Regulators Mount Up
A still silence lingered over US regulators in the wake of FTX’s collapse. It was eerily quiet. Like a calm before the storm. Silence was shattered this week. US regulators came out guns blazing. The barrage isn’t over. It’s not good for the US crypto industry.
There are four developments in US crypto regulation. I’ll explain what happened, what it means, why it’s a big deal and the implications from each.
Banking restrictions for crypto companies
Stablecoins being deemed securities
Proposed custody rules that cut off institutions from crypto
Staking services considered securities offerings
The four developments are the culmination of regulatory action in the last few weeks, most notably this past week. Here’s the litany of regulatory actions:
The Fed and other federal agencies issued a new policy advising banks not to engage with crypto companies.
Paxos confirmed the SEC is investigating its issuance of stablecoins.
The New York Department of Financial Services ordered Paxos to cease issuing the Binance stablecoin. Paxos abided.
The SEC charged Terraform Labs and its founder with securities violation. The indictment argues that the stablecoin UST is a security.
The SEC charged Kraken with selling unregistered securities as part of its staking business. Kraken immediately shut its US staking business and paid a fine.
The SEC proposed a major revamp of asset custody rules. If passed, institutions would struggle to buy crypto.
US regulators are done pulling punches. Regulators saw crypto as innovative a few years ago. That’s changed in the wake of Voyager Digital, Celsius, Gemini Trust Co. and Genesis Trading who are all US regulated entities that took customer deposits and lost them. And of course, FTX. Not only did FTX commit one of the largest frauds in history, its founder regularly appeared with and advised politicians and regulators.
The events of 2022 burned regulators. They’re now emboldened. The legal case against crypto is not stronger today than previously, but the public is far more sympathetic to it.
The key takeaways are:
Banking restrictions are severely limiting for crypto companies. US crypto companies are being ostracized from the financial sector. It’s real bad for US crypto companies. Nothing is going to change before the next election.
Stablecoins likely aren’t securities. The SEC’s argument for why UST is a security does not apply to asset backed stablecoins in general. The actions against Paxos pertain to its relationship with Binance.
Proposed asset custody laws intend to limit crypto. It could become far harder, perhaps nearly impossible, for US institutions to own crypto.
Staking likely does not constitute a securities offering. The case against Kraken specifically pertains to how it conducted its staking-as-a-service business. It was a securities offering. Other centralized staking service providers operate differently.
This article serves as a consolidated summary of key regulator events and insights that can be gleaned from them. It does not constitute any form of financial advice or legal opinion. As a bonus, I’ve added some thoughts on Binance.
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Crypto banking restrictions
In January 2023, the Federal Reserve Board, the Federal Deposit Insurance Corporation (FDIC), the Office of the Comptroller of the Currency (OCC) issued a joint statement highlighting “significant risks associated with crypto-assets and the crypto-asset sector.” The joint statement is a new policy. Its purpose is to dissuade state banks from participating in crypto related banking activities.
The entities that issued the joint statement are big players in the finance world. The Federal Reserve Board, chaired by Jerome Powell, has several responsibilities including monitoring risks in the financial system. The Fed also provides emergency liquidity to banks. Ever notice that your savings account is insured up to $250,000? That’s the FDIC. They provide the insurance. In exchange, they ensure banks aren’t reckless. The OCC regulates national banks.
What does it mean?
The US has a dual regulatory structure. There are state and federal regulators. This statement is issued by federal regulators. National banks aren’t really able to interact with crypto. State banks, however, are governed by state regulators. Some states, like Wyoming, are more lenient. State banks have been the ones engaging with US crypto companies. Crypto is a new profitable business for state banks.
The joint policy indicates that state banks should not do anything that national banks would not be allowed to do. It’s a contradiction. If the state regulator allows an activity, then it’s usually fine. But when it comes to crypto, federal regulators don’t like that crypto business is happening at the state level beyond their reach. They don’t want state banks engaging in risky crypto business that could jeopardize the US banking system.
If state banks were to conduct crypto related business that was in breach of federal laws then they could lose their FDIC insurance and/or their access to the Federal Reserve. That’s an enormous problem for banks.
