Why the crypto world flunks when the SEC calls Coins Securities

1. What does the SEC do?

Its chairman, Gary Gensler, like his Trump-era predecessor, Jay Clayton, has said that many digital assets have the characteristics of securities. Gensler warned that the agency planned to take a hard line to enforce the rules for these tokens. Anxiety among crypto traders grew when the market regulator in July 2022 took the unusual step of identifying nine crypto assets it deemed to be securities as part of an insider trading case. Seven of them were traded on Coinbase, America’s largest crypto trading platform. The SEC also investigated whether Coinbase had listed assets for trading that should have been registered with the agency. In March 2023, Coinbase said it had received a notice from the SEC — known as a Wells notice — signaling the agency’s intention to take enforcement action against the company. The notice identified several products or offerings that it considered to be securities, including Coinbase’s staking service and part of its publicly traded digital assets.

2. What does it mean that something is a security?

In its simplest form, whether or not something is a security under US rules is basically a question of how much it looks like stock issued by a company raising money. To make that determination, the SEC uses a legal test, which comes from a Supreme Court decision from 1946. Under this framework, an asset can be under the SEC’s purview when it involves investors kicking in money with the intention of profiting from the efforts of the organization’s management. In December 2020, the agency sued Ripple Labs Inc. for allegedly raising money by selling the XRP digital token without registering it as a security. The SEC claimed that the company financed its growth by issuing XRP to investors who were betting that its value would rise. The case is now a massive legal battle, in which Ripple has hired a former SEC head, Mary Jo White, as a lawyer.

3. Why is calling a token a security issue?

First, such designations will make running a cryptocurrency exchange more expensive and complex. In accordance with US regulations, the brand has strict investor protection requirements for platforms and issuers. This burden will put smaller platforms at a disadvantage compared to competitors with deeper pockets. In addition, exchanges will be subject to continuous scrutiny by regulators, which could lead to fines, penalties and, in the worst case scenario, criminal prosecution if criminal authorities were ever involved. It could also mean losing future funding from investors who may be scared off by these increased compliance burdens and regulatory scrutiny. Proponents of more regulation believe securities designations will result in more information and transparency for investors because of the SEC disclosure requirements that will apply.

4. Who is against that approach?

Crypto enthusiasts say their business is decentralized in a way that makes old rules ill-suited, and crypto trading platforms argue that the assets they list should be considered commodities, not securities. In the US, rules governing the trading of commodities, and their derivatives, are more focused on ensuring that companies, producers and farmers can effectively use derivatives to hedge against the risk of commodity price fluctuations than on the role of retail investors. Other crypto firms have said they are willing to follow the SEC’s rules, but that the agency needs to provide more clarity on how they apply to digital assets.

5. What does the crypto community want?

There have been efforts on Capitol Hill to give the Commodity Futures Trading Commission, the US derivatives watchdog, more power to directly regulate crypto assets. Currently, it primarily monitors crypto futures and has the ability to take enforcement action if there is fraud or manipulation in the underlying market, as it has done in dozens of crypto cases. Crypto leaders and titans of traditional markets like Citadel Securities joined an industry push behind a bill from top lawmakers on the Senate Agriculture Committee that would give the derivatives regulator more turf — at the expense of the SEC. Opponents of that approach say the SEC’s securities-focused rules provide more protection for mom-and-pop investors. The industry-backed effort stalled after the collapse of cryptocurrency exchange FTX, which was one of the most vocal companies backing the effort.

6. How do the agencies share crypto?

To some extent, their approaches reflect their origins. Formed in the wake of the 1929 market crash, the SEC sees its core mission as protecting investors by requiring ample disclosure of financial entities. The CFTC traces its roots to the Department of Agriculture, helping farmers protect themselves from drought. The CFTC – and the US rules around commodities and their financial derivatives – are widely seen as a less burdensome regulatory regime. So it’s little surprise that the crypto public desperately wants the CFTC to be their regulator and not the SEC.

7. Which coins are considered a security or not?

The short answer is that beyond the very largest cryptocurrency, there is a lot of ambiguity. US regulators including the SEC agree that Bitcoin, which is by far the largest digital asset, is not a security. It was started by one or more unknown people who go by the pseudonym Satoshi Nakamoto and does not exist as a way to raise money for a specific project. The second largest token, Ether, was deemed not to be a security under the Trump administration by a senior SEC official who signaled that while Ether may have started out qualifying as a security – the Ethereum Foundation used it to raise money – it had grown into something decentralized enough that it probably no longer was. But after Ethereum changed to a system where coins “staked” play a role in recording transactions, Gensler said the fact that coins deposited can earn interest could lead regulators to start treating it as a Safety. The CFTC considers Ether a commodity, and the CME lists futures on it as well as Bitcoin.

Gensler has said the agency could waive some of the rules to better suit digital assets, while ensuring investors are protected, if exchanges cooperate with the agency to register. However, he has not provided a road map of how exactly that can be achieved. The SEC also stepped up enforcement against crypto companies following the failures of several in 2022, including FTX, which is now at the center of a criminal investigation into the misuse of customer funds. Meanwhile, some lawmakers have pointed to last year’s turmoil as reason to need clear rules for the industry, although it’s unclear whether a Republican-led House and a Democrat-led Senate can find enough common ground to reach an agreement. Ongoing litigation, including the Ripple case and the SEC’s insider trading case, may also help shed light on some of the more murky legal questions surrounding the industry, including which tokens are securities and which are commodities. All of these debates are happening against a backdrop of increased scrutiny from the Biden administration, which has warned about the risks of crypto, including in a March report from the Council of Economic Advisers.

9. Is this a problem elsewhere?

Yes. Globally, various regulators have taken a variety of positions on whether to treat cryptocurrencies as securities. The UK’s Financial Conduct Agency regulates digital assets that it considers investments that come with rights to repayment or a share in profits, while “payment tokens” such as Bitcoin or “utility tokens” that provide access to a service are unregulated. Singapore regulates both types, but under different laws. It considers coins that are digital representations of other assets, such as unlisted stocks, to be securities. In June, the EU reached a preliminary agreement to introduce common cryptocurrency rules in all 27 member states and develop a new legal framework to regulate public offerings of crypto assets.

• A report from the Ministry of Finance on issues related to crypto regulation.

• A look at the crypto industry’s push in Washington to avoid securities regulation.

• Gary Gensler’s first interview about crypto after taking over as SEC head with Bloomberg Businessweek.

• A BGOV OnPoint of cryptocurrency legislation being considered by Congress.

• A Bloomberg QuickTake from 2018 shows how long these battles have been going on.

• The statement on crypto regulation signed by Biden.

• An article about the SEC’s battle with Ripple.

• UK FCA’s breakdown of regulated versus unregulated tokens.

–With help from Ben Bain.

More stories like this are available at bloomberg.com