SEC Drops the Hammer
Making sense of the SEC cases against Binance and Coinbase
The SEC dropped the hammer on US crypto. In a frantic 48 hour period the SEC charged Binance and Coinbase with failing to register. The suit against Binance outlines fraudulent activities. The SEC is seeking to shut down Binance’s US business immediately. The SEC claims Coinbase’s business is operating outside regulatory confines.
The SEC’s actions would be calamitous for US crypto if successful. It would shut down crypto trading in the US and send shockwaves across the global industry.
This week's legal actions are the culmination of years of work and a litigious approach by the SEC. It was a bumpy ride.
I read the 136 page suit against Binance and the 101 page suit against Coinbase. I combed Twitter and listened to nearly every podcast on the topic. I distilled what I learned and my own opinion in this article. I detail what happened, why it's a big deal, outline the facts of the two cases, assess the market’s reaction and suggest how things could play out.
What happened
On Monday June 5, 2023, the SEC filed 13 charges against Binance and its founder Changpeng Zhao. The securities violations include commingling customer assets, transferring client assets to Binance controlled accounts, misleading investors, and wash trading. Binance was also charged with failing to register its US business with the SEC and offering unregistered securities. Zhao was personally charged. The SEC holds him liable as the control person for Binance’s US entities.
“Through thirteen charges, we allege that Zhao and Binance entities engaged in an extensive web of deception, conflicts of interest, lack of disclosure, and calculated evasion of the law,” said SEC Chair Gary Gensler.
On Tuesday June 6, 2023, the SEC charged Coinbase with failing to register with the SEC and offering unregistered securities.
On Tuesday June 6, 2023, the SEC filed an emergency action to freeze and repatriate the assets of Binance’s US and prevent the destruction of documents.
On Tuesday June 6, 2023, ten states including Alabama, California, Illinois, Maryland and New Jersey issued a cease and desist order to Coinbase. The ten states require Coinbase to shut down its staking business immediately or within a month. Coinbase can relaunch its staking business once it has either i) proven it’s not offering an unregistered security or ii) has registered it. The orders only pertain to Coinbase’s staking product.
The SEC aims to permanently end Binance’s business in the US. The SEC wants an injunction to stop Binance’s US businesses immediately and appoint a receiver to wind it down. The SEC requests that Coinbase stop violating the Securities Act and register according to the Security Act’s framework. The SEC wants both Binance and Coinbase to disgorge all ill gotten gains, pay a civil penalty and stop offering unregistered securities.
All in 48 hours! Chaos ensued in crypto markets and Twitter.
Why this is a big deal
1. SEC is trying to shut down crypto in the US
The SEC actions aim to shut down crypto trading in the US. The SEC is seeking both parties to cease operations. The SEC wants to shut down Binance US immediately.
The SEC is no longer regulating by enforcement. It is trying to end crypto trading by enforcement.
2. SEC is going after the biggest fish
Binance is the largest global exchange. Coinbase is the largest US exchange and crypto business. The SEC strategy has been to enforce against smaller actors who could not defend themselves. The SEC then uses those legal wins to mount a case against the largest actors.
Targeting the largest actors serves to publicize the SEC’s actions and chokes off the industry at its root. Binance and Coinbase are the primary on ramps into crypto. Crippling them hampers capital flow into the industry. Binance and Coinbase comprise the vast majority of crypto trading volumes. The SEC believes the tokens traded are securities. Cutting the two of them off indirectly regulates the tokens they trade. It's too onerous for the SEC to sue each token. Instead the SEC sues the exchange. Dismantling the exchange prevents trading of the tokens the SEC sought to regulate.
3. Markets reaction highlights its resiliency
Market prices were relatively stable given the SEC actions pose a direct threat to the two most notable companies in the industry. The muted market reaction implies two things:
It was expected.
People don’t care that much. They live outside of the US or they don’t think the SEC will be successful.
