Coinbase has reported losses for the last five quarters, but things just got even worse for them. The SEC (led by Chairman Gary Gensler) sued them, accusing them of running an unregistered securities exchange. Now, Coinbase and CEO Brian Armstrong are in an existential fight. But honestly, I think it’s a good thing for crypto.
I’ll explain why, but first I want to set the tone. To do that, I need to lean on the genius of Christopher Nolan, and I’ll try not to let the ensuing flood of adrenaline affect my writing. Any Dark Knight fans out there?
At the end of the movie, when Batman decides to take the fall for Harvey Dent’s crimes, Commissioner Gordon can’t believe it, but Batman explains:
“I’m whatever Gotham needs me to be… you’ll hunt me. You’ll condemn me, set the dogs on me.”
Gordon grasps what he’s saying, but Gordon’s son doesn’t. He’s not sure why the hero needs to take the fall for the bad guys. So now it’s Gordon’s turn to explain:
“Because he's the hero Gotham deserves, but not the one it needs right now. So, we'll hunt him, because he can take it. Because he is not our hero. He is a silent guardian, a watchful protector, a Dark Knight.”
Ahh! Even just transcribing that gives me chills. Ok, but what’s the point?
Coinbase and Armstrong aren’t Batman-level heroes, but I can make the argument that they are taking the fall for someone else.
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A Year of L’s for Crypto
Over the past year, crypto’s market cap swung down from $3 to $1 trillion. And that’s been driven mostly by self-inflicted wounds. I’ve written already about some of those missteps, but it’s easier to see the domino effect in a quick recap:
May 2022: Terra-Luna collapses, wiping out $45B in value. Terra was a stablecoin pegged to USD, and Luna was its trading pair. Terra de-pegged when two “whales” moved $500M in an hour.
June 2022: Three Arrows Capital (3AC), a crypto hedge fund, blows up. Crypto prices were declining, and their last desperate bet was to put $200M into Luna. That did not go well.
July 2022: Voyager Digital, a crypto lender who had loaned $650 million to 3AC, files for bankruptcy. At their peak, they had 3.5 million users and $6B in assets.
November 2022: FTX files for bankruptcy and CEO Sam Bankman-Fried is later accused of fraud. They lost money on Terra-Luna and were toppled by Binance’s CEO selling-off FTT (FTX coin).
January 2023: Genesis, a crypto lender, files for bankruptcy. They had loaned $2.4B to 3AC.
With that happening, you better believe that regulators are feeling pressure to control the chaos. It’s like the public is saying to them: “look at this shit! What are you doing about this!?”. Adding to that pressure is the sting of embarrassment with the SBF fraud in particular. Not only did he defraud consumers, investors, and lenders. He also made US Government officials look silly, after spending lots of time and money on Capitol Hill. I wrote about this in The People of Crypto Part 1:
SBF was one of crypto’s fiercest and most effective advocates to lawmakers. He played the political game, donating to campaigns to get meetings. He educated congress and other influential players on what crypto was, why it mattered, and where the risks were.
So if you’re a regulator, how do you respond? Aggressively.
Banking Pressure
First, they’re turning the screws on traditional banks and financial institutions to discourage them from working with crypto companies.
Publicly, that started with a joint statement from the Fed and the FDIC in January 2023 explaining the risks of crypto. While the text of that statement says:
“Banking orgs are neither prohibited nor discouraged from providing banking services to customers of any specific class or type”
…the tone of the statement essentially says the opposite. It promises there will be “robust supervisory discussions” for any bank that is doing or wants to do crypto stuff. That sounds scary.
Privately, that pressure on banks has been even more intense. Congressman Byron Donalds has been among those calling this “Operation Chokepoint 2.0”. It’s a reference to the DOJ crackdown in 2013 on industries thought to be at high risk for fraud and money laundering (ATMs, pawn shops, payday lenders, etc.). The DOJ investigated banks that worked with these industries and made it painful to be in those businesses. Version 2.0 is a similar campaign, but against crypto. Donalds says: “[The agencies] are finding various ways to squeeze an outcome that they want.”
Nic Carter – a well-known venture capitalist and crypto founder – claims to have spoken to several bank executives, and added that:
“Regulators threaten and bully bank leadership behind the scenes, then publish public ‘guidance’ stressing that banks are still free to custody crypto or service crypto clients. In reality, they’re not free to do this, by any means.”
Not to be Captain Obvious, but it's hard for us to know what’s being said behind closed doors. However, we can see a few examples of implied pressure:
Signature Bank had $29B in deposits from digital-asset clients in 2022, which represented 27% of the business. They planned to trim it to 15% and put a cap on deposits from any crypto customer. Regulators were “consulted” as part of those plans.
Paxos National Trust and Protego Trust Co. applied for banking licenses to hold crypto assets for clients, and they received preliminary approval in 2021. Since then, according to the WSJ, they’ve been “left in limbo”. The OCC (agency responsible for these approvals) typically quotes a 120 day turnaround time for decisions…
I don’t blame regulators for trying to keep the contagion of crypto blow-ups from spilling over into traditional banks (especially with the ongoing regional banking crisis…). That being said, if you’re going to take the drastic step of cutting-off an industry from banking access, you really should explain why and be transparent. The banks would benefit from that too, since they wouldn’t be caught in the awkward position of having to explain to customers why they can’t keep their accounts.
Lastly, while I understand the regulators’ logic, I don’t agree with it. Lawful businesses and customers should be able to get banked. If those businesses aren’t lawful, that’s a different issue, but there hasn’t been a ton of clarity on what is and isn’t lawful.
