The Securities and Exchange Commission’s move to prevent a cryptocurrency exchange from skirting its rules represents a new line in the regulatory sand, according to experts.
Academics who study digital assets and securities laws reacted after Coinbase Inc. revealed this month that the agency threatened to sue the company over its plan to offer interest on crypto assets backed by U.S. dollars, called USD stablecoins. It ended up withdrawing the plan on Sept. 17.
Coinbase’s program, called Lend, would have allowed users who deposit the stablecoins to earn a 4 percent annual yield for lending them to others. This amount is eight times the national average for high-yield savings accounts, Coinbase said.
CEO Brian Armstrong said the company tried working with the SEC. “They responded by telling us this lend feature is a security. Ok – seems strange, how can lending be a security,” Armstrong said Sept. 7 on Twitter.
Legal experts say the agency was rightly calling for disclosure that’s traditionally provided to investors for such programs. The other digital asset companies that offer similar services should take heed, they say.
Lee Reiners, the executive director of the Global Financial Markets Center at the Duke University School of Law, said Coinbase’s proposal was clearly an offer of securities under what is called the Howey test, based on a 1946 Supreme Court case.
“When you ask a regulator if you can do something, and they tell you that something is illegal, that does not mean they are picking on you or singling you out. It means they are doing their job,” he said. Dropping the program was “inevitable,” he said.
According to the SEC, Howey has three elements.
The first is the investment of money, which Reiners said encompasses cryptocurrency. The second is a common enterprise; with Coinbase Lend, there was to be an intermingling of crypto deposits from different customers, satisfying this part of the test. The third is a reasonable expectation of profit derived from the efforts of others; in this case, Coinbase offered a 4 percent profit, Reiners said.
The agency’s stance could be a blow to many other cryptocurrency ventures, although Coinbase could still offer Lend if it were approved through the traditional securities registration process. That would provide potential investors with details on risk, Reiners said.
Arthur Wilmarth, who recently retired after teaching banking law for 35 years at the George Washington University School of Law, said the arguments that the crypto lending program was similar to bank lending don’t hold water.
Regulators and the courts have been consistent that security-like products that offer a profit can be exempt from the securities laws only if they come under alternative regulation such as from bank regulators, he said.
Wilmarth said a compelling case for the added regulation is that stablecoins might not be so stable. Cryptocurrency could become “too big to fail,” growing to sufficient size that the government would feel compelled to aid it in a downturn, he said.
“The whole market is over $100 billion,” Wilmarth said. “What if the stablecoin market gets to a trillion and they start having runs on it? They are going to run to the Fed and say you’ve got to bail us out.”
Unlike banks, stablecoin borrowing and lending operations do not pay for deposit insurance and do not have the same capital requirements, he noted.
Not a difficult case
There are historical cases of regulators allowing new ways of funding outside of traditional regulation, he said, mainly when there was a compelling need. For example, money market mutual funds became an alternative way for customers to earn returns during high inflation when banks had restrictions on the interest they could provide.
Wilmarth does not see a compelling need today.
Steven Lofchie, a transactions lawyer with Cadwalader, Wickersham & Taft LLP, said some people believe that “if you do something and it involves digital assets, you are out of the securities laws, and that is clearly not true.”
The SEC’s authority in the Coinbase case was never in doubt, he concluded. “There are difficult cases, this is not one of them,” he said. In a blog post on his firm’s website, he said it was a question of whether the company can borrow from retail investors without coming under the securities laws. The answer is no, he said.
Kevin Werbach, professor of legal studies and business ethics at the Wharton School of the University of Pennsylvania, said the 4 percent that Coinbase offered is in line with some other crypto lending services, and even less than some decentralized finance platforms.
“The two main concerns about crypto lending rates are that they may reflect unjustified regulatory arbitrage rather than real advantages over bank or money market products,” Werbach said in an email. “And that they may be artifacts of an artificially inflated crypto market.” He wondered whether rates would be sustainable if the “historically volatile crypto market goes into another sustained downturn, or faces serious regulatory headwinds.”
Werbach acknowledged that the SEC has undertaken an inconsistent and selective enforcement policy over digital assets in the past, and he urged it to provide as much explicit guidance as it can.
“The SEC needs to show the industry that there is a real difference in treatment between those attempting to do the right thing, and those flaunting their lack of compliance,” he said.
Coinbase provided little in the way of details about how it would earn enough to pay 4 percent.
“We strive to provide the most secure option for all of our rewards offerings, and the current APY we’re offering is reflective of that,” Ian Plunkett, the company’s director of global policy communications, said before the company withdrew the plan. “We’re always working to increase interest earning opportunities, and look forward to additional offerings in the future.”
Phillip Basil, director of banking for Better Markets, applauded the withdrawal.
“This will allow Coinbase time to fully consider the regulatory implications of product offerings that involve what most likely are securities,” he said in an email. “It also prevents needless costs that would have been incurred by Coinbase, the SEC, and, importantly, any consumers of the product as a result of SEC enforcement actions.”
Better Markets was founded in the wake of the financial crisis to advocate for consumers.
The SEC will continue to focus on the crypto industry, Chairman Gary Gensler told the Senate Banking Committee on Sept. 14. “We just don’t have, I believe, enough investor protection in crypto finance, the issuance of these tokens, the trading, and particularly the lending.”
There are more than 6,000 types of digital currencies. While their characteristics vary, Gensler said on Sept. 21 at a Washington Post event that it is “highly likely” that some of them are securities. Many trading and lending platforms work with multiple assets, raising the chances that they fall under the SEC’s regulatory authority.