You’re willing to deposit your hard earned savings at a local bank because the FDIC (essentially the government) insures deposits. Banks also benefit from their access to the Federal Reserve. When a bank has a liquidity shortfall, they get funding from the Federal Reserve. The Fed backstop means bank-runs don’t happen anymore. The Fed backstop and FDIC insurance makes trusting your local bank much easier. If a bank no longer has either, it’s going to lose its deposits. No deposits, no banking business. There is no sense risking FDIC insurance and access to the Fed to grow a bank's crypto-related business.
So state banks, understandably, are pulling away.
Why it’s a big deal?
The policy is working. Crypto enterprises are being cut off from the US banking system. Relationships are ending. Wires are taking longer to process if at all. State banks are stepping back from engaging in anything relating to crypto linked businesses. It’s a major problem for US crypto companies. Operating in the US without interacting with the financial system is impossible.
Is this legal?
Hmmm…it’s debatable. It’s not the first time the financial industry is used to cut off nefarious actors. The Obama administration did something similar to ostracize the online poker industry in 2011-2012. Banks were no longer allowed to process payment from online poker companies. A billion dollar industry vanished. Similar action was taken to sideline the firearms and adult entertainment industry. The western world shut out Russia from its financial system when it invaded Ukraine.
The legality is nebulous. Private enterprises are used to carry out reform. It’s the government’s way of quickly imposing rule change without passing legislation.
Don’t hold your breath for any changes here short of a new government in DC. The Biden Administration has said they want to foster blockchain innovation. Be that as it may, actions speak louder than words.
Are stablecoins securities offering?
The Paxos proceedings
On February 12, 2023, the WSJ broke a story that Paxos had been served a Wells notice by the SEC. The SEC privately sends Wells notices to entities it plans to investigate for potential securities violation. The notice allows the receiver to organize its lawyers and defense. Sometimes nothing comes of it. The notice is not publicized. In this case, the notice was leaked to the WSJ.
Paxos confirmed on February 13 that it received a Wells notice on February 3, 2023. The notice alleges that “BUSD is a security and that Paxos should have registered the offering of BUSD under the federal securities laws.” The SEC is considering taking action against Paxos. Paxos disagrees. It believes BUSD is not a security.
On February 13, 2023 the New York Department of Financial Services ordered Paxos to cease issuing BUSD. Paxos complied that day.
A little background
Paxos is a US based crypto infrastructure business. Paxos is regulated as a NY Trust Company by the NY Department of Financial Services. Paxos’ largest business is issuing stablecoins on behalf of other entities. The largest such entity is Binance. Binance’s stablecoin is BUSD. There was $16 billion of BUSD outstanding prior to the SEC and NY Department of Financial Services actions.
Let’s assess each one separately.
SEC v Paxos - are stablecoins securities?
The SEC has not brought charges to Paxos. The SEC has not publicly made its argument for why Paxos issuance of BUSD constitutes a securities offering.
Nonetheless, the market has been up and arms wondering if the SEC is going to come down on stablecoins.
The key question is: are stablecoins securities?
SEC Chairman Gary Gensler thinks so. In June 2021, he stated in a speech:
“Make no mistake: It doesn’t matter whether it’s a stock token, a stable value token backed by securities, or any other virtual product that provides synthetic exposure to underlying securities. These platforms — whether in the decentralized or centralized finance space — are implicated by the securities laws and must work within our securities regime.”
The common argument for stablecoins not being securities is that there is no expectation of profit. That’s shortsighted. The expectation of profit comes from the Howey Test. The Howey Test is a precedent for investment contracts set by case law in 1946. The basis of the Howey Test is if there is an “investment of money in a common enterprise with a reasonable expectation of profits to be derived from the efforts of others,” it's a security.
