SEC Crypto Crackdown Explained: Unregistered Securities, Gemini, Kraken

• The SEC has stepped up its campaign to reign in what its chairman has called the “Wild West” of crypto.
• Gary Gensler has gone after the Winklevoss twins and Kraken, the world’s third largest crypto exchange.
• But the targeting of unregistered assets has left some in the crypto sector with one answer: it’s war.

After many calls to clean up the Wild West of crypto, it seems the SEC is finally getting its act together.

It has gone after big names like Gemini and Kraken – and it uses unregistered securities rules as its keystone.

We explain what these are and what the industry makes of the regulatory impact.

What has been targeted?

The SEC has been swift in recent weeks in its push to rebuke crypto offerings it deems to be in violation of the rules, relying on the argument that they are unregistered securities.

The most high-profile case came against crypto giant Genesis and the Winklevoss twins’ Gemini in January, after the SEC accused the disastrous “Gemini Earn” program of being an offering of unregistered securities.

Then Kraken, the world’s third-largest crypto exchange, last week paid a $30 million settlement to the SEC and agreed to end its “staking” program, in which investors lock up their holdings of digital assets for an interest-based reward.

And this week, crypto firm Paxos was forced by the New York Department of Financial Services (NYDFS) to stop minting its Binance-branded stablecoin following a planned SEC lawsuit over the sale of unregistered securities. This differs from previous stake colors.

A spokesperson told Insider that it categorically disagreed with SEC staff, arguing that the BUSD coin was not a security.

Why now?

The collapse of FTX in November, locking out billions of dollars in customer deposits, undoubtedly increased the need to rein in potentially risky offerings, as did the event’s spillover effects on Genesis and Gemini.

But regulators’ discomfort with crypto stretches back years — as long as the asset has been popular. In October 2021, SEC Chairman Gary Gensler referred to the crypto sector as “a bit of the Wild West”.

New evidence suggests that programs like staking have become a means for crypto firms to inflate the value of their assets using consumer funds.

An investigation into now-bankrupt crypto giant Celsius found that the company had used customer funds to prop up the value of its original coin in an attempt to return high returns to investors.

What is an unregistered security?

A security is simply a financial instrument that is traded for profit. They form the basis of investment contracts for tanks such as shares, debt and derivatives.

The SEC points to the Howey test to determine whether an asset can be classified as a security. This test has four prongs, all of which must be passed to be determined as a security: [1] An investment of money [2] in a joint enterprise [3] with expectations of profit [4] to come from the efforts of others.

In the United States, if an asset is considered a security, it must be registered with the SEC. For example, an initial public offering (IPO) of a stock that has recently been listed on the stock exchange represents the first offering of newly registered securities.

Securities must be registered as it provides the issuing company with relevant shareholder information to pay dividends and provide relevant share-related information. It also helps reduce fraud by registering the legitimate owner of the security.

According to the SEC, an unregistered security is simply one that has not been rubber-stamped by the regulator.

Unregistered securities have been the subject of several scams, and the SEC says their hallmarks include the promise of high returns without risk, aggressive sales tactics and being backed by unqualified investment professionals. As such, its use is limited.

Only accredited investors, defined as those with a net worth higher than $1 million or an annual income of more than $200,000, can trade unregistered securities, essentially shutting out most retail investors. The threshold is seen as a measure of financial sophistication and suggests a buffer for qualified investors against potential losses.

However, the debate in the crypto world is not about whether or not the assets should be registered, but more fundamentally about whether they should be classified as securities at all.

So, what’s the confusion?

There has long been a debate about whether a digital asset – essentially software – is a commodity like gold, or a security like an ETF. To this end, crypto is usually regulated by the Commodities and Futures Trade Commission (CFTC), which indicates its status as a commodity.

However, Gensler has argued that most cryptocurrencies meet the legal definition of a security, and should be registered with the SEC.

But the evolution of the crypto sector, namely through programs like staking and initial coin offerings (ICOs), is blurring the lines and giving the SEC ammunition to pursue a clampdown.

The crackdown focuses on firms that promised returns to customers, either for staking crypto for a blockchain or for lending crypto with guaranteed percentage returns, as with Kraken and Gemini’s Earn program, respectively. These can be seen as investment contracts.

Crypto enthusiasts tend to argue that the asset fails all four branches of the Howey test to determine a security or investment contract, since it does not generate value through the efforts of others.

Meanwhile, Coinbase’s general counsel Paul Grewal last week also dismissed the idea of ​​staking as a security. In a memo, he argued that staking failed all four branches of the Howey test, not just the fourth of value creation.

“Trying to impose securities laws on a process like staking does not help consumers at all,” Grewal wrote. “Instead, unnecessarily aggressive mandates will prevent US consumers from accessing basic crypto services in the US and push users to offshore, unregulated platforms.”

More fundamentally, crypto industry bigwigs from Brian Armstrong to Anthony Scaramucci have rallied around the SEC’s decision on Kraken’s “staking” program, describing it as an attack on economic freedoms.

What will be next?

Crypto firms and the SEC must wait for the outcome of various lawsuits to set a precedent. The result could mean crypto firms have to register offerings and assets as securities, but some argue this has left them in no man’s land.

“Regulation by enforcement is confusing for crypto enthusiasts,” Globalblock Crypto, a digital asset brokerage, said in a note.

“The SEC claims that ‘all crypto projects have to do is come in and register,’ but when they do, they’re just told ‘no’. People are desperately trying to figure out how to offer a product legally, while getting zero guidance.”

Scott Melker, “The Wolf of All Streets” crypto trader, had several language choices.

“”It’s clear that the US is going to war with the crypto industry,” he tweeted.

“If it’s war they want, it’s war they’ll get.”