fostered innovation, protected investors, or held bad actors accountable; instead, it has punished many compliant companies while pushing investors toward high-risk, opaque offshore entities.

The result of this strategy seems to contradict the SEC's mission.

I do not intend to explain why this is happening; the cryptocurrency industry is not the first to face similar challenges. Our job is to strive to see this field with clarity. Ultimately, we just want to predict the direction of developments. For industry operators and investors, understanding regulation and policymaking is essential for assessing risk.

To this end, let’s first look at the case of Coinbase.

The Saga Between Coinbase and the SEC

As a publicly traded company, Coinbase is one of the most trusted brands in the crypto space.

The auditing firm behind Coinbase is Deloitte, and it has long sought compliance through voluntary cooperation with regulators. Here is a brief overview of the history between Coinbase and the SEC:

• Before 2020: Coinbase obtained money transmitter licenses in all relevant states (2014), a BitLicense in New York (2017), SEC-recognized alternative trading system status (ATS) (2018), and an SEC-registered self-directed broker-dealer license (2019). The ATS and trading broker licenses are currently awaiting regulatory approval.
• October 2020: Coinbase submitted its initial public offering draft S-1 to the SEC.
• December 2020: Coinbase submitted a legal analysis of its staking services.
• February 2021: The SEC issued a second comment letter, and Coinbase responded with a legal analysis regarding whether the tokens listed on its spot exchange are securities.
• April 2021: The SEC announced the effectiveness of Coinbase's S-1; Coinbase went public.
• November 2021: Coinbase met with SEC Chair Gensler to discuss registering as a securities trading platform.
• July 2022: Coinbase submitted a formal rulemaking petition that included 140 specific questions for the SEC.
• Q4 2022: Coinbase met with SEC staff (including the enforcement division) 12 times to discuss registration pathways and related matters, holding a total of 30 meetings over 9 months.
• January 2023: SEC enforcement staff notified Coinbase that they would continue to take enforcement action.
• March 2023: Coinbase received a Wells notice from the SEC.
• April 2023: Coinbase sued the SEC, demanding a response to its July 2022 rulemaking petition.
• May 15, 2023: The SEC responded to Coinbase's petition.

We currently do not know the specifics of the SEC's enforcement action against Coinbase; we only know that it is indeed happening.

Disclosure: We are not lawyers. We believe the most important factor in all of this relates to the fact that the SEC reviewed Coinbase's business and approved the company's S-1 listing in April 2021. Now, this does not exempt Coinbase from enforcement action.

The reasons are as follows:

Since Coinbase's S-1 was approved, the SEC has not issued any new regulations. Congress has not passed any new laws related to crypto assets. Furthermore, Coinbase's core business has not changed.

Coinbase disclosed its asset listing process and staking business to the SEC at the time of its IPO. Additionally, the SEC has been aware of how Coinbase custodies user assets.

All of this suggests to the investing public that the SEC considers the business to be legal and compliant. Therefore, investors in Coinbase's IPO have all the information needed to assess risk.

Now, by issuing a Wells notice, the SEC implies that Coinbase's core business is illegal or non-compliant and that enforcement action will be taken.

However, Coinbase's core business has not changed, and no new regulations or laws have been enacted since Coinbase went public.

Thus, it is difficult to determine what exactly the SEC's issue is—this itself is a problem. We believe that if the public, investors, entrepreneurs, and Coinbase itself do not know what they did wrong, regulation will only backfire.

The Howey Test

Coinbase claims that they do not engage in securities trading. They shared their listing process with the SEC at the time of their IPO, asserting that they rejected over 90% of the crypto assets seeking to list.

Meanwhile, SEC Chair Gary Gensler has repeatedly stated publicly, "All crypto assets are securities, except Bitcoin." Keep in mind, this is not formal policy; it is merely a public statement made by Gary Gensler.

He has also made completely contradictory public statements. In fact, in 2018, he stated that over 75% of ICO tokens are not securities.

He even made statements about how crypto networks become "sufficiently decentralized" over time, which changes how they are treated as securities.

Ultimately, to meet the threshold of securities law, the SEC must prove that specific crypto assets traded on Coinbase are part of an ongoing investment contract. Coinbase believes they are not, for two reasons:

There is no investment contract between Coinbase users buying and selling crypto assets and the issuers of those assets. Token issuers cannot raise funds from users trading on Coinbase.

Previous cases applying the Howey test to crypto assets targeted issuers raising funds through the sale of unregistered securities. This is different from the secondary market in which Coinbase operates. Coinbase believes that secondary market trading does not meet all four conditions of the Howey test:

• Investment of money: In the secondary market, investments do not flow to the issuer or promoter.
• Common enterprise: This does not exist for users purchasing crypto assets on Coinbase. Similarly, this condition applies to the primary market, not the secondary market.
• Expectation of profits: There is no expectation of profits for crypto assets with consumer/commodity characteristics. For example, Ethereum users need to purchase tokens to pay gas fees to access services on the network.
• Profits from the efforts of others: Again, this applies to the primary market, not the secondary market.

What Happens Next?

It remains to be seen what enforcement action the SEC will take against Coinbase. Is it related to asset listings? Staking? Custody? We do not know. We only know that the SEC is planning to take action against Coinbase.

Coinbase has some of the best lawyers and policy experts working for it, and with $5 billion in cash, it may be better positioned than any other crypto company to challenge the SEC.

The market seems to be pricing in the worst-case scenario. However, we believe that Coinbase is likely to win or settle.

It is worth noting that the SEC recently concluded insider trading charges against a former Coinbase employee, and the SEC also alleged that the related assets are securities. However, the settlement statement did not declare the involved crypto assets as securities, suggesting that these allegations were dropped.

