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SEC inquiry & class action lawsuits catch Coinbase flat-footed

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Gary Gensler, the chair of the Securities and Exchange Commission (SEC) has declared war on all crypto exchanges operating in the U.S., setting up an additional battle with the Commodity Futures Trading Commission (CFTC), which seeks to establish itself as the main crypto regulator.

On July 21, 2022, the SEC fired the first shot by announcing an inquiry into Coinbase, the largest crypto exchange, for listing securities on its platform. Three weeks later, on August 4, Forbes reported that a staffer of Senator Cynthia Lummis leaked the news that Binance.US, as well as all other exchanges in the U.S., are also under SEC investigation.

Meanwhile, the SEC actively avoids moves that would clarify the actual rules and SEC Chair Gensler shamelessly throws around his obscene wealth, preferring to meet with his brokers rather than any of the key companies over which his agency claims jurisdiction. 

Independent researchers have been probing Gensler’s investment portfolio, noting that he seems to be shorting crypto-focused stocks like AMC Theatres and Gamestop through Vanguard Group and BlackRock.

Coinbase Manager accused of Insider Trading

It all started after Ishan Wahi, a former product manager at Coinbase, alerted his friend Sameer Ramani and his brother Nikhil Wahi 14 different times when tokens were going to be listed on the platform so they could stock up on them in time to pocket over a million bucks.

They tried to evade detection using ethereum wallets disguised with other names, and then they tried to escape. Ishan Wahi tried to flee on a one-way flight out of the U.S., but he got pinched. Sameer Ramani seems to have gone into hiding.

The Wahi brothers pleaded not guilty and officially, they are innocent until proven otherwise, but in reality, they are totally screwed. They demonstrated consciousness of guilty by hiding their activity and trying to flee, so prosecutors will be licking their chops. The Justice Department (DoJ) has them dead to rights and they will be going away for a long, long time.

The same day the DoJ announced its complaint against Wahi and his accomplices, the SEC announced its inquiry into Coinbase, specifying nine digital assets, seven of which are listed on Coinbase, that it alleges are securities. Included among the condemned are the AMP Token, Powerledger, Kromatika, DFX Finance, Rally, Rari Governance Token, DerivaDAO, LCX, and XYO, the creators of which have all remained mum on the inquiry.

Piling on, a law firm filed a class action lawsuit accusing Coinbase of listing assets that should have first been registered with the SEC. Nevertheless, Coinbase shares skyrocketed in value when its new partnership with BlackRock was announced. The partnership will allow institutional investors to get exposure to digital assets which many investors regard as the key to the maturation of the market.

However, the showdown between the SEC and Coinbase is rippling across the entire market and will have broad implications for the future of digital assets because the case hinges on whether seven tokens traded on Coinbase of nine specified by the SEC are securities or commodities. 

If they are securities like those issued by companies, it will massively hobble the business model of the major exchanges, obliging them to abide by strict investor-protection requirements, compliance and transparency burdens, and constant regulatory scrutiny, including the possibility of criminal prosecution. 

 Coinbase rejected the accusation that it lists securities in a tweet. 

After this tweet, Coinbase probably thought the SEC would be appeased and that Gensler would go back to meeting with his money managers and flouting his vast wealth in Washington. Not so fast!

Coinbase’s no good very bad year

Coinbase branded itself as the most trusted name in the crypto-economy with a mission of delivering financial liberty, but the company made a fateful choice in May 2021 when CEO Brian Armstrong announced that Coinbase would expand the number of tokens offered on the platform.  

These volatile vehicles referred to in crypto parlance as “shitcoins,” have no obvious value other than the hype which drives their prices up and which have become a haven for pump and dump scams, hacks, and rug-pulls that have famously left investors sobbing and screaming in group therapy sessions. 

Over the next year, Coinbase saw an expansive project stall in India and the launch of its NFT product platform fell flat. Still, in the 18 months before the crash, Coinbase’s staff went from 1,250 to 6,100. Some of them in the customer service department were just sitting at home, waiting for the phone to ring.

Then, when the crypto market crashed in May, Coinbase’s stock price tanked, losing 60% of its value. In the first quarter, Coinbase’s revenue dropped 27% from a year earlier, to $1.17 billion, even as its expenses more than doubled, to $1.72 billion, so it had to lay off 1,100 employees.

Now, Coinbase’s back is against the wall. If it delists the shitcoins, like it did XRP, the company would seem to validate the SEC’s accusations. For CEO Brian Armstrong, there’s no choice but to stand tall.

Coinbase: Victim or Perpetrator?

Although it joined the shitcoin party and made badly timed expansions, Coinbase seemed to be making a good faith effort to follow the law.

According to a petition Coinbase filed with the SEC on July 21, the company beseeched the SEC to “propose and adopt rules to govern the regulation of securities that are offered and traded via digitally native methods, including potential rules to identify which digital assets are securities.”  

The SEC unveiled its complaint against Coinbase for selling unregistered securities the same day the company filed the petition urging the SEC to clarify what constitutes an unregistered security. By opting for “regulation by enforcement,” the SEC chooses to leave the rules vague while dropping the hammer on anybody who crosses their poorly defined line. 

Caroline D. Pham, Commissioner of the CFTC, clearly criticized the approach of the SEC in a tweet calling for a “transparent process that engages the public” and stating that “regulatory clarity comes from being out in the open, not in the dark.”  

The SEC keeps crypto world guessing

For months, Industry professionals have been vociferously begging the SEC to define what the rules are. Instead of giving any kind of professional or cogent answer, the SEC charges one or another company for breaking them.

