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SEC Hunger Games: Coinbase has been chosen, who’s next?

In July 2022, the US Securities and Exchange Commission (SEC) announced insider trading charges against a former Coinbase employee and his two associates.

The three defendants allegedly front-ran public listing announcements on the Coinbase exchange and generated $1.1 million USD in illicit trading profits. The insider trading charges alone might barely make headlines, but the SEC’s designation of nine cryptocurrencies as “crypto asset securities” could have profound implications for the outlook of the broader industry.

Following the announced insider trading complaint, Bloomberg reported that the SEC has launched a probe into Coinbase for allegedly offering unregistered securities.

The string of recent SEC actions will undoubtedly create much angst for the crypto industry, whose call for regulatory clarity has been mostly unheard of. Industry officials have long lamented the enforcement-first or enforcement-only approach taken by the SEC. Enforcement without transparent rules is a bit like choosing who enters the Hunger Games; you’re not sure who gets picked and you don’t know how the game works until it begins.

Targeted enforcement is constrained by the number of SEC lawyers dedicated to crypto, while prudential regulation can cast a wider net and improve the agency’s coverage. This article takes a closer look at recent SEC actions and offers a view on how the agency could potentially improve its effectiveness.

Howey put to the test

As part of the SEC insider trading complaint, the agency declared nine cryptocurrencies as securities. To the SEC’s credit, the complaint does lay out the agency’s application of the Howey Test and attempts to support the conclusion that investors of the above tokens indeed “invested in a common enterprise” and “had a reasonable expectation of profits based on the efforts of others

Put differently, a simplified version of the SEC’s conclusion is that the above entities received funds from third parties as investments for use of business operations, and those investors had expectations for profit based on the management of those entities. It is, however, a seemingly low bar and would potentially encapsulate many of the tokens in the market today.

Source: SEC v. Wahi, et al.

Crypto industry embroiled

The crypto industry will no doubt cry foul as the SEC continues to stretch its reach and flex its securities regulation mandate. Chair Gary Gensler has previously made his position clear that he believes most coins and tokens are securities. The SEC’s actions have been met with forceful response, including statements from regulators and lawmakers in addition to industry officials.

Commodity Futures Trading Commission (CFTC) Commissioner Caroline D. Pham released a statement commenting on the striking use of “regulation by enforcement” by the SEC and the need for “a transparent process that engages the public to develop appropriate policy with expert input.”

Pennsylvania Senator Pat Toomey, ranking member of the Senate Banking Committee, also penned a scathing letter to the SEC, criticizing the agency of pursuing “a capricious and ineffective approach to consumer protection known as regulation-by-enforcement that is chilling financial innovation and contributing to significant financial losses for unsuspecting American consumers.”

Finally, of course, Coinbase has been vocal in its rejection of the SEC’s claims, offering a determined rebuttal by its Chief Legal Officer titled “Coinbase does not list securities. End of story.” Coinbase also offers transparency around its asset listing process and claims that it conducts a rigorous evaluation of every potential listing.

Regulators can do better

Back in February 2022, the SEC won the case against BlockFi Lending LLC for selling unregistered securities as an unregistered investment company. BlockFi paid a hefty fine of $100 million USD but in hindsight, with all of the turmoil surrounding centralized crypto lending platforms, it’s certainly not clear that BlockFi was the worst of the bunch. As Toomey alluded in his letter, could the SEC have prevented more consumers from harm if it had cast a wider net through prudential regulation instead of targeted enforcement?

Following the BlockFi suit, SEC Commissioner Hester Peirce questioned whether the penalty actually prevents consumer harm and lamented about the consequence of access removal to crypto products as opposed to increasing transparency of such products.

In response to the SEC announcement of the agency doubling enforcement staff for crypto, Peirce tweeted “The SEC is a regulatory agency with an enforcement division, not an enforcement agency. Why are we leading with enforcement in crypto?”

Indeed the targeted enforcement approach has failed to catch many of the most troubled firms, such as Celsius or Voyager. The SEC can greatly improve both its coverage, effectiveness and fairness of its investor protection mandate through several improvements in prudential regulation:

  1. Improving clarity by setting transparent rules and regulations. The industry includes operators who want to do the right thing and obey laws and regulations. Help these operators by setting clear expectations.
  2. Leveling the playing field by applying standards across all operators, not the ones that will generate the biggest “win” for the agency. This would also alleviate manpower constraints of time-intensive targeted enforcement actions.
  3. Encouraging and promoting self-policing by helping the industry establish a self-regulatory organization (SRO). These SROs, such as the Financial Industry Regulatory Authority (FINRA) help maintain compliance in TradFi and can help do the same for crypto.

The SEC could benefit from a change in its incentive structure and move away from gaining kudos through winning big cases. Today, banking regulators are incentivized not by “wins” but instead by tempering the risk of huge “losses” that bring embarrassment to both the banking sector and its regulator. With all of the recent mishap and insolvent crypto firms, perhaps that should be motivation enough as well.

Written by: Michael Shing, XREX Director of Risk Management

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