4. Accelerated collision course toward US regulatory clarity
There are three separate regulatory developments in the US. The CFTC suit against Binance. The CFTC states assets including BTC, ETH and stablecoins are commodities. The SEC suit against Binance and Coinbase. The SEC claims most tokens are securities. The McHenry, Thompon, et all draft bill that was released the week before the SEC dropped the hammer. All three are driving at regulatory clarity in the US.
A race is now on between the CFTC, the SEC and Congress to form the public and courts opinion on what regulation should look like.
5. SEC wants to apply securities market structure to crypto markets
Securities markets have three distinct players: exchanges, broker dealers and clearing agencies. Regulation evolved to separate the three to limit fraud. Centralized crypto exchanges, like Binance and Coinbase, do all three. That’s a problem for the SEC. It’s an acute problem in the wake of FTX. FTX’s rampant fraud would have been harder to execute if different entities custodied the assets, exchanged assets and settled trades. FTX is the prime example of why securities markets are structured the way they are. FTX vindicates the SEC desire to impose securities market structure on crypto markets.
DeFi already separates the three activities. Uniswap is the exchange where buyers and sellers interact. Ethereum is the clearing agent where trades are settled. Self-custodied wallets like Metamask are the equivalent of broker dealers. But that’s not the case on centralized exchanges.
Crypto regulation is in a bind. Blockchain technology has disintermediated the three actors enabling drastically lower transaction costs and instantaneous settlements. And, in the case of the DeFi example, the three critical activities are performed by independent protocols. It's a breakthrough innovation. But on-ramps from centralized exchanges are required to participate in crypto. Plus users favor the experience of centralized exchanges over DeFi competitors. Therein lies the problem. If the DeFi example becomes commonplace in the future, then there’s less need for regulation. But in the interim, regulation is needed to prevent the likes of FTX.
The options are for the SEC to introduce new rules to make the exception for crypto centralized exchanges. That’s unlikely. Alternatively, centralized exchanges need to separate the three activities into independent entities. They’re not keen on that. Plus it doesn’t address the fact that the SEC thinks they’re trading unregistered securities.
Without saying it directly, the SEC wants Coinbase and Binance to split up their businesses so that the exchange, broker dealer and clearing agent functions are conducted by three separate entities. And then register each entity with the SEC. And then only trade in registered securities, which is exactly zero tokens. Alternatively, according to the SEC, centralized exchanges could keep their existing structure and only trade BTC. Neither of those options are palatable.
6. The SEC alleges Binance is fraudulent
Rumors of Binance shady business practices have swirled for years. The CFTC suit detailed circumventing US regulations, enabling terrorist financing and trading against its clients. The SEC suit corroborates the CFTC’s claim that Binance knowingly circumvented US regulation. The SEC adds that Binance wash traded and moved client funds into accounts controlled by Zhao.
Case details
The cases against Binance and Coinbase are nearly identical with one critical exception. Coinbase is a matter of registration violations. Binance is a case of registration violation and securities violation.
Registration violations: Binance & Coinbase
There are four facets to the overlapping registration violation argument the SEC made against Binance and Coinbase.
1. Binance and Coinbase combined three separate activities into one and didn’t register them
The three separate regulated entities (i) an exchange, (ii) a broker dealer and (iii) a clearing agency each perform a different function. Exchanges bring together buyers and sellers of securities. NYSE and Nasdaq are exchanges. A broker dealer represents investing clients and custodies their assets. Investors don’t interact directly with exchanges, licensed broker dealers do. Charles Schwab, Fidelity, TD Ameritrade, Morgan Stanley, e-trade are examples of the many broker dealers. A clearing agency is the intermediary between the exchange and broker dealer. The clearing agency ensures the trades are properly settled. The Depository Trust Company is the primary clearing agency for the US securities market. Separating the three functions reduces conflicts of interest and the potential for fraud.
Binance and Coinbase perform all three functions. The SEC claims that Binance and Coinbase operate an exchange by bringing together buyers and sellers. Binance and Coinbase play the role of clearing agent by settling trades for their respective exchanges. Binance and Coinbase solicit potential investors, handle client funds and charge users transaction based fees, which makes the two companies broker dealers. No one is refuting that Binance and Coinbase play these three functions. US securities regulation does not allow the same entity to perform all three functions.