The Securities Act of 1933 established the law. It is far broader than the Howey Test. The Act defines a security as:
“The term ‘‘security’’ means any note, stock, treasury stock, security future, security-based swap, bond, debenture, evidence of indebtedness, certificate of interest or participation in any profit-sharing agreement, collateral-trust certificate, preorganization certificate or subscription, transferable share, investment contract, voting-trust certificate, certificate of deposit for a security, fractional undivided interest in oil, gas, or other mineral rights, any put, call, straddle, option, or privilege on any security, certificate of deposit, or group or index of securities (including any interest therein or based on the value thereof), or any put, call, straddle, option, or privilege entered into on a national securities exchange relating to foreign currency, or, in general, any interest or instrument commonly known as a ‘‘security’’, or any certificate of interest or participation in, temporary or interim certificate for, receipt for, guarantee of, or warrant or right to subscribe to or purchase, any of the foregoing.”
The definition is so broad the SEC can shoehorn almost anything into it as Gabriel Shapiro, General Counsel at Delphi Labs indicated.
Stablecoins are backed by cash-like assets including treasuries. Adam Cochrane, venture investor, pointed out that makes stablecoins look like money market funds, which are securities regulated by the SEC. But unlike money market funds, no interest is paid to stablecoin holders.
Marc Boiron, Chief Legal Officer at Polygon Labs, explained on The Chopping Block why it's hard to envision stablecoins as securities. There are attributes that define securities beyond the Howey Test’s determination of an investment contract. For example, a note is part of the Securities Act definition of a security. Case law, specifically 1993 Reves v Ernst & Young, established that not all notes are securities. Reves v Ernst & Young set out three questions to establish if a note is a security.
Is there an investment or commercial purpose?
Is the offering broadly or narrowly distributed?
Is there an alternative regulatory regime?
Stablecoins are not investments. They are used in investment activity. But no one buys a fiat backed stablecoin for investment or commercial purposes. Stablecoins are widely distributed, which suggests they could be a security. Marc explained that the answer to the alternative regulatory regime question is less evident. Case law and SEC suggests state law is not an alternative to replace federal securities law. However, the BitLicense issued by the NY Department of Financial Services is robust and requires significant disclosure. It could pass as an alternative.
Aside from the regulatory regime debate, Marc posits “what else would you want to know other than the stablecoin is backed 1:1?” That’s the disclosure that’s necessary. Major stablecoins are already providing that disclosure, though we may want better audits.
It’s unclear whether or not stablecoins are securities. But the idea that the SEC’s claim has no merit and can be dismissed is incorrect. The looming threat of stablecoin regulation in the US will persist.
NY Department of Financial Services v Paxos - it’s a Binance thing
The NY Department of Financial Services ordered Paxos to stop issuing BUSD “as a result of several unresolved issues related to Paxos’ oversight of its relationship with Binance in regard to Paxos-issued BUSD.” A spokesperson for the Department stated that Paxos was unable to administer the token in a “safe and sound” manner. “[Paxos] violated its obligation to conduct tailored, periodic risk assessments and due diligence refreshes of Binance,” the spokesperson stated via email to Reuters.
The NY Department of Financial Services claims that Paxos’ partner, Binance, engaged in something it should not have. Paxos is responsible for how its product is being used. If Paxos’ client, in this case Binance, uses Paxos’ product in a way the regulator does not approve, the regulator can go after Paxos.
Paxos takes USD and issues BUSD on the Ethereum blockchain. For every $1 of BUSD issued on Ethereum, Paxos has $1 of collateral. The Department authorized Paxos to do this. Pursuant to requirements, all stablecoins issued by Department of Financial Services regulated entities are required to be fully backed 1:1 by cash or cash equivalents.
BUSD on Ethereum was ported to Binance’s blockchain, known as BNB. There is a lot more to do with BUSD on BNB than on the Ethereum blockchain. An asset is “wrapped” on one chain, meaning it’s locked and can’t be used on the origin chain. A synthetic “wrapped” version of the asset is created on the chain it is ported to. There is a 1:1 match. BUSD on Ethereum was wrapped and became wrapped-BUSD on BNB. This is common practice in crypto.
In January, blockchain analytics company ChainArgos discovered that in 2020 and 2021 wrapped-BUSD was created on BNB without 1:1 backing. Stablecoin dollars were fabricated out of thin air. In January, Binance admitted that it did not always have 1:1 backing. $1 billion of additional wrapped-BUSD on BNB had been minted without the accompanying BUSD collateral on Ethereum. Binance backfilled the missing collateral subsequent to the shortfalls.
