Hello readers,
It doesn’t matter where you sit. Whether you’re an entrepreneur or an aspiring one. An operator or someone looking for a job in crypto. You could be an ancillary service provider. An investor. A fund manager. A developer. An engineer. A product manager. An attorney. Or a marketer/salesperson.
If you’re touching the industry in any way, you need to have a line of sight on forthcoming regulations & policymaking.
With the topic heating up in the US and MiCA becoming law in Europe in July, it’s time for a deep dive.
This is a big topic. To make it easier to read and digest, we broke our coverage into two parts.
Part 2 will hit your inbox tomorrow. It covers:
Operation Choke Point 1.0 in 2013 and its Similarities to Today
Regulatory Game Theory
Best Case and Worst Case Outcomes
Disclaimer: Views expressed are the author's personal views and should not be taken as investment or legal advice.
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Let’s go.
Protect investors.
Maintain fair, orderly, and efficient markets.
Facilitate capital formation.
The SEC promotes full public disclosures, protects investors from fraudulent and manipulative market practices, and monitors corporate takeover actions.
Generally speaking, the SEC is responsible for the orderly functioning of the largest capital markets in the world. They also have the power to create new rules, as long as they fit the framework created by Congress in 1933/1934. It’s good that we have them.
Ultimately, the framework created by Congress and enforced by the SEC is designed to create an environment in which bad actors are held accountable, and good actors are given the opportunity to innovate.
The crypto industry cannot mature and reach its true potential without thoughtful regulation. But the current regulatory frameworks were created in 1933/1934. Crypto is a new innovation, but we have yet to pass new laws or regs that contemplate assets created via public blockchains.
There are many ways in which crypto assets are fundamentally different from traditional securities. To name a few:
There is no investment contract (secondary trading).
Crypto assets do not convey legal ownership.
Crypto assets do not grant the holder rights to interest or dividend payments.
Many crypto assets have commodity-like features in which the asset is used to pay for or consume services.
Crypto assets are digital bearer instruments and can be self-custodied.
Crypto assets can be transacted in a peer-to-peer manner.
Crypto assets trade globally and settle nearly instantly 24/7 365.
Services such as custody, accounting/transfer agent, exchange, audit, etc. can be bundled due to the nature of public blockchains.
Smart contracts enable new peer-to-peer business models and the automation of markets such as asset exchange.
The transparent nature of public blockchains and automatic audit/validation features create new tools for regulators and new ways to comply with investor disclosures.
Crypto networks become more decentralized as they mature. As this happens, centralized control is transferred to a distributed network of token holders and service providers. The lack of centralization can make it difficult to adhere to the current disclosure requirements for traditional securities.
All of this is a curveball for the SEC which wants to put crypto into the same bucket as traditional securities and call it a day. This isn’t going to work.
But we shouldn’t give up on the goal of protecting investors while facilitating capital formation. We just need to adapt the rules. Or create new ones. We think this will fall on Congress, not the SEC. We aren’t there yet. It’s complicated and messy.
Of course, crypto has not escaped the complicated nature of politics.
Rather than promote innovation, protect investors, and hold bad actors accountable, the SEC’s current approach — regulation by enforcement — has unfortunately punished many firms seeking compliance while pushing investors into the hands of risky, opaque, off-shore entities.
This strategy appears to oppose the mandate of the SEC.
We don’t want to harp on it. Or opine on why this is the case (politics & incentives of various parties). It is what it is. It’s not as if crypto is the first industry or new innovation to encounter similar challenges.
Our job is to try to see the playing field with clear eyes.
At the end of the day, we’re simply trying to project where things will go from here. As industry operators and investors, understanding regulation and policymaking is about evaluating risk.
To that end, let’s take a look at the case against Coinbase.
As a public company, Coinbase is one of the most trusted names in crypto.
The firm benefits from a “Big Four” audit (Deloitte) and has a long history of seeking compliance through voluntary engagement with the regulator. Here’s a quick rundown to highlight its history with the SEC (shout out DeFi Education for the list):
Prior to 2020: Coinbase acquired a money transmitter license in all relevant states (2014), a BitLicense from the State of New York (2017), an SEC-noticed Alternative Trading System company (2018), and an SEC-registered broker-dealer license (2019). The ATS and broker-dealer are currently dormant, awaiting regulatory approval to commence operations.