In 2020, Ripple Labs Inc., creator of the cryptocurrency XRP, came under the regulatory knife. In February, BlockFi became the next victim to this rogue approach when the SEC fined the trading platform a cool $50 million over an unregistered security.

The SEC uses the Howey Test to determine whether an investment meets the definition of a security, applying four prongs all of which the investment must satisfy to qualify as a security. They seem simple; 1) the investment involves money, 2) in a common enterprise, 3) with the expectation of profit, 4) to be derived from the efforts of other people. Beyond that, the clarity dissipates because the four prongs also contain 38 separate considerations, some including several sub-points. 

The SEC has designated that bitcoin and ethereum are not securities; they are commodities because they are sufficiently decentralized and not derived from the efforts of others. However, when it comes to DAO tokens and the new coins launched in ICOs, even seasoned securities lawyers are left scratching their heads. 

In 2019, SEC Commissioner Hester Peirce wrote in a blog post on the SEC website, “I worry that non-lawyers and lawyers not steeped in securities law and its attendant lore will not know what to make of the guidance.” 

If one of the SEC’s own commissioners casts doubt on its approach, it might be reasonable to clarify its approach, right? WRONG! Incomprehensibly, the SEC is digging in its heels.

SEC Chair is Anti-Crypto Oligarch 

Perhaps, it should come as no surprise that Coinbase is now the target of SEC enforcement, but the head of the agency has tainted its decisions with his own carelessness and overt impropriety. It now seems ironic that Gensler’s elevation to SEC chair was considered a win for Elizabeth Warren because Warren is an outspoken advocate for good government and anti-corruption, yet Gensler can’t be bothered to avoid the appearance of corruption and laziness.

Gary Gensler doesn’t meet with Congress. He also refused to meet with Ripple (XRP) holders. In fact, his public calendar shows no meetings with anybody in the business of digital assets. Oh, but Gensler met seven times with Vanguard Group, the investment firm that controls 90% of his $100 million dollars.

Aside from Gensler’s shady dealings, there may be a deeper reason for the mind-boggling refusal of the SEC to help non-lawyers understand its complex legal lore.

Rohan Grey, the research director of the Digital Currency Institute, told Politico that “It’s mostly been non-regulation by enforcement because the SEC is worried that they can’t necessarily win the case.” 

This issue of the regulators’ ad hoc and subjective enforcement seems to stem from the vagueness of the law surrounding digital currencies versus securities. In other words, the SEC’s definition of a digital security is analogous to Supreme Court Justice Potter’s famous definition of obscenity: “Nobody really knows how to define it, they only know it when they see it.”

Gary Gensler said that the “vast majority” of cryptocurrencies are securities, echoing former SEC Chair Jay Clayton‘s testimony before the Senate in 2018 that “every ICO I’ve seen is a security.” 

When asked about this controversy on the Unchained Podcast, CFTC Commissioner Pham disagreed, saying that digital assets should be taken on a “case by case basis” to determine whether they are securities or commodities, pointing to the need to update and clarify old laws when dealing with new technology.   

Larger Implications

Beyond the “very substantial fines” and being required to register with the SEC, the Coinbase inquisition heralds a potential shift for the entire industry, and other exchanges are scrambling to avoid similar scrutiny. Binance.US acted quickly to remove AMP from its platform, but it was already too late. The SEC is on the warpath and no exchange is safe!

The AMP token is still available on other exchanges, and so are the other tokens the SEC has targeted, which may face SEC probes if they fail to register. Welp! All the God-fearing exchanges have to do is register and they may avoid the SEC’s wrath, right? Nope! They can’t because registering with the SEC presents a potentially insurmountable barrier for crypto exchanges. 

Michael Bacina, an Australian digital assets lawyer with Piper Alderman, told Cointelegraph that “it may be difficult, if not impossible, for [the exchanges’] current business model to exist as a licensed and registered exchange” because of “key compliance incompatibilities between blockchain systems and existing U.S. market regulations.” 

Indubitably, the SEC knows this. However, regardless of whether the SEC concludes that these various tokens are in fact securities, the animosity of the SEC is clear, and you can bet all the exchanges are saying their prayers. Except maybe FTX, whose founder, Sam Bankman-Fried (SBF) generously funded Joe Biden’s campaign and plans to effectively purchase the entire Democratic Party in 2024.

In an interview with Decrypt’s gm podcast, SBF said, “What I would most like to see would be regulatory frameworks, registration form frameworks, coming out for both platforms and assets, and I’m optimistic that over the next year we will see some from multiple agencies. That doesn’t mean you can’t make decisions in the meantime. That doesn’t put you in a position where it is impossible to judge what anything is … and it’s very intentional that we have listed fewer tokens on FTX US than many platforms have.

Makes me wonder if SBF knew something Coinbase did not. In any case, Coinbase swears that it has a rigorous process to establish what’s what, but other exchanges that don’t have the personal cell numbers of Congresspeople (like SBF) may not. Therefore, we can expect an industry-wide chilling effect on shitcoins, which may be for the best.

Some exchanges that cannot afford to delist shitcoins may have to abandon their product offering in the U.S. or try to balance their offering with a mix of official “crypto commodities” and shitcoins. Recent legislation has clarified that bitcoin and ethereum are commodities and the CFTC will regulate them.

At this point, it is unclear whether the SEC and the CFTC are playing some version of regulatory “good cop, bad cop,” or if the two agencies are actually working against each other. For the world of crypto, it is painfully clear who the bad cop is.

Author: Tim Tolka, writer, journalist, and BI researcher

The editorial team at #DisruptionBanking has taken all precautions to ensure that no persons or organizations have been adversely affected or offered any sort of financial advice in this article. This article is most definitely not financial advice.

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