Exchanges, broker dealers and clearing agencies operating in the US need to register with the SEC. It’s the law. Binance and Coinbase did not register. By not registering the two companies deprived the public of disclosures and protections.
2. Crypto assets are securities
The SEC disclosed a non-exhaustive list in the Binance and Coinbase suits of what crypto assets were listed on the respective exchanges that the SEC believes are securities (see below). The formation of the list is bizarre. Some tokens are noted as a security on one exchange but not the other. The mentioned tokens are:
The SEC explains that these tokens all share similar attributes that make them securities per the Howe Test. They are:
Marketing materials suggested there was an expectation of profit.
The profit would come from the efforts of a specific group. The group was often highly incentivized. They were issued free tokens.
The proceeds of the raise funded development of the project. Successful development would lead to an increase in the token value.
A burn mechanism is used in some cases. Burning tokens removes them from circulation, which increases their value and further solidifies the expectation of profit.
3. Staking products are unregistered securities offering
The SEC alleges that Binance’s and Coinbase’s staking-as-a-service product constitutes an unregistered securities offering. According to the SEC, an investment contract is formed when the staking client invests their money and relinquishes control to the respective staking service provider. The staking investors invest in a common enterprise. The investor’s fortune is tied to Binance’s and Coinbase’s ability to validate. The invested assets are pooled. Clients pay the common enterprise a commission. Binance and Coinbase are in complete control of their respective staking operations. Staking investors have an expectation of profit. Binance and Coinbase marketed the return potential from staking.
4. Binance and Coinbase knew they were listing unregistered securities
The SEC details that Binance and Coinbase knew their exchanges were trading unregistered securities and proceeded anyway. The respective cases differ in this regard. The SEC states that Coinbase tried to legitimize its actions, whereas Binance flagrantly knew it was in breach.
Coinbase reviewed token listing applications. It created a rating council that determined the degree to which a token mimicked a security. Coinbase’s listing team guided project teams to adjust their token model such that the token did not resemble a security. The result was a listing on Coinbase. Coinbase doubled the assets listed on its platform from 2019 to 2020 and doubled again in 2021. Coinbase made available tokens that its own rating council determined to be at high risk of being a security. The SEC claims the framework Coinbase applied was a facade to legitimize listing unregistered securities. The SEC alleges that Coinbase listed tokens it knew were likely securities in order to increase trading volume and profits.
Binance did not employ listing frameworks. The SEC details how Binance knew it was listing securities. Binance’s COO’s quote from December 2018 summarizes it best:
“we are operating as a fking unlicensed securities exchange in the USA bro.”
Securities violations: Binance only
The SEC alleges Binance conducted five main securities violations.
1. Enabled US customers to circumvent law
Binance maintained that US clients only interacted with the Binance US business. In reality, Binance deliberately didn’t enforce its procedures to prevent US clients from interacting on Binance.com. Binance helped clients circumvent US regulation to enable US clients to trade on Binance.com.
US operations and exchange is required to target US clients. Traders prefer exchanges with the most volume. They offer the best execution price. Binance’s global exchange, known as Binance.com, has the most volume. But it’s not legally available to US clients. The SEC alleges that Binance recruited American traders to the Binance US exchange and then illegally moved to the Binance.com exchange.
2. Wash traded to artificially inflate trading volumes
Zhao controlled entities participated in wash trading on the Binance US exchange. Wash trading involves trading assets between two entities owned by the same party to give the appearance of trading volume and market pricing.
3. Commingled customer funds and moved them without client authority
Binance freely transferred investors crypto and fiat assets as it pleased. The SEC believes client funds were moved into accounts controlled by Zhao.
4. Made false and misleading representations to investors
Binance’s US entities made misrepresentations to investors about the controls in place while raising $200 million from private investors ($40 million of which came from US investors) and attracting billions of dollars in trading volumes.