October 2020: Coinbase submits first draft S-1 to SEC to go public
December 2020: Coinbase submits its legal analysis of its staking services
February 2021: SEC sends second comment letter, Coinbase respond with their legal analysis on whether coins listed on its spot exchange are securities
April 2021: SEC declare Coinbase’s S-1 effective; Coinbase shares list under the ticker COIN; million of investors participate in the offering
November 2021: Coinbase met with Chair Gensler to discuss registering a securities trading platform
July 2022: Coinbase files a formal petition for rulemaking, including 140 specific questions for the SEC
Q4 2022: Coinbase meets with SEC staff (including Enforcement) to discuss paths to registration and related matters 12 times, a total of 30 meetings in 9 months (!)
January 2023: Enforcement Staff informed Coinbase they would beproceeding with enforcement actions and would no longer engage on the registration process.
March 2023: Coinbase receives a Wells Notice.
April 2023: Coinbase sues SEC to compel a response to the July 2022 rulemaking petition.
On Monday, May 15, the SEC responds to Coinbase’s Request for Action
We currently do not know what the enforcement action will be against Coinbase. We just know that one is coming. That’s what the Wells Notice indicates.
Disclosure: we are not lawyers. That said, we think the most important element of all of this pertains to the fact that the SEC scrutinized Coinbase’s business in April 2021 and approved the firm’s S1 to go public. Now, this doesn’t preclude an enforcement action or exempt Coinbase from compliance moving forward. But it’s compelling nonetheless.
Here’s why:
Since the approval of Coinbase’s S1, the SEC has not issued any new regulations. Congress has *not* passed any new laws pertaining to crypto assets. Furthermore, Coinbase’s core business has not changed.
[It appears this is where Coinbase’s lawyers, Sullivan & Cromwell, are focusing their efforts.]
Coinbase shared its asset listing process and staking business with the SEC when it went public. Furthermore, the SEC was already aware of how Coinbase was taking custody of user assets.
All of this implies to the investing public that the SEC thought the business was legal and in compliance. Therefore, investors in Coinbase’s IPO had all of the required information to evaluate risk.
Now, via issuance of the Wells Notice, the SEC is implying that elements of Coinbase’s core business are illegal or non-compliant, with enforcement actions forthcoming.
Again, Coinbase’s core business has not changed, and there haven’t been any new regulations or laws since Coinbase went public.
So it’s difficult to determine exactly what the SEC has an issue with — which is an issue in and of itself. We think it’s counterproductive that the general public, investors, entrepreneurs, and Coinbase itself (!) don’t know exactly what they have done wrong.
This is unfortunately what regulation by enforcement looks like.
Coinbase claims they do not deal in securities. Their listing process was shared with the SEC when they went public, and they claim they turn away over 90% of assets seeking listing.
Meanwhile, Gary Gensler, the current chairman of the SEC, has publicly stated numerous times that “all crypto assets are securities except for Bitcoin.” Keep in mind that this is not a formal policy. It’s just Gary Gensler making public statements.
He’s also made public statements that completely contradict himself. In fact, while referencing the SEC in 2018, he stated that over 75% of ICOs *were not* securities.
He even made statements about how crypto networks can become “sufficiently decentralized” over time, therefore changing their treatment as securities.
Not a good look. But again, mere statements are not a formal policy.
Ultimately, to meet the threshold of securities laws, the SEC must prove that specific digital assets traded on Coinbase are part of ongoing investment contracts. Coinbase argues that they are not, for two primary reasons:
There is no investment contract between Coinbase users who buy and sell crypto assets and the issuer of those assets. Token issuers cannot raise capital from users trading on Coinbase.
Prior cases applying the Howey Test to crypto assets targeted issuers who raised capital by selling unregistered securities. This is separate from the secondary market that Coinbase deals in. Coinbase argues that secondary market trades fail all 4 prongs of the Howey Test:
Investment of Money: In secondary markets, the investment does not go to the issuer or promoter. It goes to the previous owner.
Common Enterprise: This does not exist for users buying crypto assets on Coinbase. Again, this prong applies to primary markets, not secondary markets.
