Coinbase and the SEC are going head to head. It’s a heavyweight bout between America’s crypto titan and its regulatory juggernaut. The fight will go the 12-round distance. There will be no TKO. Judges will decide on the outcome. And it probably won’t be unanimous.
They’re fighting over the fate of crypto in the US.
On March 22, 2023 Coinbase disclosed that it received a Wells Notice from the SEC. A Wells Notice is a private communique from the SEC to a company indicating that the SEC is considering taking enforcement action against the target for possible violations of securities laws. There were rumors of Wells Notices being sent to many in crypto. This one stings the most because it's Coinbase, it pertains to most of Coinbase’s businesses and Coinbase is going to fight it.
All of Coinbase’s businesses remain operational.
So why is this a big deal?
What’s Coinbase’s defense?
Wait, but then how did the SEC approve Coinbase’s IPO two years ago?
What does it all mean?
Brought to you by FRNT.
FRNT is a leading crypto investment bank. It’s also the author of the best crypto daily note. I’ve been a daily reader for over 3 years. Subscribe to get distilled insightful crypto daily news.
Why is it a big deal?
1. It’s Coinbase
Coinbase is the largest US crypto business and one of the largest in the world. It’s a public company with a $15 billion market cap. It purposely operates in the US according to the US laws and regulation (at least according to Coinbase’s interpretation of them). The SEC has brought a litany of actions against crypto participants in the wake of FTX (read Crypto Crackdown: Regulators Mount Up).
Until now, the SEC’s actions targeted specific violations and stopped short of Coinbase. The belief amongst the US crypto community was that the SEC targeted cases it could win and where defendants could not defend themselves. No legal battle would ensue, which means no precedent would be set. The regulatory landscape would remain as clear as mud. Crypto in the US would be marginalized.
On March 22, that belief was proved wrong. Coinbase was served a Wells Notice regarding “an unspecified portion of our listed digital assets, our staking service Coinbase Earn, Coinbase Prime, and Coinbase Wallet.” What that essentially means is that the SEC believes Coinbase was trading unregistered securities and/or conducted sales of unregistered securities.
2. Coinbase and the SEC are squaring off
Coinbase is going to fight this. Their press release made that abundantly clear:
if necessary, we welcome the opportunity for Coinbase and the broader crypto community to get clarity in court
Brian Armstrong, Coinbase CEO, tweeted the same after the SEC shut down Kraken’s staking service.
Coinbase has the resources to fight this, unlike the SEC’s other crypto targets. Coinbase has $4.4 billion of cash on its balance sheet.
The stakes are too high for Coinbase not to fight this. 84% of Coinbase’s total revenue comes from the US. Coinbase generated $2.4 billion of revenue in 2022 from trading crypto. Trading represents 70% of Coinbase’s revenue. When the SEC refers to “an unspecified portion of [Coinbase’s] listed digital assets;” they’re referring to Coinbase’s trading business. It appears that the SEC alleges that the bulk of Coinbase’s business is doing something it shouldn’t be; trading unregistered securities without a license.
SEC Chairman thinks everything, except bitcoin, is a security. 55% of Coinbase’s trading volumes comes from trading btc and eth. Assuming eth is half of the 55%, that implies roughly 75% of Coinbase’s trading volume comes from what the SEC believes are securities.
The remaining 30% of revenue comprises of staking rewards, custody and subscription fees and interest income. When the SEC refers to “staking service Coinbase Earn, Coinbase Prime, and Coinbase Wallet,” they’re referring to the other 30% of Coinbase’s business.
The Wells Notice amounts to a wide sweeping allegation that nearly all of Coinbase’s business is potentially in violation of securities law. Coinbase will fight this like its life depends on it, because it does.
The Wells Notice has been published. It outlines a range of punishment including:
…a civil injunctive action, public administrative proceeding, and/or cease-and-desist proceeding, and may seek remedies that include injunctions, a cease-and-desist order, disgorgement, pre-judgment interest, and civil money penalties.
