Loyola University Chicago School of Law, Weekend JD 2023
In October 2021, the cryptocurrency exchange platform Coinbase released a proposal for a regulatory framework that would designate a single regulator for the digital asset markets. This proposal comes less than a month after Coinbase’s CEO had a public meltdown on Twitter after the Securities Exchange Commission (SEC) sent the firm a Wells Notice, a warning of potential litigation, about their planned cryptocurrency lending platform allegedly violating securities regulations. As the digital asset market grows and the financial institutions involved become more influential, regulators continue to struggle with jurisdictional and definitional questions around the new products.
Current regulatory framework
The new SEC Chair Gary Gensler has signaled his intent to more closely regulate the digital asset space under a securities framework. In a September 2021 hearing before the Senate Committee on Banking, Housing, and Urban Affairs, Gensler testified that the SEC intends to fill gaps in the current regulatory regime by taking their “authorities as far as they go,” that the SEC has “broad authority” and that “the test to determine whether a crypto asset is a security is clear.”
Whether or not a digital asset can be regulated as a security is determined by the Howey Test, which was established by the Supreme Court in 1946 via SEC v. Howey. Under the Howey Test, a transaction is an investment contract (and thus subject to securities regulations) if 1) it is an investment of money; 2) in a common enterprise; 3) with the expectation of profit; and 4) any profit to be derived from the efforts of others. The SEC has issued guidance on how it applies the Howey Test to digital assets, but as of yet there appears to be more gray area than clearly established lines, creating difficulties. Notably, however, the prior SEC Chair Jay Clayton has stated that Bitcoin is not a security, as it does not pass the Howey test, but the SEC’s guidance does appear to implicate initial coin offerings (ICOs) with an expectation of profit as securities.
Outside of securities regulation, other regulators have a stake in digital asset regulation as well. Most notably is the Commodity Futures Trading Commission (CFTC), which regulates U.S. derivatives markets, and the National Futures Association (NFA), the industry self-regulatory organization under the CFTC. The CFTC has taken the position that Bitcoin is a commodity and that they have jurisdiction when a virtual currency is used in a derivatives contract — a position that made the CFTC the sole regulator involved in cryptocurrencies as the CBOE Options Exchange and CME launched bitcoin futures contracts in 2017. Coinbase has applied to the NFA for membership to be able to offer these derivatives on its platform as well.
Coinbase’s proposal for a single regulator for the digital asset markets comes as the firm finds itself under scrutiny by existing regulators, notably the SEC. In June 2021, Coinbase announced it intended to launch a crypto lending product called Lend, which would have allowed its customers to earn interest on their cryptocurrency holdings and allowed Coinbase to loan out the holdings to other borrowers as a bank would. In September 2021, Coinbase CEO Brian Armstrong angrily tweeted that the SEC had threatened to sue over the Lend program, and the firm’s Chief Legal Officer followed up with a statement via blog the next day. The blog specifically mentioned that the SEC “refused” to share their reasoning, and that they only represented that they assessed the Lend platform “through the prism of decades-old Supreme Court cases” including Howey.
Legal experts say the SEC’s case against Coinbase’s lending program was clear, however, and that it all amounts to disclosure requirements. Adam Letvin, professor at Georgetown Law, pointed out that the SEC did not tell Coinbase that it cannot offer a cryptocurrency lending product, however — it only represented that if they did, they’d have to register it with the SEC prior as all securities are required to be. Further, the SEC did not sue Coinbase — the Wells Notice that the SEC served was solely a courtesy notice that the SEC staff intends to recommend charges and provided Coinbase a window to make their case or make adjustments prior to avoid litigation. Instead, Coinbase has since updated its June blog to state that it is no longer launching Lend due to the scrutiny.
To Coinbase’s claims that the SEC owed them a dialogue, Letvin himself tweeted, “The SEC doesn’t have the obligation (or the resources) to issue guidance about things that should be obvious to a baby securities lawyer… It’s really astounding that Coinbase thinks it’s entitled to anything more.” Additionally, Lee Reiners, the executive director of the Global Financial Markets Center at the Duke University School of Law said “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.”
Designing your own regulator
Not long after the public feud with the SEC, Coinbase has taken the position that the current U.S. regulatory regime is incapable of effectively regulating digital currencies, and is proposing a new regulator for itself and other digital asset companies. The firm’s Digital Asset Policy Proposal argues for a new federal agency to consolidate digital asset regulations across other agencies and an SRO similar to FINRA or the NFA supervised by the new agency. The company has said that “laws drafted in the 1930s to facilitate effective oversight of our financial system could not contemplate this technological revolution,” and singles out securities laws for being too disclosure based to be appropriate for them.
Coinbase’s proposal has drawn criticism from multiple angles, and not only because it followed a spat with the SEC. Financial and legal experts argue that a single regulator would add an unnecessary layer of complexity to the markets, and that a new regulator would only further silo the regulatory structure when more consolidation is called for. Advocacy groups like Better Markets described Coinbase’s actions as regulatory capture, noting that it failed to capture the SEC and is out shopping for a new agency. This appears to be supported by Forbes’ reporting that back in 2018, Coinbase provided testimony to Congress arguing the exact opposite position, when at the time Coinbase feared new laws that would add regulatory burdens to the industry. And further, smaller exchanges have been concerned with Coinbase’s approach to regulation in general, noting that it may be harmful to the industry if Coinbase is the only company with a seat at the table, guiding the regulatory environment for everyone.
There does not seem to be an appetite for Coinbase’s proposal for a new regulator, but change may be coming. The Biden Administration has stated that it wants Congress to further regulate digital assets, but with existing agencies overseeing them. In response, the industry has ramped up its lobbying efforts, spending $4.9 million in the first nine months of 2021 as compared to $2.8 for 2020. Additionally, former regulators during the Trump administration such as former head of the CFTC Christopher Giancarlo and former acting comptroller of the currency Brian Brooks have joined the industry as advocates.
The views expressed in this blog are those only of the author and not that of any employer.