5. The US entity was not autonomous, Zhao was in complete control
Binance created independent US entities and hired US based executives to conform to US law. In reality, Zhao was directly involved in the US operations. It was not independent. Zhao owns 81% to 100% of the US businesses. Binance controlled the finances and bank accounts of Binance’s US operation and custodied the funds of Binance US clients. In November 2020, the US business’ CEO told Binance CFO that the “entire team feels like [it had] been duped into being a puppet.”
The SEC also alleges that Binance’s native token BNB, its stablecoin BUSB and its Simple Earn lending product constitute unregistered securities offering.
BNB: Binance raised $15 million in its ICO in 2017. The ICO was offered to US and global investors. BNB was marketed as an investment in the success of Binance. Binance used 20% of its profits to buy back and burn BNB.
BUSB: BUSB was sold to US investors. Binance promoted the APY BUSB owners could generate. BUSB purchasers invested in a common enterprise, which deployed capital to generate the advertised APY.
Simple Earn: Binance pooled crypto assets from US and global investors. It lent those assets to borrowers. Interest charged to borrowers was shared amongst lenders and Binance.
Defendants responses
Binance
Binance issued a press release the same day of the SEC filing denying any wrongdoing. On Thursday, June 8, 2023 Binance suspended USD deposits. USD withdrawals will cease June 13. It appears that banks have jettisoned Binance US. Binance US is also delisting all USD pair trades.
The SEC suit was not a surprise. The CFTC sued Binance in March. The CFTC suit alleged fraudulent activity (to learn about the CFTC suit read CFTC v Binance: Crypto Goes to Commodity Court).
Coinbase
Coinbase's response started before it was sued by the SEC. The suit was not a surprise. Coinbase disclosed it received a Wells Notice on March 22, 2023. Coinbase denies wrongdoing and is going to fight the case. Coinbase went on the offensive subsequent to receiving its Wells Notice.
In SEC v COIN: The Heavyweight Battle for US Crypto I detail Coinbase’s defense for:
Why the tokens it lists are not securities
Why the SEC does not have authority
Why Coinbase’s staking product is not an unregistered securities offering
Why registering a token and a crypto exchange with the SEC is not possible
Coinbase offensive includes a new marketing campaign proclaiming “it’s time to update the system.”
Coinbase preemptively sued the SEC on April 24, 2023. The action forces the SEC to answer in federal court whether or not it intends to provide regulatory guidance for the crypto industry. Coinbase petitioned the SEC in July 2022 to provide guidance. The SEC didn’t respond. Coinbase escalated the matter by suing the SEC. The SEC is now legally obliged to respond.
Suing the SEC is unusual. It’s legal maneuvering on Coinbase’s part. By answering yes, the SEC commits itself to clarifying securities laws applicability to crypto. By answering no, Coinbase has court document evidencing that the SEC is unwilling to engage with the industry it aims to regulate. That could be valuable as Coinbase mounts a case demonstrating that the SEC has been uncooperative.
On Wednesday, June 7, 2023 the third circuit court determined that the SEC had seven days to respond to Coinbase’s lawsuit. Stay tuned for more.
Market’s reaction
By Friday, June 9, five days after the SEC first filed its suit against Binance, the tokens listed in the Binance and Coinbase suit (excluding BNB) were down 16% on average. BNB token and COIN stock declined 15% and 17% respectively over the same period. BTC and ETH were down 3% each (see table below).
Binance.com faced $2.2 billion of net withdrawals in the last seven days, which represents about 4% of its estimated $56 billion asset base. Binance US faced $100 million net withdrawal. Binance has previously experienced larger withdrawals.
Coinbase experienced $1.5 billion net withdrawal in the last week, which represents 1% of its total $130 billion worth of customer deposits as of March 31, 2023.
The market appears to have had a muted reaction relative to the consequential impact these two suits could have. The market’s response implies:
Business as usual for Coinbase. The stock dropped 17%. But COIN has been jolted -20% three times already this year. It’s a volatile stock that moves with regulatory headlines. This move is no greater than prior moves. It's business as usual for Coinbase. All its units continue to operate until the suit is settled.