3. Litigation will force US regulation
Coinbase will take the SEC to court. They will claim that the assets they are trading are not securities and their staking and custody services are not securities offerings. Litigation will force US regulation of crypto into the spotlight. A decision on what all this stuff is, that has evaded regulators and politicians, will have to get made. Either the court will opine on the existing law or it will say it can’t and it’s up to Congress to pass legislation.
The litigation process may finally bring some clarity to US crypto regulation, but it will take a while. The SEC sued Ripple in 2020 for selling unregistered securities offering. The court battle is ongoing.
Clarity for US crypto is a good thing. This suit will help us get there. It will be painful along the way.
What’s Coinbase’s defense?
Coinbase has publicized its defense. It claims that it does not trade securities. It has appealed to the SEC that its staking product does not constitute the sale of unregistered securities.
Coinbase presented its legal argument why the assets it lists are not securities, why the SEC does not have authority to regulate all digital assets, and how the SEC’s approach violates due process in an amicus brief filed March 13, 2023 with the United States Western Court of Washington at Seattle. An amicus brief is filed by a party that is not involved in a legal case, but is allowed to provide information and insights on matters pertaining to the relevant case. The case in question is SEC v Wahi, Wahi & Ramani. The case that charges former Coinbase employee and associates with insider trading of securities.
Coinbase’s “not securities” defense
The SEC alleges that the Coinbase-listed digital assets are securities because they constitute an ‘investment contract.’ Coinbase argues that (i) there is no contract at all. Therefore, the Howey Test is not even relevant. Coinbase goes further stating (ii) that even if the Howey Test were applied, the digital assets that Coinbase lists fail the Howey Test.
(i) No investment contract
According to Coinbase’s interpretation of case law, an ‘investment contract’ requires an actual contract. Specifically, the contract must include (1) a contract between a promoter and an investor that (2) imposes post-sale obligations on the promoter and (3) gives the investor a right to receive profits from the promoter’s venture. None of the Coinbase listed digital assets have such a contract.
Coinbase states that “the SEC seems to tacitly assume that Howey silently deleted the word “contract” from the statutory phrase ‘investment contracts’.” The Howey case explained that the ‘contract’ requirement was satisfied by multiple agreements between the two parties involved. Yet the SEC has not shown what contract exists between any parties involved in the insider trading case related to the Coinbase listed digital assets. Coinbase explained:
The developers of the assets do not owe continuing legal obligations to the defendants or any secondary-market purchasers, and the defendants and secondary-market purchasers lack any legal entitlement to a share in the developers’ profits. Instead, the Coinbase-listed assets are simple assets— like gold or other commodities.
This does not mean that all digital assets are not securities. Initial coin offerings, for example, could constitute an investment contract. But no such contractual arrangements exist with digital assets trading in secondary markets. Coinbase exclusively trades digital assets in secondary markets it determines are not securities.
(ii) Fails Howey Test
Coinbase argues that even if the SEC applied the Howey Test to the digital assets in question, they would not constitute securities. According to Coinbase “Howey requires the SEC to allege that the contract at issue involves ‘an investment of money in a common enterprise with profits to come solely from the efforts of others’.”
Coinbase believes the ‘common enterprise’ run by a ‘manager’ or ‘promoter’ established by the Howey case does not apply to its listed digital assets. Many digital assets are decentralized. There is no single entity controlling the asset.
The ‘expectation of profit’ also fails according to Coinbase. Coinbase argues that “purchasers of digital assets can have no legitimate expectation of profits when they have no contractual rights to profits.”
The Supreme Court has held that “the securities laws do not apply,” “when a purchaser is motivated by a desire to use or consume the item purchased.” Some purchasers of digital assets buy them for their utility, such as using them as money for remittances, securing a blockchain and engaging with blockchain applications.