I suspect that is why the NY Department of Financial Services is going after Paxos. The Department stated that it “has not authorized Binance-Peg BUSD on any blockchain.” The “Binance-Peg” is referring to wrapped-BUSD on BNB.
The NY Department of Financial Services did not force Paxos to cease the issuance of Paxos’ own stablecoin called Pax-Dollar. Pax-Dollar is regulated by the Department.
The NY Department of Financial Services does not have a problem with stablecoins. It does, however, have a specific problem with how BUSD was issued. I believe the department’s problem stems from the under collateralization of wrapped-BUSD on BNB.
Why it’s a big deal?
Stablecoins are a big deal in crypto. $137 billion worth of stablecoins have been issued. They’re arguably crypto’s best innovation. A US-dollar backed stablecoin is digital currency pegged to the US-dollar. The peg is maintained by having $1 of cash or equivalents held for every stablecoin issued. The appeal of stablecoins is that their value is constant. They’re denominated in a familiar unit. Stablecoins are a faster, more accessible and cheaper way to conduct commerce. They can be sent to anyone in the world at any time instantly for low cost. A US bank account is not required to transact in dollar backed stablecoins. A quarter of US outbound remittance is done using stablecoins. Stablecoins are used to facilitate DeFi borrow, lend and trading products.
Stablecoins are big business with an even bigger potential. Anything that risks derailing the use or innovation of stablecoins in the US is a bad omen. The NY Department of Financial Services action is less of an issue. It’s a Paxos and Binance specific issue, not a stablecoin writ large issue. The SEC stablecoin regulation is a big deal. It could thwart usage and development in the US.
The fallout from this will be:
Paxos in trouble: Haseeb Qureshi, co-founder of Dragongfly, claims the bulk of Paxos’ revenue comes from issuing BUSD. If that’s the case, Paxos’ has a major revenue hole to fill. Binance is not coming to Paxos’ defense.
USDC and Tether gain share: The amount of BUSD’s circulating has declined from $16 billion to $14 billion in the last week. USDC and Tether will take its share.
Stablecoin US future in peril: Regulation remains unclear.
TBD stablecoin as security: Waiting to hear what argument the SEC makes against Paxos. In the meantime, the SEC’s charges against Terraform have clues.
Chilling effect: US retail and institutions will be far more cautious using stablecoins.
SEC v Terraform Labs - UST a security
On February 16, 2023 the SEC charged Terraform Labs and its founder Do Kwon with “orchestrating a multi-billion dollar crypto asset securities fraud.” Securities fraud is a serious offense. This action is a big deal because it's the first time the SEC has made a formal case that a stablecoin is a security.
I use the SEC charges against Terraform to understand the SEC’s argument that stablecoins are securities. (For a refresher on Terra/Luna read WTF LFG?...crypto crash explained.)
SEC’s stablecoin = security argument
The SEC claims stablecoin USTerra (“UST”) was sold as a security based on the Howey Test. The gist of the argument is:
Investment of money: UST investors tendered crypto assets or fiat for UST. The UST was used to earn a 20% return via Terra’s Anchor protocol.
Common enterprise: Terraform developed and maintained profit-bearing opportunities for UST investors, like the Anchor protocol. Anchor pooled UST assets to lend them to borrowers. Returns from Anchor were distributed to UST investors equally in proportion to their investment size. Accordingly, UST investments in Anchor were tied to the success of Anchor overall. The de-peg in May 2022 led to the collapse of all Terraform assets proving the fortune of each was linked.
Expectation of profits based on the efforts of others: 70% of UST was invested in the Anchor protocol prior to Terra’s collapse. UST investors placed their UST in Anchor to get the advertised 20% annual returns. Terraform was directly involved in generating Anchor returns. Do Kwon ordered over half-a-billion UST to be deposited into Anchor to fund the 20% returns.
UST can be exchanged for LUNA: UST investors had the right to convert their UST into LUNA. The SEC separately argued that LUNA is a security. If something can be exchanged for a security, then that thing is also a security.