Enforcement
As a second prong of their approach, the SEC has stepped up enforcement efforts. Previous lawsuits from the SEC in this area were towards individual coins and companies themselves, but the latest actions go up a level, attempting to rein in activities more holistically.
Last week, the SEC sued Binance and Coinbase. The Binance suit is more intense… it even personally accuses CEO “CZ” of wrongdoing. For Coinbase, the core complaint is that it’s running an unregistered securities exchange – operating as an exchange, a broker, and a clearing agency for unregistered securities.
The headlines about the suit left me with a bunch of questions… let’s tackle them one by one.
How does the SEC define and regulate exchanges, brokers, and clearing agencies?
Exchanges provide a marketplace for buying/selling securities. The SEC regulates them to make sure consumers get transparent pricing and aren’t manipulated.
Brokers execute securities transactions on behalf of other people. The SEC regulates them to make sure conflicts of interest are avoided.
Clearing agencies are intermediaries that help settle securities transactions. The SEC regulates them to make sure settlements are fair and consumers trust markets.
The SEC’s Coinbase complaint explains that these functions are typically handled by separate legal entities, but that isn’t 100% true. The Nasdaq and NYSE (exchanges), for example, have their own clearing divisions. Maybe there are controls and policies in place to keep those teams separate and protect against conflicts of interest, but they aren’t significantly separated.
So Coinbase could probably register and put those controls in.
Why doesn’t Coinbase just register?
The truth is that they have tried to work with the SEC and register. Here’s a quote from a March 2023 memo written by Chief Legal Officer Paul Grewal:
“…the SEC asked us if we would be interested in discussing a potential resolution that would include registering some portion of our business with the SEC. We said absolutely yes. Specifically, the SEC asked us to provide our views on what a registration path for Coinbase could look like – because there is no existing way for a crypto exchange to register. We developed and proposed two different registration models…We met with the SEC more than 30 times over nine months… In January, the day before our scheduled meeting, the SEC canceled on us and told us they would be shifting back to an enforcement investigation. We now understand that there is disagreement within the Commission itself on how to proceed with a registration path. This was just two months ago.”
Coinbase Chief Legal Officer Paul Grewal; Source: Law.com
I’m completely guessing, but my hunch is that Coinbase’s offer to register a portion of their business was empty. They probably argued to the SEC that everything they already listed was not a security, and the registration would just help them list other new things. The SEC probably thought that wasn’t sufficient.
How does the SEC define securities?
They rely on the “Howey Test”, which defines a security as:
An investment of money
In a common enterprise
With the expectation of profit
To be derived from the efforts of others
Are cryptocurrencies securities?
Regulators haven’t issued clear guidance about all cryptocurrencies, and emotions run hot depending on who you ask. But if you ask me… yes, I think most of them are based on the Howey Test. Let’s look at Ether, the token of the Ethereum Network and second most popular cryptocurrency…
An investment of money – yes, I put $$ in to get Ether
In a common enterprise – yes, investors tie their fortunes together, hoping that the price goes up
With the expectation of profit – yes, investors want returns
To be derived from the efforts of others – yes, developers are coding
Some people (including regulators like the CFTC) have in the past said that Bitcoin is an exception, since it’s more like “digital gold” (failing #3), and it can’t be altered (failing #4), but I think that’s wrong. First, its price fluctuations aren’t like gold at all, they’re like a penny stock on drugs. Second, it actually can change – the most recent upgrade was “Taproot” in 2022, designed to speed up the network.
In my view, the only cryptocurrencies that fail the Howey Test are stablecoins, since there’s no expectation of profit (failing #3). Coinbase argues that nothing they list is a security, but that they would like to list securities in the future. The SEC, on the other hand, named 13 specific cryptocurrencies in its Coinbase complaint that it has decided are as securities.
But is this the right test? Others have made the argument that baseball cards and other collectibles check these boxes but haven’t been hit with regulation.
What happens next
Coinbase has put out press releases and tweet storms making it clear they intend to fight this lawsuit, and I think that’s a great thing. Regulatory uncertainty has always hung over crypto like a cloud, but now – one way or another – crypto investors (cough, me) and companies are going to get real clarity. Based on past actions by the SEC, this will take years to play out. Here’s how I see the most likely outcomes:
(50% chance) The SEC wins its lawsuit and forces Coinbase to register via traditional methods or shut down. Coinbase transforms the business in order to register, which explodes their operating costs, but they survive.
(30% chance) Coinbase wins and forces the SEC to give a new, easier registration path. Coinbase registers on that new path and continues business as usual.
(20% chance) Congress passes a new law that endorses the approach Coinbase has been taking. In fact, there’s one being drafted right now that would designate some coins as commodities (not securities) and would give clearer guidance to crypto companies. The EU just passed such a law.
And if you’re wondering… “what the hell happened to the Batman analogy?”
Well here it is – SBF was the bad guy, who cozied up to regulators and then screwed them over. And relative to others in the space, Coinbase and Armstrong seem to be the good guy. So the SEC will hunt them, because they can take it and it’s what the industry needs. If this industry is going to be anything real, it has to beat or embrace regulation – we can’t just avoid the boss battle for the rest of time.
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Bonus Bullets
Quote of the Week:
“[Social media sites are] like nightclubs or something, where people hang out there for a while, and then they get sick of it, and they leave. And I think Elon, I’m sure he’s accelerating [Twitter’s] demise, but you can’t be like, “Oh. Wait, guys. We put in a new sound system. Come back.” That’s just not how it works. You go there because your friends are there, and then they get sick of it and go somewhere else.
— Ben Smith, Founder of Semafor
Quick News Reactions:
Netflix charity golf — They will host and live stream a charity golf tournament. Athletes from The Drive to Survive show (F1) and Full Swing show (golf) will play together. Pure gold.
