What will be the outcome of SEC's crackdown on crypto?

23-06-08 15:52
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Original Title: "The SEC Comes for Crypto"
Original Source: Bloomberg
Original Author: Matt Levine
Original Translation: Kxp, BlockBeats


SEC sues Crypto


In March, I wrote that "a foolproof rule of thumb is that all crypto exchanges are committing crimes, and if you're lucky, your exchange is only committing some procedural crimes," just like that:


1. Is your exchange operating an illegal securities exchange in the United States? At least from the SEC's perspective, every crypto exchange in the US is illegal. You may hold a different view - many executives of crypto exchanges do - and we will discuss more debates in the following text. However, in reality, if you are trading crypto, you cannot be too timid to strictly comply with US securities laws. 


2. Is your exchange stealing all customer funds? Some are, and some are not. If you are a customer, this is the most important thing you should be concerned about.


These things are not particularly relevant, after all, every crypto exchange is violating US securities laws. "I shouldn't give my money to those people because they are breaking US law." This is indeed a reasonable position that can save you from many crypto disasters, but it will also make it impossible for you to trade crypto.


Yesterday, the SEC sued Binance, the world's largest crypto exchange, and its founder Zhao Changpeng, accusing them of operating an illegal securities exchange. Today, the SEC sued Coinbase Inc., the largest crypto exchange in the United States, accusing them of operating an illegal securities exchange.


There are two main types of conflicts between crypto exchanges and the SEC. The better scenario is when you get into trouble for operating an illegal securities exchange. In April of this year, the SEC sued Bittrex Inc., accusing it of operating an illegal securities exchange. Any reasonable interpretation of the Bittrex case suggests that similar cases will be brought against Coinbase and Binance. In the eyes of the SEC, simply being a crypto exchange is already illegal.


Another bad scenario is getting into trouble for embezzling funds. In December of last year, the SEC sued a large crypto exchange, FTX Trading Ltd. This article is the SEC's complaint against FTX. I fully believe that the SEC believes FTX operated an illegal securities exchange in the United States. However, the complaint barely mentions this issue. There were just too many other things. FTX allegedly embezzled all funds, and when an exchange embezzles all funds, the SEC takes notice. When it doesn't embezzle all funds, the SEC focuses on the issue of an illegal securities exchange.


Therefore, one question regarding this week's case is: Did the SEC sue Coinbase and Binance because they are cryptocurrency exchanges, or because they are bad cryptocurrency exchanges? Is the SEC's claim "you allow people to trade crypto, but we believe it is illegal" or "you allow people to trade crypto and steal their money"?


For Coinbase, I think the answer is obvious. As a cryptocurrency exchange, Coinbase is very compliant. It is a publicly traded company registered in Delaware and listed on NASDAQ. It went public in 2021 through a direct listing and submitted extensive disclosure documents to the SEC. Its financial statements are audited by Deloitte. Its business model seems to be to collect funds from customers, use these funds to purchase cryptocurrencies, and securely store these cryptocurrencies in places named after customers. I dare not draw any conclusions about any cryptocurrency participant, and I have made mistakes before, but my impression is that Coinbase will not steal funds.


In fact, the SEC's allegations against Coinbase are very dry and focused solely on the fact that Coinbase is not registered as a securities exchange. Similarly, in the eyes of the SEC, every crypto exchange is violating US securities laws. However, Coinbase does so politely and relatively harmlessly. Although not entirely harmless - "Coinbase's unregistered conduct deprives investors of important protections, including SEC inspections, record-keeping requirements, and safeguards against conflicts of interest," the SEC said - it is still relatively harmless.


For Binance, the answer is more interesting. As far as cryptocurrency exchanges are concerned, Binance is considered to be moderately compliant. It has not disclosed its headquarters information and has built a series of confusing entities to avoid regulation. (According to the SEC's compliance director in 2018, "We don't want Binance.com to be subject to any regulation.") Similar to FTX, Binance has its own token, called BNB; it has its own affiliated trading companies; and it provides separate platforms for US customers (Binance.us) and customers in other regions (Binance.com). In March of this year, it was sued by the US Commodity Futures Trading Commission mainly because it allowed US large customers (high-frequency market makers such as Jane Street and Tower Research) to trade on the Binance.com exchange through its overseas affiliated companies, although the CFTC's allegations also mentioned the issue of terrorist funding.


Moreover, the SEC's complaint against Binance also includes allegations of improper conduct by Binance. Binance has some affiliated market makers, including Sigma Chain AG and Merit Peak Ltd., which are said to be controlled by Zhao Changpeng and conduct trading on Binance.com and Binance.us. The SEC suggests that they have been involved in suspicious activities:


"For example, as of 2021, at least $145 million has been transferred from BAM Trading (i.e. Binance.us) to Sigma Chain accounts, and an additional $45 million has been transferred from BAM Trading's trust account B to Sigma Chain accounts. From this account, Sigma Chain spent $11 million to purchase a yacht."