In terms of timing, it may take many years to clarify this issue.

Finally, we believe that expanding the current federal securities laws to include crypto assets is unnecessary and misguided. The policy issues surrounding crypto asset regulation should be addressed by Congress.

We believe that the bipartisan bill proposed by Senators Gillibrand and Lummis is a good starting point. We have heard that an updated version of the bill is being finalized. Additionally, a new market structure bill was passed last Friday: it was drafted by House Financial Services Committee Chair Patrick McHenry and House Agriculture Committee Chair Glenn Thompson (R-PA). In defining the roles of the SEC and CFTC, the bill outlines key terms such as decentralization, blockchain (limited to public blockchains), digital assets, digital asset issuers, and stablecoins in an effort to create new laws related to cryptocurrencies.

Congress's View on Cryptocurrency

Roughly speaking, the U.S. seems largely opposed to cryptocurrency innovation.

The media tends to focus on negative news that triggers fear, uncertainty, and doubt.

For example, Senator Elizabeth Warren's initiation of the "Anti-Crypto Alliance" movement and the recent enforcement actions from the White House.

However, publicly available data provided by Coinbase paints a more nuanced picture.

In particular, the legislative branch of Congress seems to have a different attitude than the executive branch. There are more Republican and Democratic policymakers supporting cryptocurrency innovation than those opposing it.

The data below pertains to publicly available information related to legislative records, media statements, social media posts, party membership, and open letters. Each member of Congress is then rated to determine whether they support or oppose crypto innovation. Members for whom information could not be collected or publicly verified were not rated.

Source: Coinbase Public Policy Legislative Portal

We have also heard that the existing divides in Congress are more generational than ideological.

Interestingly, Coinbase's data seems to align with a recent statement made by Congressman Ritchie Torres during a discussion with Bankless:

My view is that the divide over cryptocurrency is not partisan or ideological, but generational. You will find that younger Democrats are more open to cryptocurrency innovation. As you know, Congress is an elderly-dominated institution. Currently, all three leaders of our Democratic core group are over 80 years old, and nearly all committee chairs are over 70. Therefore, there tends to be a rejection of new technologies like cryptocurrency among congressional leaders.

Regarding the older members of Congress who oppose cryptocurrency:

There seems to be a form of anti-crypto disorder that clouds clear and rational thinking about cryptocurrency. A large part of this stems from ignorance. You will find that members of Congress who support cryptocurrency are much better educated than those who oppose it. My role as a policymaker is not to assess the utility of cryptocurrency. The role of government is not to stifle innovation; the role of government is to ensure that innovation is safe for consumers and investors. That is what we should be doing.

Cryptocurrency is not a partisan issue. Most studies show that slightly more Democrats than Republicans own and use cryptocurrency in the U.S.

The 2024 Election Cycle

Remember, Twitter was initially a small platform where nerdy engineers shared what they had for breakfast. Facebook started as an on-campus social club at Harvard.

But within a decade, both platforms had a significant impact on global election cycles.

We believe that Bitcoin and cryptocurrencies (along with artificial intelligence) are likely to become hot topics in the 2024 election cycle.

Democrats

The Democratic National Committee has announced that it does not intend to hold primary debates, suggesting that Biden has secured the nomination.

At the same time, Biden, the White House, and the current regulatory agencies appointed by the president (SEC, FDIC, Fed) seem largely opposed to cryptocurrency.

That said, we believe that as we approach the next election cycle, their stance may change.

Keep in mind that many younger members of Congress support cryptocurrency, and many of their constituents do as well.

According to a recent study by Grayscale, 52% of Americans (including 59% of Democrats and 51% of Republicans) agree that "cryptocurrency is the future of finance"; 44% of respondents indicated that they would like to invest in crypto assets in the future.

As mentioned earlier, Democrats are more likely than Republicans to own crypto assets.

At the same time, various estimates show that about 20% of American adults own crypto assets. According to the Federal Reserve itself, one in ten American adults held or used cryptocurrency in 2022 (a bear market year). Coinbase has 110 million verified users (audited by Deloitte). Finally, 67% of Americans agree that the financial system needs significant change or complete reform.

When all of this is combined, we believe that as the election cycle approaches, the White House may have to adjust its policy on cryptocurrency.

Republicans

Republican presidential candidates are more likely to support crypto innovation. Republican leader Ron DeSantis has stated that he will "ban CBDCs" and support innovations related to Bitcoin and crypto technology. As governor, DeSantis made Florida one of the most crypto-friendly regions in the U.S.

It is currently unclear what Trump thinks about cryptocurrency. He has previously made negative comments about Bitcoin but launched an NFT project last year. Notably, states like Florida and Texas largely support the crypto industry.

Since cryptocurrency is seen as "anti-establishment," we believe it aligns with the campaign narrative favored by Trump. When we combine this with the fact that congressional Republicans tend to support crypto innovation, it is reasonable to predict that Trump will ultimately align with the industry.

Conclusion

Cryptocurrency users possess unique diversity and nonpartisan tendencies.

There are not many political issues that cover both parties like this. Therefore, we believe that cryptocurrency will present some interesting challenges and incentives for policymakers. As Charlie Munger likes to say, "Show me the incentives, and I will show you the results." Will politicians continue to be incentivized to scapegoat cryptocurrency for other agendas? At least for the next year, it is difficult to see that happening. Instead, it is more likely that incentives will lead to support for cryptocurrency from both sides.

We see signs of this in publicly available data and in the drafting of new legislation.

As the Ripple and Coinbase cases progress, we will have the opportunity to see how the courts view the SEC's enforcement actions.

We will be watching this closely, but the outlook may be brighter than the market expects.