Coinbase argues that:
The fact that some people purchase digital assets as investments cannot transform the entire asset class into securities, particularly when it is impossible to know which or how many purchasers are using or investing in particular digital assets.
In short, even if Howey’s test were implicated here (and it is not), the SEC could not satisfy it. And the fundamental mismatches between Howey’s test and digital assets further demonstrate that the Coinbase-listed assets are a world apart from “investment contracts” under the securities laws.
Why the SEC does not have authority
Coinbase believes that the SEC does not have authority to regulate digital assets. It explains:
To reach the Coinbase-listed assets, the SEC is forced to excise the essential elements of an “investment contract” so that it covers assets that involve no contract, no post-sale obligations, no sharing of profits, and at best a tenuous connection to the requirements of Howey. That retroactive Executive amendment of the statute would sweep the $1 trillion crypto industry within the nearly 90-year-old securities statutes. It also would endow the SEC with broad and novel authority to regulate the sale of a vast number of other commodities and assets. Such unprecedented power in a single agency to “substantially restructure” a massive portion of the American economy at least requires “clear congressional authorization.”
The Supreme Court has determined that when a long-established statute enables unheralded power to regulate a large part of the American economy, the regulating agency in question must first get ‘clear congressional authorization.’ Coinbase believes regulating digital assets is such a case.
Due process was violated
Coinbase believes the SEC regulation by enforcement approach circumvents public due process in exchange for “erect[ing] a legal framework retroactively through litigation.” Due process prevents a regulatory agency from punishing a regulated party if the agency “fails to provide a person of ordinary intelligence fair notice of what is prohibited.”
The SEC has not provided any explicit meaningful guidance about which digital assets it believes to be subject to the securities laws, and more importantly why…Although the SEC has brought enforcement suits in the crypto context before, its complaint in this case [SEC v Wahi, Wahi & Ramani; ie the insider trading case] was the first time the agency explained to the public, to the defendants, or to Coinbase why it believes the digital assets at issue here are securities. “Notice” on the day enforcement proceedings begin is the antithesis of fair notice.
The agency has had more than a decade to provide regulatory clarity. Yet during that time the SEC has provided conflicting messaging, according to Coinbase. Senior SEC official William Hinman stated in 2018 that a “token […] all by itself is not a security, just as the orange groves in Howey were not.” The SEC published a Framework including over 60 factors to assess if a digital asset is an investment contract under Howey. As part of Coinbase’s public filing process in 2020, the SEC stated that btc and eth are not securities and in regards to “all other digital assets there is currently no certainty under the applicable legal test that such assets are not securities.” The SEC has not stated any formal guidance since. Yet in 2023 the SEC Chairman made personal public comments that all digital assets, except for bitcoin, are securities.
The SEC has sought to effectuate this apparent change in policy by seeking retroactive penalties against industry participants who did not predict that the agency would abandon its earlier statements. And in this case, the agency is attempting to obtain judicial approval that its new “rule” applies to Coinbase.
Coinbase’s staking defense
Coinbase has also made public its defense of why its staking business does not constitute a securities offering. It published its explanation on February 10, 2023, the day after the SEC forced Kraken to shutdown its staking service. On March 20, 2023, Coinbase petitioned the SEC in response to the SEC’s comments in the Kraken case:
Today’s action should make clear to the marketplace that staking-as-a-service providers must register and provide full, fair, and truthful disclosure and investor protection.
Until this [Kraken] settlement, the Commission had not conveyed that it might consider staking services to constitute an investment contract and therefore a securities offering requiring registration with the SEC. And the SEC had not previously made this position known despite ample opportunity to engage the crypto industry and its participants with its concerns. Indeed, Coinbase began providing detailed presentations on what staking services are and how they work as early as December 18, 2019, and Coinbase repeatedly explained its own staking services throughout its S-1 process when becoming a public company nearly two years ago.
Coinbase argues at length that staking services are not all the same, why its staking service does not constitute a securities offering and case law to support it. The gist of the argument is even if you did apply the Howey Test to Coinbase’s staking product, it fails.