The Expectation of Profits: For digital assets with consumptive/commodity-like features, the expectation of profit prong is not met. For example, users of Ethereum need to buy the token to pay for gas fees to access services on the network.
Efforts of Others: Once again, this applies to primary markets rather than secondary markets. Furthermore, established digital asset networks have different dynamics due to the nature of decentralization and automation of services via smart contracts.
We’re keeping it high-level, but if you’re interested in a much deeper analysis of crypto assets as they pertain to securities laws in secondary markets, check out the work of Lewis Cohen and the team at DLx Law.
It’s currently a wait-and-see regarding what enforcement actions are taken against Coinbase. Is it related to asset listing? Staking? Custody? Coinbase Wallet? We don’t know. We just know that the SEC is planning an action on Coinbase.
Coinbase has some of the best lawyers and policy folks working on their behalf. And with $5 billion of cash on hand, Coinbase is probably better suited to challenge the SEC than any other crypto firm.
The market seems to be pricing in the worst-case scenario. But we think Coinbase has a good chance at winning or settling, for the reasons listed above.
*It’s important to note that the SEC recently settled the insider trading allegations against a former Coinbase employee. The SEC had also charged that the assets in question were securities. However, the settlement statement involves no statement or admission that the crypto assets at issue were securities. It appears those charges were dropped.
As far as timing, we’re likely still multiple years away from any clarity on the issue.
Ultimately, we think that expanding the current federal securities laws to characterize fungible crypto assets as securities is unnecessary and misguided.
Instead, legitimate policy concerns will be addressed by Congress.
The bi-partisan bill proposed by Senator Gillibrand and Lummis is a fantastic start in our opinion. We’re now hearing that an updated version of the bill is in the works. Furthermore, a new market structure bill dropped last Friday: it was drafted by Rep. Patrick McHenry (R-NC) — the Chair of the House Financial Services Committee, and Glenn Thompson (R-PA) — the Chair of the House Agriculture Committee. While delineating the role of the SEC vs the CFTC, the bill defines key terms such as decentralization, blockchain (public blockchains only), digital asset, digital asset issuer, stablecoins, etc. in an effort to create new laws pertaining to crypto.
To the naked eye, it would appear that the US is largely opposed to crypto innovation.
The media tends to focus on negative headlines — driving fear, uncertainty, and doubt.
Examples include Senators such as Elizabeth Warren's (D-MA) campaign to build an “Anti-Crypto Army,” and the White House's (and the President’s appointed regulatory agencies) recent enforcement actions.
But publicly available data constructed by Coinbase is painting a more nuanced picture.
In particular, it appears that the Legislative Branch of Congress has a different posture from the Executive Branch. This is highlighted by the fact that more Republican and Democrat policymakers (in both the House and the Senate) are in favor of crypto innovation than are opposed to it.
The data below looks at publicly available information pertaining to legislative records, media statements, social media posts, caucus membership, and public letters. Each member of Congress is then rated to determine if they support or oppose crypto innovation. Members, where information could not be gathered or publicly verified were not rated. The data isn’t perfect, but helpful nonetheless.
We’re also hearing that any divide that does exist in Congress is more generational than ideological.
Interestingly, Coinbase’s data seems to line up with recent statements made by Rep. Ritchie Torres (D-NY) in a discussion with Bankless:
“My perception is that the divide on crypto is not partisan or ideological as much as generational. You’ll find that younger Democrats are much more open to the innovative possibilities of crypto.
As you know, Congress is something of a gerontocracy. Until recently, our three leaders in the Democratic Caucus were all above 80 years old. Almost all Committee Chairs are over 70. So, among the leaders in Congress, there tends to be xenophobia about new technologies like crypto.
Regarding older members of Congress that are stubbornly opposed to crypto:
“There seems to be an anti-crypto derangement syndrome that has clouded clear and rational thinking about the subject of crypto. Much of it is rooted in ignorance. What you’ll find is that the pro-crypto members of Congress are much more educated than the opposition.
My role as a policymaker is not to evaluate the utility of crypto. The role of government is not to sabotage innovation. The role of government is to ensure that innovation is safe for consumers and investors. That’s our role. “
It makes sense that crypto is not a partisan issue because crypto users occupy both sides of the aisle.
Most studies show that there are slightly more Democrats that own and use crypto than Republicans in the US.
