Just as Coinbase announced a partnership with Blackrock underlining its position as the leading crypto and other blockchain-based asset platform, the regulatory clouds appear to be intensifying. Recently, the US Securities and Exchange Commission (SEC) launched legal action against Coinbase claiming that nine of its listed coins are securities and therefore the company is in breach of securities law. At the same time, the US Department of Justice has, in conjunction, pressed charges against three individuals for insider trading claiming they have front run a number of these coin listings. The charge that one Coinbase employee, Isahn Wahi, and two others made as much as USD 1.5 million are being denied by the three. This case has focused attention on Coinbase, but we believe that this fails to recognise the point at issue – who is responsible for regulating crypto and how should it be regulated? That Coinbase is involved in this case is pure coincidence and should not be seen as reflective of bad practice by the company. Indeed, Coinbase itself gave up the names of the three to the SEC and dismissed the employee involved.
The bigger issue is that regulation is well behind the curve. In fact, existing regulation is so unfit for purpose that Bitcoin and Ethereum have been deemed commodities by the Commodity Futures Trading Commission (CFTC) and accepted as so by the SEC. This is because they are now so big that trying to implement securities law would risk destabilising and possibly driving the dominant bitcoin trading hubs offshore – in short it risks the US competitive positioning in crypto assets.
There is a clear set of battle lines emerging on who should regulate crypto, with the SEC and the CFTC going head to head. The SEC’s position is difficult because there is no brightline definition of a security. As a result, it is trying to legislate by litigation; this is not ideal. The SEC is staking its claim on the definition of a “security”, which includes investment contracts as established in the 1946 Supreme Court case of the SEC versus Howey. The CFTC claims, meanwhile, that crypto is a currency and, therefore, a commodity regulated by the Commodity Exchange Act of 1934, a law that was created long before crypto existed. There is a clear competitive dynamic between the SEC, which implements securities law, and the CFTC, which implements derivatives law. Oversight for the SEC is undertaken by the congressional finance committee while oversight for the CFTC is undertaken by the agricultural committee. Both have different agendas and lobbyists.
We believe that it is this race for oversight that is driving SEC policy and that the targets in legal actions are merely a means to an end rather than being targeted specifically for their own working practices. In fact, Coinbase as the latest recipient of SEC action, is keen to engage in the discussion on legislation but the SEC appears less willing. Coinbase is keen to highlight its recent petition to the SEC which outlines several points about the SEC needing to overhaul its regulations if it really wants to define crypto as a security. In other words, the SEC still has work to do in order to truly regulate crypto and this underscores that the industry is not being uncooperative for failing to “come in and register”. A much bigger case that is being litigated actively by both sides is against Ripple and that development may go some way to defining new case law, although we are sceptical.
The overall outcome here is likely to be slow but we see three possible outcomes. The first and most unlikely is that the SEC prevails. In this instance the setup would strongly favour existing broker/dealers who could start to easily offer crypto trading capability on their existing platforms at the expense of the current exchanges. The second is that the CFTC prevails and that crypto is deemed a currency. A Senate Bill proposed at the end of August by the agriculture committee would give the CFTC the leading role in overseeing the two largest cryptocurrencies and the platforms where they are traded. The Bill proposes that the remaining cryptocurrencies would be divided between the CFTC and the SEC, though the process for making those determinations is not yet clear. The third outcome, and the one to which we attach the largest likelihood, is that in time Congress will be pushed into creating new legislation for crypto, something for which they have shown little appetite to date, but it seems to be the only workable long-term solution. This is a new asset class requiring new legislation. It is worth noting that policy trend lines are moving away from the SEC and more towards Congress giving the CFTC spot authority (via three separate bipartisan bills) while giving the Fed stablecoin oversight. In other words, the role of the SEC is important, but it is only one piece of the puzzle.
Any solution that leaves total oversight in the hands of the SEC would place the US in a very uncompetitive position and therefore we think is unlikely to prevail. Any other outcome will leave existing platforms with business models that are unimpaired and indeed those, like Coinbase, who are trying to be transparent and ‘onshore’ are ultimately likely to cement their positions as clear leaders in the market.