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From September 2019 to June 2022, the trading company Sigma Chain AG, owned and controlled by Zhao Changpeng, conducted money laundering transactions on the Binance.US platform, artificially inflating the trading volume of Crypto asset securities.


There are also more general accusations:


"SEC also claimed that Zhao Changpeng and Binance control the assets of the platform's customers, allowing them to mix customer assets or transfer customer assets according to their own wishes, including transferring them to Sigma Chain, an entity owned and controlled by Zhao Changpeng."


However, the SEC did not elaborate much on these charges, and most of the accusations against Binance are the same as those against Coinbase: accusing Binance of operating a crypto exchange that is open to US customers and has listed securities, but has not registered as a securities exchange in the US. I tend to view yesterday's lawsuit as a recognition of Binance. The SEC and the previous Commodity Futures Trading Commission conducted a thorough investigation of Binance and wrote a 136-page complaint, listing all the bad things, but what they found was that Binance operated a crypto exchange.


Although the arguments of the two accusations are largely the same, the attitudes of Coinbase and Binance are completely different. The key legal issue is whether the Crypto Tokens listed on Binance and Coinbase are securities. If they are securities, then it is likely that Coinbase and Binance (as well as Bittrex and all other exchanges) are operating illegal securities exchanges; if they are not securities, then everything is fine. Coinbase realizes that this is a potential risk and has established committees and procedures to consider and mitigate the risk. The SEC wrote in its accusation against Coinbase:


Given that at least some crypto assets are provided, sold, and distributed by a group of identifiable individuals or promoters, in September 2018, Coinbase publicly released the "Coinbase Crypto Asset Framework", which includes a listing application form for crypto asset issuers and promoters to make their crypto assets available on the Coinbase platform.


The listing application of Coinbase requires issuers and promoters to provide information about their crypto assets and blockchain projects. It specifically requires information related to the Howey test for crypto assets to be provided.


In addition, in around September 2019, Coinbase and other crypto asset companies jointly established the "Crypto Rating Council (CRC)". The CRC subsequently released a framework for analyzing crypto assets, which "extracts a series of questions aimed at clarifying the four elements of the Howey Test" and assigns scores from 1 to 5 to crypto assets, with 1 indicating "assets that have little or no features consistent with an investment contract" and 5 indicating "assets that have many features consistent with securities treatment".


When announcing the establishment of CRC, Coinbase stated: "Although the SEC has issued useful guidance, whether a given crypto asset is a security ultimately requires substantive analysis."


These answers are very responsible, although the US SEC disagrees with Coinbase's conclusion and has raised objections to the process.


From the end of 2019 to the end of 2020, the number of Crypto assets tradable on the Coinbase platform doubled, and doubled again in 2021. During this period, Coinbase added Crypto assets with high-risk scores to the Coinbase platform. In other words, in order to achieve exponential growth on the Coinbase platform and increase its own trading profits, Coinbase made strategic business decisions to add Crypto assets to the platform, even though it was aware that these Crypto assets had securities features.


Meanwhile, Binance's excellent Chief Compliance Officer described his approach to conducting a substantive analysis of Binance's security tokens for listing in the United States:


As Binance's Chief Compliance Officer candidly told another Binance compliance officer in December 2018, "We are operating an unlicensed securities exchange in the United States."


Coinbase has hired many lawyers to conduct extensive analysis and write numerous checklists to ensure that they are operating a crypto exchange legally in the United States. Binance's attitude is "obviously this is illegal in the United States, oh well." The SEC fully agrees with Binance's viewpoint.


For Coinbase, this may be a good thing: it can portray itself as a law-abiding good guy in court, while Binance looks like a law-ignoring bad guy; Coinbase may win the dispute with the SEC, while Binance may lose. But I have to say, so far, Binance's approach seems wiser. (Of course, don't write it down, etc.) Binance noticed that operating a crypto exchange in the United States is illegal, and took measures to minimize and isolate its risks in the United States: it has relatively few customers in the United States and seems to keep most of its business outside the United States. Coinbase, on the other hand, is trying its best to operate a legal and regulatory-compliant crypto exchange in the United States, but now the SEC says it is impossible. If the SEC is right, what is left for Coinbase?


SEC sues Crypto: What is a security?


Okay, let's discuss the basic theory of SEC cases. We've already discussed this when the SEC sued Bittrex:


1. If you operate a securities exchange that offers securities trading in the United States, you need to register it as a securities exchange and register with the SEC.