So what? - Read across for broader stablecoin legislation
The SEC’s argument that UST is a security is based on specific characteristics that do not apply to asset backed stablecoins more broadly. The crux of the argument is based on Terraform’s Anchor protocol. It’s Anchor that provided the “investment of money for returns into a common enterprise with the expectation of profits.” The equivalent of Anchor does not exist for fiat backed stablecoins. Asset backed stablecoins don’t carry a right to be converted into a security. They can only be redeemed for fiat.
On those grounds, it’s hard to argue that the SEC’s case against UST can be applied to asset backed stablecoins. That bodes well for the US stablecoin industry. But it doesn’t spell victory. SEC put forth its best argument against Terraform. The merits of the argument don’t pertain to stablecoins more broadly. But that doesn’t mean the SEC couldn’t devise another argument for fiat backed stablecoins. After all, the definition of security is all encompassing. The SEC’s investigation into Paxos’ stablecoin will be more telling.
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New custody rules make owning crypto much harder
On February 15, 2023, the SEC announced a proposal to amend existing rules for Registered Investment Advisors. The SEC is also tasked with regulating the companies and individuals that advise Americans on investing in securities. Those companies and individuals are known as Registered Investment Advisors.
The proposal includes 434 pages of suggested rule amendments. There are wide sweeping changes, some of which directly pertain to crypto. This is not “regulation by enforcement.” A term used to describe the SEC’s approach to crypto. The SEC has a penchant to sue crypto participants for doing things incorrectly, instead of introducing or clarifying rules. This proposal is open for public commentary for 60 days. Representatives from all industries, including crypto, will provide feedback. The culmination of which will likely be some form of new rules.
Potential impact on crypto
The SEC is proposing to expand its regulation remit beyond securities to assets more broadly. The widening mandate will impact crypto in the US specifically and other asset classes generally. The proposal will make it harder to own and trade crypto. It’s designed to bring crypto under the auspices of the SEC and limit crypto usage. Republican SEC Commissioner Mark Uyeda said as much:
“this approach to custody appears to mask a policy decision to block access to crypto as an asset class.”
The two key things to understand are custody and market structure.
My understanding was informed by Mike Selig, counsel at Willkie Farr. Mike was on the Unchained Podcast with Laura Shin (fellow reader of Crypto Clarity). Matt Levine also influenced my thinking.
Registered Investment Advisors are required to custody the “securities and funds” they manage on behalf of their clients with “Qualified Custodians.” Qualified Custodians are vetted entities that hold client “securities and funds” in segregated accounts among other things. They are typically a federal or state-chartered bank or savings association, a trust company or a registered broker-dealer. The proposed rule change would expand “securities and funds” to “any client assets of which an adviser has custody.” That means anything a Registered Investment Advisor touches, needs to be held by a Qualified Custodian, including crypto.
That doesn’t sound so bad. After all, if I’m going to entrust someone else to hold my crypto, like I trust them to hold my securities portfolio, I’d like to make sure it’s done properly. Ohh yea…and crypto custodians have a habit of losing their clients money.
It’s not that big of a deal, many Registered Investment Advisors already hold crypto assets with Qualified Custodians out of an abundance of caution.
But here’s the rub:
Evergreen asset definition: “any client asset” is really broad. Anything today or in the future could fall into that.
Expanding regulatory scope beyond securities: Any conceivable asset that you want someone else to custody would fall under SEC regulation. That’s a much broader mandate.
Indirect SEC regulation of Qualified Custodians: The SEC does not regulate Qualified Custodians. Under the proposal, Registered Investment Advisors require Qualified Custodians to abide by rules set by the SEC. Through Registered Investment Advisors, the SEC ends up dictating how Qualified Custodians operate.
The biggest issue is that most centralized exchanges are not Qualified Custodians. SEC Chairman Gensler said it himself:
“the current business model in crypto exchanges does not meet the qualified custodial standard.”
Paul Grewal, Coinbase’s Chief Legal Officer, is hopeful that Coinbase’s New York-chartered trust entity “will remain a qualified custodian.” We’re in for a heated public debate.
Why it’s a big deal?
Registered Investment Advisors tend to trade crypto through centralized exchanges. Most of which are not Qualified Custodians. So if Registered Investment Advisors can’t interact with centralized exchanges, they can’t trade crypto. If they can’t buy and sell crypto, Registered Investment Advisors won’t offer it to their clients. Crypto is cut off from many US investors. Mutual funds, hedge funds, virtually any large pool of capital in the US falls under Registered Investment Advisor rules.