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.
Subscribe for free to get new articles in your inbox.
How strong are Coinbase’s defenses?
I don’t know.
My research leads to one conclusion. The more pro-crypto you are, the more you think Coinbase’s defense is impregnable. The more anti-crypto you are, the more you think all digital assets are securities. Public perception is not based on legal merits, it's based on pro or anti crypto beliefs.
On the one hand, Coinbase seems to make a strong defense. There’s no investment contract to speak off. Even if you apply the Howey Test, which you shouldn’t since there is no investment contract, digital assets listed on Coinbase fail. In addition to these two interpretive arguments, Coinbase presents the case for how the SEC does not have the regulatory authority. And even if it did, it did not conduct due process.
On the other hand, Coinbase’s argument focuses on the fact that there is no investment contract and the secondary trading it facilitates. That argument seems applicable to Coinbase’s business directly, but perhaps less so to digital assets more broadly. For example, it’s hard to argue there’s no contractual expectation of profits from ICOs. Coinbase concedes that. The contractual expectation of profits in secondary trading of digital assets is nebulous. But if you’re facilitating the trading of a digital asset in the secondary market whose value is partly derived because it can be traded and its primary issuance had a contractual expectation of profit, where does that leave you?
The argument “well SEC you never said this was a security” is shortsighted. Ignorance is not a defense. There is a framework. You’re supposed to operate within it. I am sympathetic to the “hey the framework doesn’t work for this new asset, let’s develop something that does. The SEC is not engaging. And now the SEC is fining everyone.” view. Industry and government need to work together to evolve regulation at the same pace of innovation. The problem today for crypto is that the time to do this was two years ago. There is very little sympathy in DC for crypto due to 2022’s spectacular collapse and crypto bros brazen attitudes.
Wait, but Coinbase is a public company overseen by the SEC…
The fact that we got to the point where the SEC is allegedly claiming most of Coinbase’s business is operating illegally is weird.
Coinbase is a public company!!!
It’s overseen by the SEC!
Coinbase was launched in 2012. It deliberately built its business in the US under the regulators eye. Coinbase submitted its registration to become a publicly listed company with the SEC in October 2020. Coinbase executed its Initial Public Offering becoming a listed company in April, 2021. The SEC reviews and signs off on all companies before they’re listed. I worked on an IPO of a multi-billion dollar company listing in New York, London and Hong Kong in my investment banking days. It’s a painfully arduous process. Regulators pour over every aspect of your business to ensure it’s legit. It’s scarred in my mind. I worked seven days a week for six months straight on one IPO.
The registration process includes submitting detailed information on business model, processes, financial information and risks. A lengthy discussion period follows where the SEC asks loads of questions. Coinbase attests (and here) that the SEC asked about its process to list digital assets. The goal of Coinbase’s digital asset listing procedure is to omit those that could be construed as securities. Most assets Coinbase reviews are not listed.
Seven months after the initial registration, Coinbase became a public company. It had addressed all the SEC questions. According to Coinbase:
Throughout the registration process, the [SEC] Staff never said that Coinbase’s business model violated the securities laws, or that Coinbase unlawfully listed unregistered securities on its platform, or that Coinbase must register as a national securities exchange or an alternative trading system.
The SEC was fine with Coinbase’s business model in April 2021. Yet two years later, the SEC is no longer fine with Coinbase’s business model.
No securities laws have changed in the interim. In fact, there have not been new securities laws since 1934. Coinbase’s business model is largely the same.
Coinbase disclosed the regulatory risk in its IPO prospectus:
A particular crypto asset’s status as a “security” in any relevant jurisdiction is subject to a high degree of uncertainty and if we are unable to properly characterize a crypto asset, we may be subject to regulatory scrutiny, investigations, fines, and other penalties, which may adversely affect our business, operating results, and financial condition. [...] …we recognize that the application of securities laws to the specific facts and circumstances of crypto assets may be complex and subject to change, and that a listing determination does not guarantee any conclusion under the U.S. federal securities laws.