Rest of the world doesn’t care about SEC v Binance. There has not been a bank run on Binance. Its depositors are mostly in the Middle East and Asia. They don’t care that Binance’s US entity didn’t register properly with the US regulator. They may be concerned that funds might have been (or currently are) improperly custodied or transferred. But they’re not panicking. They probably still prefer Binance to other local options.
There aren’t many other options. Binance has a dominant 70% share of global crypto trading volumes. Participating in crypto means interacting with Binance.
How will things play out?
1. Binance US is done. Binance is fine (for now?)
I suspect that Binance US’ operations are over. The SEC essentially ordered an emergency cease and desist for Binance US. In the subsequent days, US banking partners have abandoned Binance. Binance US will die from depleting trading volumes and an uncompetitive product before the SEC suit officially kills it.
Binance perhaps pays a fine to settle. Zhao continues to operate Binance. The US business doesn’t matter to Binance. The crypto landscape in the US makes the geography even less of a priority for Binance.
The calculus is differs if the Department of Justice charges Binance and Zhao. The CFTC and SEC cases outlined fraud at Binance that Zhao was aware of. I don’t think this is the end. I suspect a DoJ suit is coming. If that’s the case, Binance and Zhao directly could be compromised.
2. Coinbase faces off with the SEC in a multi-year court battle
Legal pundits expect 2 to 4 years for the court case to be settled. The SEC has now made its case why Coinbase is in breach of securities registration rules. Coinbase had previously outlined its defense (read SEC v COIN: The Heavyweight Battle for US Crypto). The arguments from both sides are now in the public. It’s up to the courts.
The consensus amongst legal experts is:
Coinbase defense for why its staking product is not a security is strong. Some staking services are likely securities offerings, others are not. It depends how the staking product was constructed.
Coinbase’s argument that it did not list unregistered securities is challenging. The burden of proof for the SEC is low. The SEC just needs to prove that one of the nearly 600 tokens Coinbase lists is a security for it to prove that Coinbase operated an unregistered securities exchange.
Coinbase is a good faith actor. It has tried to engage with the SEC, operates within its interpretation of the law and lobbied for clarification of rules.
3. Congress moves faster than the courts
On Friday June 2, 2023, Patrick McHenry, Chairman of the House Financial Services Committee, and Glenn Thompson, Chairman of the House Committee on Agriculture, and two others released draft legislation addressing digital asset regulation in the US. The legislation aims to clarify and fill regulatory gaps while balancing consumer protection and fostering innovation. I think that with the support of two ranking members legislation could pass before the Coinbase case is settled. That means within 3 years.
The SEC will also likely look different before the Coinbase suit is settled. Chairs of federal regulatory agencies typically change with new Presidents. A Republican President will almost certainly replace current SEC Chair Gensler. A Democratic President, including Biden, could replace him as well. Insiders suggest Gensler is losing trust amongst Democrats. A new SEC Chair could arrive as soon as early 2025, which is likely before the SEC suit is settled.
4. US crypto exchange landscape changes
I suspect US crypto centralized exchanges will look different either as a consequence of legislative or legal action. The separation of exchange, broker dealer and clearing agent make sense for securities markets. It prevents fraud and manipulation. Perhaps that means centralized crypto exchanges in the US need to separate their businesses. Alternatively, new regulation is required to address the blockchain based system. A system that disintermediated the three actors.
So what…
The SEC dropped the hammer but the crypto industry didn’t shatter. The SEC suits are a big deal for US crypto. The SEC is trying to kill crypto trading in the US. But it’s not so simple. It won’t happen overnight. Coinbase and others are willing to fight for the industry. The severity of the SEC charges may accelerate Congressional legislation. In the meantime, it's business as usual. But it’s far from over. The SEC may not be done litigating. The next big target would be DeFi protocols. Uniswap could be in its sights. The DoJ could be coming for Binance. Buckle up for a bumpy ride.
Regulation can’t kill crypto. It’s a self-sovereign asset. But it sure can make adoption much harder.
Stay curious.
Thinking for this article was informed by @EmilyMMeyers @CampbellJAustin @matt_levine @hosseeb @jchervinsky @Orlando_btc @lex_node and @adamscochran. Thank you.
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