Institutional ownership of crypto assets becomes nearly impossible.
Why is this happening?
I believe the SEC wants to impose equity market structure onto US crypto markets. In US equity markets, custody and trade execution are done by separate regulated entities. In crypto, centralized exchanges provide both custody and trade execution services. As crypto has shown, when entities (FTX et all) do both, it’s ripe for abuse of customer funds. Furthermore, upon bankruptcy, depositors have no added protection. The SEC’s proposal, rightfully so, is trying to prevent manipulation of customer funds and improve their claims in the case of bankruptcy.
Will this work? What could the impact be?
There are two prongs to assess the outcome of the proposed regulation:
Will it pass?
What impact could it have on crypto markets?
I know the proposal will be contentious because it has far reaching implications beyond crypto markets. I don’t have a view on what version of it will pass. But something will pass.
As for the impact some version of this rule proposal could have on crypto markets there are four things to consider:
US specific: The rules only apply within the US. Americans tend to forget how global crypto is. This isn’t topical in Asia where crypto is gaining momentum or in Europe where the UK is passing progressive crypto regulation.
Decentralized exchanges: Decentralized exchanges are beyond these proposed rules, or likely any rules. Decentralized exchanges are becoming ever more popular. So are self-custody solutions. The problem is you need to go through a centralized exchange to get to a decentralized exchange. But even that is changing.
Derailing US institutions investing in crypto: Regardless of the outcome of this proposal US institutions are now even more (if that’s even possible) concerned about getting into crypto.
Reshaping global crypto market structure is nearly impossible: It’s wishful thinking that the SEC can impose equity market like structure onto the global crypto market. The horses have left the stable.
Do staking services constitute a securities offering?
The SEC charged Kraken on February 9, 2023 with “unlawful offer and sale of securities” in violation of the Securities Act of 1933. Kraken’s staking-as-a-service product constitutes the sale of unregistered securities. To settle the charges, Kraken agreed to immediately terminate its US staking business and pay a $30 million fine.
Kraken was fine operationally. It took customer’s tokens. Staked them on their behalf. Paid them back when they asked for their money. There was no fraud. No negligence. That’s an important distinction to make in crypto these days.
The SEC does not allege that Kraken operated its staking business incorrectly. It claims that Kraken did not make the proper disclosures. Had it done so, Kraken would still be operating.
The SEC is tasked with protecting investors. Although no Kraken staking-as-a-service clients were harmed, the SEC purports they could have been and that they should have been informed of the risk they were taking.
The issue is Kraken specific
The way Kraken operated its staking business makes it clear that it was selling unregistered securities. The fact that Kraken did not contest the charges, shuttered its business and paid a fine corroborates my opinion.
Kraken’s staking-as-a-service business constitutes the sale of security for several reasons. Kraken marketed the program as an investment with “up to 21%” returns. Kraken had managerial oversight. It took custody of clients' assets. Assets were pooled. Kraken paid a fixed return whereas staking rewards fluctuate. Kraken paid out interest on a cadence that had no bearing on when the staking rewards were received. Kraken managed a pool of unstaked tokens to allow redeptions at any time. All this meant that clients took on “Kraken” risk by using its staking-as-a-service product.
Recall that if someone “invests money in a common enterprise and reasonably expects profits or returns derived from the entrepreneurial or managerial efforts of others,” the offering constitutes a securities contract. Kraken is the common enterprise. Clients expected a return from Kraken’s efforts.
This is a Kraken specific issue. Not all staking services operate like Kraken. In fact, most don’t.
Why it’s a big deal?
Staking is a big deal in crypto. Major blockchains mostly operate Proof of Stake consensus mechanisms. They represent a combined $240 billion of market capitalization ($200 billion is Ethereum).
Staking ensures blockchain security. Security is critical to blockchain usage. Validators “stake” their tokens as a bond when they verify transactions. If validators incorrectly input transactions, their staked tokens are “slashed,” meaning they’re lost.