Remember, Twitter started as a small platform where nerdy computer engineers shared what they were eating for breakfast. Facebook started as an exclusive social club at Harvard.
But within 10 years, both platforms became major influences behind election cycles globally.
We think there is a good chance that Bitcoin and Crypto (as well as AI) become hot-button issues during the 2024 election cycle.
The Democratic National Committee has already announced its intent to not hold Primary Debates. It appears that Biden is being handed the nomination.
Meanwhile, Biden, The White House, and the current regulatory apparatus (SEC, FDIC, Fed) appointed by the President appear to be largely opposed to supporting crypto innovation. Operation choke point 2.0, the President’s 2023 Economic Report, and the proposed legislation to tax the industry are indicative of their posture.
With that said, we think their position may evolve as we near the next election cycle.
Remember, many young members of Congress within the Democratic party support crypto. As do many of their constituents.
Per a recent study by Grayscale, 52% of Americans (including 59% of Democrats, and 51% of Republicans) agreed with the statement that “cryptocurrencies are the future of finance.” 44% of respondents indicated they expect to invest in crypto assets in the future.
As mentioned, Democrats are more likely to own crypto assets than Republicans.
Meanwhile, various estimates reveal that approximately 20% of American adults have owned or currently own crypto assets. According to the Federal Reserve Board itself, 1 in 10 American adults held or used crypto in 2022 (a bear market year). Coinbase has 110 million verified users (audited by Deloitte). Finally, 67% of all Americans agree that the financial system needs major changes or a complete overhaul.
When you add it all up, we think it’s reasonable to project that The White House may have to adjust its approach to crypto as the election cycle picks up.
Republican candidates for President are more likely to support crypto innovation. Ron DeSantis, a Republican frontrunner has already indicated he would “ban a CBDC” and support innovation and property rights pertaining to Bitcoin and crypto at large. As governor, DeSantis has made Florida one of the most crypto-friendly hubs in the country.
It’s currently somewhat unclear what President Trump’s take on crypto is. He has made negative statements about Bitcoin in the past but also launched an NFT project last year. It’s worth noting that important red states such as Florida and Texas are largely supportive of the crypto industry.
Because crypto is viewed as “anti-establishment,” we think it fits Trump’s preferred campaign narrative. When we combine this with the fact that Republicans in Congress tend to support crypto innovation, it’s reasonable to project that Trump will ultimately align himself with the industry.
Crypto users are uniquely diverse and non-partisan.
Not many political issues cover both sides of the aisle like this. Therefore, we think crypto will present some interesting challenges and incentives for policymakers. As Charlie Munger likes to say: “Show me the incentives, and I’ll show you the outcome.” Will politicians continue to be incentivized to scapegoat crypto for some other agenda? We find it hard to see this being the case when we look out 1 year+. On the contrary, it would appear that both parties could be incentivized to signal support for crypto.
We are seeing signs of this in publicly available data.
We’re now seeing it in the drafting of the new legislature.
And we will get a chance to see how the courts view the SEC’s *regulation by enforcement* actions as cases with Ripple and Coinbase progress.
We’ll have to wait and see, but the outlook is probably brighter than the market appreciates right now.
That’s all for part 1.
Thanks for reading.
Part 2 will hit your inbox tomorrow. It covers:
Operation Choke Point 1.0 in 2013 and Similar Treatments Toward Crypto Firms
Regulatory Game Theory and the Passage of MiCA in Europe
Worst and Best Case Outcomes
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Individuals have unique circumstances, goals, and risk tolerances, so you should consult a certified investment professional and/or do your own diligence before making investment decisions. The author is not an investment professional and may hold positions in the assets covered. Certified professionals can provide individualized investment advice tailored to your unique situation. This research report is for general educational purposes only, is not individualized, and as such should not be construed as investment advice. The content contained in the report is derived from both publicly available information as well as proprietary data sources. All information presented and sources are believed to be reliable as of the date first published. Any opinions expressed in the report are based on the information cited herein as of the date of the publication. Although The DeFi Report and the author believe the information presented is substantially accurate in all material respects and does not omit to state material facts necessary to make the statements herein not misleading, all information and materials in the report are provided on an “as is” and “as available” basis, without warranty or condition of any kind either expressed or implied.