2. Binance and Coinbase offer trading of security tokens.


3. They did not register their US exchange as a securities exchange.


4. Problems arise one after another.


The first point is quite subtle; for example, some stock trading venues are not registered as securities exchanges, even though they are registered with the SEC under other regulations. However, from the SEC's perspective, it is important that the rules for securities exchanges are designed to protect investors. In particular, they often require the separation of three key functions that are typically combined in Crypto: the exchange that matches buyers and sellers, the broker-dealer that acts as an agent for clients in executing trades, and the clearinghouse that actually moves funds and securities. In the stock market, you can place an order to buy a stock on the New York Stock Exchange through Robinhood's website, and the Depository Trust Co. will hold and settle the stock. In the Crypto market, you can place an order to buy Crypto on Coinbase's website, and Coinbase will hold and settle the Crypto.


But the main point here is the third one: Are Crypto Tokens securities? The SEC's basic view is that most Crypto Tokens - not all, except for BTC, but most of them - are securities under US law. Coinbase's view, of course, is that many Tokens are not securities. In this issue, the key is whether some popular Crypto Tokens listed - the SEC cited a series of Tokens, including Solana's SOL, Cardano's ADA, Polygon's MATIC, Filecoin's FIL, Decentraland's MANA, Algorand's ALGO, Axie Infinity's AXS, and Voyager Digital's VGX - are securities or not.


The US Securities Act defines "securities" as including, but not limited to, any "stocks", "equity certificates of profit-sharing agreements", "pre-organization certificates or subscription certificates", "transferable shares, investment contracts, [or] voting trust certificates". The most commonly used term is "investment contract", which was explained by the US Supreme Court in the famous SEC v. W.J. Howey Co. case in 1946:


"According to the Securities Law, an investment contract refers to a contract, transaction, or plan in which a person invests his money in a joint enterprise based on the contract, transaction, or plan, and the income is brought by the efforts of the promoter or third party, regardless of whether the shares in the enterprise are represented by formal certificates or tangible assets used in the enterprise. This definition can achieve the statutory purpose of mandatory disclosure of "comprehensive and fair disclosure of many types of tools that belong to the universal concept of securities in our business world." It reflects a flexible, rather than static principle, a principle that can adapt to the countless and diverse plans that attempt to promise profits using other people's money. "


Investors provide funds and share in the profits and earnings; promoters manage, control, and operate the enterprise. Therefore, arrangements reflecting the interests of investors involve investment contracts, regardless of the legal terminology used in such contracts.


"The key to the test is whether the plan involves investing money in a joint venture and the expected profits come entirely from the efforts of others. If this test is met, then it is irrelevant whether the enterprise is speculative or non-speculative, and whether there is a sale of property with or without intrinsic value."


This became known as the "Howey Test," in which the court will inquire whether there is (1) an investment of money, (2) in a common enterprise, (3) with an expectation of profits, (4) solely from the efforts of others. The SEC has been asserting since at least 2017 that most crypto companies fit this description.


For example, let's take a look at Solana. Solana is a blockchain that runs Crypto applications; its native token is called SOL. Here is the SEC's explanation of Solana:


"SOL" is the native token of the Solana blockchain. The Solana blockchain was founded in 2018 by Anatoly Yakovenko and Raj Gokal, the current CEO and COO of Solana Labs, a Delaware-based company headquartered in San Francisco. According to the official website of Solana, www.solana.com, the Solana blockchain is a network for building decentralized applications (dApps) that consists of a platform aimed at improving the scalability of blockchain and achieving high transaction speeds through the use of a consensus mechanism.


According to Solana's official website, SOL can be "staked" on the Solana blockchain to earn rewards, and a small amount of SOL must be "burned" when making transactions on the Solana blockchain. This is a common feature of native tokens on blockchains, used to prevent malicious users from spamming the blockchain with an unlimited number of transactions through cryptographic distributed ledgers.


Solana Labs is selling SOL to raise funds for building the Solana ecosystem:


Solana Labs has publicly stated that it will deposit the proceeds from private and public SOL sales into its controlled comprehensive Crypto asset wallet, and will use these proceeds to support the development, operation, and marketing of the Solana blockchain in order to attract more users to use the blockchain (potentially increasing demand and value for SOL, as people who want to interact with the Solana blockchain need to use SOL). For example, in connection with the 2021 private sale of SOL, Solana Labs publicly stated that it will use investors' funds for: (i) hiring engineers and support staff to help develop Solana's developer ecosystem; (ii) "accelerating the deployment of market-ready applications that will attract the next billion users to the crypto space"; (iii) "establishing an incubation studio to accelerate the development of decentralized applications and platforms built on Solana"; and (iv) establishing a "venture capital department" and "exchange" specifically for the Solana ecosystem.


