SEC goes after unregistered securities

Important takeaways

• The SEC has recently escalated its campaign against unregistered securities, which it claims put investors in risky situations without enough transparency
• Kraken has shut down its US staking service after paying a $30 million settlement to the SEC, causing concern for other proof-of-stake companies such as Ethereum
• The SEC has warned Paxos of its plans to sue them for issuing its stablecoin, BUSD, without proper registration

The US Securities and Exchange Commission recently included regulation of emerging technologies and crypto-assets as one of its priorities for 2023. The SEC intends to investigate whether crypto companies meet appropriate standards of care when “making recommendations, referrals, or providing investment advice.”

This should not be surprising after the volatility of 2022, which saw a crypto winter and the bankruptcy of a number of crypto companies. The regulations surrounding cryptocurrency are complicated and often controversial.

What is difficult about regulating cryptocurrency is determining which aspects of crypto fall within the SEC’s domain. Are crypto offerings securities? Should crypto companies provide investors with financial information before accepting their money? Regulations may provide decisive answers to these questions in the years to come.

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Existing crypto regulations

US legislation first mentioned cryptocurrencies in November 2021. In the Infrastructure Investment and Jobs Act, specific provisions laid out what a digital asset was and defined anyone who transfers a digital asset on behalf of someone else as a broker. This was a controversial move, as it placed similar requirements on crypto exchanges as stockbrokers.

As a result of the law, centralized crypto exchanges are now required to provide investors and the IRS with 1099 forms summarizing the activity of traders. However, this regulation’s effect could be beneficial for crypto exchanges if investors feel more comfortable investing in the assets. Only time will tell.

The IRS considers “virtual currency” property, meaning that crypto bought at one price and sold for a higher price may be subject to a capital gains tax. Likewise, you can deduct money lost through crypto trading as a capital loss.

There is an interesting loophole resulting from this classification. Stocks and other securities are subject to a wash sale rule, which states that if you sell a security at a loss and then quickly buy it back at a reduced price, you cannot deduct the loss on the sale from the current year’s tax. A wash sale rule does not currently apply to crypto.

The SEC uses the Howey test, outlined by the US Supreme Court, to determine whether something is an “investment contract” and therefore a security. The Howey test asserts that a security is an “investment of money in a common enterprise with a reasonable expectation that profits will be derived from the efforts of others.”

When this test applies to crypto remains up for debate.

The Ripple Lawsuit

The SEC sued Ripple Labs Inc. in 2020 for selling the XRP token without first registering it as a security. A ruling is expected in the first half of this year and could have a serious impact on the crypto world.

Central to the legal debate is whether XRP should be considered a security. If the court sides with the SEC, crypto exchanges will face more scrutiny from regulatory agencies and will likely have to register as securities if they continue to sell in the U.S.

A notable exception is Bitcoin, which the SEC does not consider a security since investors do not invest money reasonably expecting a profit. If you are confused about the delineation here, the following example may help clarify it.

Kraken settles with SEC

Earlier this month, crypto exchange Kraken paid a $30 million settlement to the SEC and ended its crypto staking program in the US. Staking is a process that involves investors unlocking crypto tokens with a blockchain validator to receive new crypto when the validator uses its tokens to validate data for the blockchain.

Since crypto tokens are expensive and most users don’t have enough to stake on their own, Kraken was one of many exchanges offering a service to pool multiple investors’ tokens and stake them on their behalf.

This is considered an investment contract by the SEC because investors reasonably expected to receive money from Kraken in exchange for joining the stake pool. With that label, the SEC expected Kraken to make certain disclosures to investors, which they did not.

The SEC’s enforcement action has chilling implications for a company like Ethereum, whose investors also use “staking as a service” options.

Many people have criticized the SEC’s approach, including SEC Commissioner Hester Peirce. He dissented, saying, “Using enforcement actions to tell people what the law is in an emerging industry is not an effective or fair way to regulate.” Peirce continued, “staking services are not uniform, so one-time enforcement actions and cookie-cutter analysis don’t cut it.”

There is a general feeling among crypto exchanges that the SEC’s securities regulations are inflexible and not built to accommodate cryptocurrency. We will have to wait and see if the SEC can convince centralized crypto exchanges to register.

Paxos and stablecoins

The SEC has warned crypto firm Paxos of its plans to sue them for issuing Binance USD (BUSD), a token created in partnership with Binance but owned independently by Paxos. BUSD is a stablecoin pegged to the US dollar, which the SEC claims is an unregistered security.

News of this second enforcement action has proven equally controversial as experts debate whether investing in a stablecoin should be considered an investment contract.

Again, the SEC’s complaint is that Paxos did not adequately warn investors of the risks associated with investing in BUSD, nor did it provide proper financial disclosures.

Other questions we will continue to discuss in the coming years include what kind of disclosures a crypto issuer should make and whether they should be held to the same standard as all other public companies.

While it’s easy to criticize the SEC for standing in the way of innovation, we’re coming off a year where investors lost billions of dollars in the crypto space. Crypto’s popularity is wavering, and it’s understandable why the SEC would consider regulation a priority for this industry.

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The bottom line

With the SEC escalating its campaign to crack down on crypto companies, we expect to see further regulation in the crypto space in the coming years. Many questions remain about this emerging industry, including whether we should classify “staking as a service” and investing in stablecoins as investment contracts.

Keep an eye out for the ruling in the Ripple case, which we expect to be handed down sometime this year.

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