People conflated the SEC’s actions against Kraken as an indictment of staking in the US. Panicked ensued. 28% of Ethereum staking is done via centralized staking services like Kraken. Kraken’s global staking product represents 7% of all Ethereum staked. A subset of the 28%, and Kraken’s 7%, is done in the US. Centralized US Ethereum stakers is a small subset of overall validators. Ethereum would not be material affected if they disappeared.
Panic ensnared Coinbase. Coinbase represents 12% of Ethereum staking. Fears swirled that the SEC would target Coinbase like it did Kraken. Coinbase stock dropped 10%. Staking is a non-cyclical high growth profitable revenue stream for Coinbase. Coinbase staking revenue is an undisclosed subset of its subscription and services revenue, which represents 20-36% of total revenue. It’s a big deal for Coinbase.
Brian Armstrong, CEO of Coinbase, responded to the fear with:
Coinbase’s argument of why its staking service is not a security is based on the four prongs of the Howey Test.
Not an investment of money: A securities investment requires investing money that is given up “in return for a separable financial interest.” Staking through Coinbase doesn’t require giving up anything. Clients retain ownership of their staked crypto and can unstake anytime.
No common enterprise: Assets are staked on a decentralized blockchain. The fortune of stakers is not tied to that of Coinbase. Staking rewards are determined by the blockchain, not Coinbase.
No expectation of profit: There is no incremental profit from using Coinbase’s staking service compared to staking yourself.
Not based on efforts of others: Blockchains determine which validators are rewarded and how much. No amount of Coinbase’s entrepreneurial and managerial effort can impact staking rewards. Coinbase uses publicly available software and computer equipment to provide staking services.
I agree with Coinbase’s logic. More importantly, Coinbase is ready to fight the SEC on this point if required. Coinbase has the resources to do it. Staking is a crucial part of their business.
The charges the SEC laid on Kraken are valid. Their merits are specifically tied to how Kraken designed its staking business. The merits of the SEC’s case against Kraken are not valid to staking in general nor to Coinbase. The SEC has not charged Coinbase with similar securities violations.
The panic over the SEC cracking down on staking was overblown. Staking, whether through centralized actors like Coinbase, or decentralized protocols like Lido and Rocket Pool will continue.
Is Binance in the clear?
Binance has been under investigation by the SEC and CFTC. There is no shortage of rumors about Binance’s shady business practices. On February 15, 2023, the WSJ reported that Binance expects to pay penalties to resolve the US probe according to Patrick Hillmann, Binance's chief strategy officer. Hillmann conceded that:
“Binance grew quickly and began as a business powered by software engineers unfamiliar with laws and rules written to address the risk of bribery and corruption, money laundering, and economic sanctions.”
Anyway, Binance is working on filing in its regulatory gaps. So everything is cool right?
Why it’s a big deal?
Binance concerns were an overhang on the market. The market's interpretation has been “ohh Binance just has to pay fines and then we can move on.” People feared much worse. Clarity that it won’t be more than fines is a sign of relief.
People may have read too much into Hillman’s statement. This one is not over yet, but so far the news is better than expected.
Tying it all together
That was an enormous regulatory download. The US woke up to regulating crypto. It’s not happening in a way that’s favorable for US crypto companies. Regulation is necessary. 2022 proved that crypto needs it. The penalty for crypto frauds of 2022 is punitively restrictive regulation that hampers accessibility. The risk is that American innovation is sapped to other geographies. Government is willing to take that risk, it's more manageable than enduring another crypto 2022. It’s more palatable to restrict the industry now than risk it getting larger and affecting American financial system.
The banking restrictions are by far the worst. Unlike the other action, there is no due course to reverse the policy.
In a week where regulation came down with a heavy hand, crypto markets rallied 10% to recent highs. That’s crypto for you!
Perhaps the interpretation is that the market expected stricter regulation. The banking restrictions and potential custody changes are decidedly bad. The read across for the broader market from staking and stablecoin charges are modestly positive. Perhaps the Binance news relief offered support. Maybe that rally is a reminder that crypto is global. US regulator don’t have that much influence.
Who knows. It’s still the wild west. Saddle up.
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Had to share this one to my subs, great rundown on everything