We have covered the regulation of crypto fairly extensively during 2023, in which year the Securities and Exchange Commission (SEC) in the US has been deeply active in the crypto market in the wake of the collapse of crypto exchange FTX in late 2022. The SEC stays the course with a remarkably eventful week so far. On Monday, the SEC sued the world’s largest crypto exchange Binance, including its co-founder and CEO Changpeng Zhao (CZ), in advance of doubling down by suing the largest US-based exchange Coinbase on Tuesday. Despite a few similarities between the allegations against Binance and Coinbase, they differ significantly, causing the allegations against Binance to be vastly harsher relative to the ones against Coinbase.
Binance allegedly commingled customer funds
The agency raised severe allegations against Binance, worst of all that Binance and its US entity named Binance US commingled billions of dollars of customer funds in cryptocurrencies to an account held by an entity controlled by CZ. Later, the funds were transferred to a third party reportedly with the purpose of buying and selling crypto assets, some of which are believed to have been used in market-making activities. If this is accurate, it awakens memories of Sam Bankman-Fried’s alleged commingling of client funds from FTX to Alameda Research.
Also, the SEC claims that another firm owned by CZ engaged in wash trading to boost the trading volume of at least Binance US. US residents are not allowed to trade on Binance due to regulatory requirements, so Binance launched Binance US for US residents a few years ago under a distinct entity stripped of a lot of products otherwise accessible to non-US residents. Despite legal requirements to maintain a Chinese wall between Binance and Binance US, the SEC believes that Binance’s off-shore operations, including CZ, retained jurisdiction over Binance US. The SEC has requested a temporary restraining order to freeze Binance US assets. Among additional allegations, the SEC makes the case that the company operates an unregistered securities exchange by facilitating trading of what the agency claims to be securities.
The allegations made against Binance are deeply serious and somewhat alarming. Indeed, Binance has not been found guilty as charged yet if it ever will. However, market participants must consider the risk that the SEC is correct in its claims. This would arguably imply strict legal consequences for Binance and CZ, creating a chain reaction across the industry, similar to FTX in November 2022, considering that Binance is by far the largest and most liquid crypto exchange. Binance stated that: “… we have engaged in extensive good-faith discussions to reach a negotiated settlement to resolve their investigations” and that user assets on Binance US have never been at risk.
Coinbase says it is not securities, whereas the SEC says it is
It is likewise the concern of securities that turns our attention toward the SEC’s lawsuit against Coinbase. On Tuesday, the SEC sued Coinbase for operating as an unregistered securities exchange, as the SEC believes that Coinbase handles securities on its platform by claiming that prominent cryptocurrencies such as Solana, Cardano, Polygon, and Filecoin, among others, are securities. The SEC does not mention Ethereum as a security. However, the agency argues that the staking service of Coinbase, including for Ethereum, is an investment contract, causing the product to involve securities. For information, we have previously published an analysis describing what securities are, along with the rather harsh implications provided that a cryptocurrency is deemed a security.
Contrary to the SEC’s view, Coinbase has previously stated that they do not engage in securities, arguing that the cryptocurrencies in question and the firm’s staking service are not securities. Following the lawsuit, Coinbase’s co-founder and CEO Brian Armstrong stated that Coinbase is going to fight the SEC in court and that they will not end their staking service at this time.
Much as the accusations against Coinbase are greatly less significant than the agency’s claims against Binance, then this matter should not be underestimated too with respect to not only Coinbase but the crypto industry as a whole. The question of whether cryptocurrencies are securities or not appears as an existential matter for the crypto industry, as the classification of most cryptocurrencies as securities would force exchanges appealing to US residents to face much more regulatory scrutiny if allowed to deal with these cryptocurrencies at all. To make matters worse, other countries may from then on follow the lead of the US, causing the security label to be the fate of most cryptocurrencies around the world. For Coinbase, if the SEC wins in court, the firm must in the worst case delist the majority of crypto assets and cease its staking product, leading to a significant blow to the company’s financials, so a lot is at stake. Yet, only time will tell how it ends.
The author holds a Coinbase Global, Inc. (COIN) long position.