The whole thing is weird because Coinbase got a ceremonial stamp of approval when it became a public company. Yet Coinbase discloses in the fine print the stamp of approval doesn’t mean much and could all change.
Could you even register?
There is no path to regulated digital assets and exchanges in the US. For simplicity sake, let’s assume digital assets are securities. Well then how do they register? And what needs to be disclosed?
There is no framework. Different types of securities require different disclosure. What would digital assets require? Who would provide the disclosure and comply with the regulation?
SEC Commissioner Peirce states that “traditional disclosures are designed for traditional corporate entities that typically issue and register equity and debt securities.” She argues that they “poorly fit the decentralized and open-source nature of blockchain-based digital asset securities.” Some traditional disclosure requirements would be irrelevant for crypto and miss out important information.
You couldn’t actually register a digital asset as a security under the current construct. That’s up to the industry and regulators to rectify.
If digital assets are securities, then they can only be traded by entities registered with the SEC. A crypto exchange would need to be a securities exchange or an alternative trading system. Coinbase applied unsuccessfully to be an alternative trading system.
There are three structural reasons why Coinbase does not fit the SEC’s regulatory requirement to trade securities.
1. Separation of businesses
Coinbase both trades and settles digital asset transactions. To be a member of a registered securities exchange, it would need to jettison its clearing, settlement, and custody services businesses. It can’t do it all. Herein lies how crypto traded through centralized exchanges and securities are traded differently. Crypto on centralized exchanges is traded, settled and custodied with the same entity. In this case Coinbase. Securities are exchanged through one entity, for example the New York Stock Exchange. They are settled by a different entity, the Depository Trust Company. The assets are custodied by a third entity, the qualified custodian.
The separation of all three adds costs and time to execute transactions. But it also adds checks and balances. The collapse of FTX proved how salient those checks and balances are. The FTX fraud was facilitated because the same entity traded, settled and custodied the assets.
So to become regulated, Coinbase would have to split up its businesses, which it doesn’t want to do. Or the SEC would need to change the existing rule, which isn’t going to happen. It would introduce massive conflicts of interest into existing financial markets. Or some new rule needs to be introduced.
2. Trade in securities and non-securities
Regulated exchanges are only allowed to trade securities. The SEC agrees that Coinbase trades at least one asset that is not a security, btc. The SEC would need to change the rules that would allow regulated exchanges to trade securities and non-securities. This would have far reaching ramifications on existing financial markets.
3. Business hours
Regulated exchanges only trade during specified open hours. Crypto trades 24/7.
You can see the frustration of the crypto industry. For those willing to abide by regulation, they’re left wondering how to do it.
Coinbase claims it has been stonewalled by the SEC. At the SEC’s request, Coinbase proposed how it could become a registered exchange. Coinbase met with the SEC 30 times during the 9 month investigation. When the SEC was supposed to provide its feedback, it canceled its meeting with Coinbase and issued a Wells Notice.
That’s a lot….but so what?
There are different implications for Coinbase, US crypto and global crypto.
1. Overhang on the stock
COIN performance will be hampered until there is more regulatory clarity. A 20% drop in the stock post announcement is small relative to the potential impact. I think that implies:
The market was aware this could come. Coinbase disclosed the SEC investigation in its Q2’22 10Q filing. The SEC hasn’t been quiet.
A lot of bad was already baked into COIN. It’s down 80% from its November 2021 highs.
The market may interpret the SEC’s case as weak.
COIN will trade on US regulatory news until there is more clarity
2. Impact on Coinbase unclear
There is now a heightened risk that SEC regulatory action could dismantle Coinbase’s business. But what ramifications could come of it is unclear. The SEC doesn’t know what should happen to a crypto exchange operating without a proper license. Judge Wiles of the New York Southern District Bankruptcy Court made that clear in a March 11, 2023 statement:
I asked the SEC’s counsel at the outset of this hearing to explain what the consequences would be if Binance.US were to be found to have been acting as an unregistered broker dealer. I asked if that would just mean that Binance.US might have to stop certain activities while it pursued a license, or if it would mean that Binance.US would have to shut down all of its activities. The SEC said it could not answer that question.
This particular point is directly relevant to the SEC’s investigation into Coinbase. The SEC appears to be investigating Coinbase for operating a securities exchange without a proper license. The same thing that the SEC alleges Binance.US has done. Yet the SEC doesn’t know, or refuses to comment, on what should happen if such an allegation were true.
For US crypto:
1. US crypto regulation is a mess
The SEC and CFTC have contradictory views on digital assets. Politicians are wading in with their own view. The SEC is litigating or threatening to litigate everything in crypto. In some cases, without providing adequate argument. Judge Wiles stated on March 11, 2023 in the Voyager bankruptcy case:
I do not know how any party could possibly be expected to address the SEC’s comments with the limited guidance that the SEC has provided. The SEC did not explain why the VGX token should be regarded as a security, for example, leaving me only to guess as to what the arguments might have been. Similarly, the SEC did not explain why it thought Binance.US might be operating as a securities broker.
That doesn’t bode well for regulatory progress.
You had a judge stating in court that the SEC has no “actual evidence or cogent legal argument” why the digital assets in question is a security nor how Binance.US was operating without a proper license.
2. A lengthy legal battle is coming
The SEC didn’t make a strong argument in the Voyager case, but I’m confident it will in the Coinbase case. The matter is not clear cut. Both sides have an ax to grind. I believe the litigation will voice opinions that will lead to regulation.
3. Talent leaving the US
The US is staunchly anti crypto. This latest bold action further cements its position. Crypto talent is leaving the US. 29% of crypto developers are in the US down from 39% five years ago.
4. The SEC true intentions
I think if the SEC really wanted to regulate crypto it would engage with industry participants, like Coinbase, to craft regulation. Regulation by enforcement suggest it’s not interested in doing that. It suggests the SEC’s true intentions are to regulate crypto away.
SEC Chairman Gensler likely won’t hold his role in any administration other than a Biden one. I suspect Gensler will not be overseeing how this finally plays out.
For global crypto:
1. Who cares?
Do people in the rest of the world care if we call one token a security, another one a commodity and a different one something else?
No. They’ll continue to operate in crypto just like they have. Others aren’t really paying attention to this.
Begs the question, does it really matter if the US calls a digital asset a security?
But, if we do regulate crypto into oblivion, it does mean US capital, ingenuity and entrepreneurship does not flood into crypto. I view that as a problem (read Why to Not Ban Crypto: The Business Case for Crypto in the US). Others will view that as success.
2. Crypto pressing ahead in the UK, Europe and Asia.
Other geographies are stepping into the vacuum left by the US.
In February 2023, the UK published a proposal to:
…place the UK’s financial services sector at the forefront of cryptoasset technology and innovation and create the conditions for cryptoasset service providers to operate and grow in the UK, whilst managing potential consumer and stability risks.”
Europe introduced the landmark Markets in Crypto Assets (MiCA) reform. The legislation is expected to pass this spring and be implemented in 2024. It provides clarity on crypto regulation. It introduced new classifications for crypto assets.
China is reversing course and allowing Hong Kong residents to trade “large cap” crypto assets. Singapore and the Middle East are open for business.
The willingness of other geographies makes sense. Being at the forefront of potential financial innovation is beneficial and usurps power from the US.
Thanks for reading Crypto Clarity! Subscribe for free to receive new posts and support my work.
Thanks for the analysis. Is this an instance where authority, in this case SEC, intentionally resorts the issue at hand to judicial and representatives for its logical conclusion, because it feels inadequate in addressing the issues appropriately without public mandates?