Howey Test:


1. Have investors invested money? Yes, SOL is sold in the form of currency to raise funds for Solana. 


2. Is there a joint venture? Yes, Solana is a company; it is a blockchain ecosystem that competes with Ethereum, Cardano, and others, with the aim of attracting users. 







Additionally, Solana Labs markets the "destruction" (or burning) of SOL as part of its "deflationary model." As explained by Yakovenko in an article titled "Solana (SOL): Extending Crypto to the Masses" published on gemini.com on April 14, 2021, "Solana's transaction fees are paid in SOL and are destroyed (or permanently removed) as a deflationary mechanism to reduce the total supply and maintain price stability of SOL." According to the Solana official website, the "total current supply" of SOL has been reduced through the destruction of transaction fees and planned token reduction activities since the launch of the Solana network. This deflationary mechanism of destroying SOL as a marketing tool for the Solana network reasonably leads investors to believe that purchasing SOL has the potential for profit, as there is a built-in mechanism to reduce the supply and increase the price of SOL.


In the complaint against Binance, the SEC cited Zhao Changpeng's description of Binance's own BNB burn mechanism:


In fact, on July 9, 2019, Zhao Changpeng described the Binance plan for BNB burning in an interview on YouTube. He stated, "One of the benefits we promised in the whitepaper is that every quarter, we will use 20% of our profits to buy and burn [BNB] at market value. We will burn up to 100 million Binance Coins, which is basically half of all available coins. Financially, it works in the same way as dividends in the economy."


My point is that its function is similar to stock buybacks, but of course, dividends and stock buybacks are essentially equivalent. The key is that shareholders - sorry, Token holders - in Crypto projects share the profits of the project by purchasing and destroying Tokens, which operates in the same way as stock buybacks.


One way to understand Crypto economics is that it builds a new way of selling promising technology and financial enterprise stocks without calling them stocks. For example, if you want to launch a Crypto exchange and want to raise funds, you can find investors and offer them stocks in your company. If the company performs well and generates a lot of profits (from charging transaction fees to customers), you will share these profits with investors. However, there are problems with this approach:


1. If you sell stocks to the public, you will need to register with the SEC.


2. If selling stocks to large venture capital firms, they will need to register with the SEC or find exemptions under SEC regulations.


3. Regardless of the method, you may need to provide investors with some financial information about the company in order to obtain their funds.


4. Your shareholders may want voting rights, ongoing financial disclosure, etc. This is customary and often required by law.


Alternatively, if you want to launch a crypto exchange, you can seek out investors and offer them your company's token. If your company performs well, there will be a lot of profit from charging customers transaction fees, and you can share these profits with investors by purchasing and destroying tokens. This is a great opportunity.


1. If you sell tokens to the public, you can declare that they are not securities and do not need to be registered with the SEC.


2. If the Token is sold to large venture capital firms, they can declare that they are not securities and freely resell them.


3. You will write a white paper to sell tokens, and it is not necessary to provide a large amount of financial or operational details.


4. You can grant Tokens any rights you want.


I am a practitioner in the encryption industry. Please translate the following Chinese text to English without considering the context or industry-specific terms and names. Do not translate English words or phrases in uppercase letters, such as ZKS, STARK, SCROLL, as they should be returned as is. If there are English characters in an a tag, do not translate and return it directly. If the content only contains punctuation marks, return them as is. Do not translate HTML tags such as

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I feel a bit unfair. I am describing a pure regulatory arbitrage. Binance's BNB or FTX's FTT are pure stock substitutes issued by a company to raise funds for its centralized business operations. However, many cryptos are not entirely like this. In some projects, people truly hold the ideal of building a decentralized ecosystem without any company ownership. Selling tokens can be a way to create and fund projects, and this economic model is indeed very different from that of shareholder-owned companies. But most of the time, the crypto ecosystem seems to be built by relatively centralized teams, and tokens are sold in the form of stocks or stock-like instruments of emerging technology companies initiated by promising teams.


You can see why people in the Crypto industry like this approach, as it combines regulatory arbitrage with an exciting new trend. You can also see why the SEC doesn't like it, as the SEC is well-versed in "the countless and varied schemes that involve promising profits to others and using their funds." The SEC is a regulatory agency that is being exploited, and it is not happy about it.


SEC sues Crypto: What to do now?


In theory, there are several possible outcomes:


1. SEC wins, Crypto is basically banned in the United States. In the US, you can still buy BTC, ETH, and Dogecoin because they are not considered securities, but any other Crypto project may be considered a security and cannot be traded in the US. Crypto declines and disappears, and everyone turns to artificial intelligence. SEC kills Crypto in a slow revengeful way by stifling it.


2. In addition, Crypto has thrived in other parts of the world, and the United States has just missed out. Crypto has been proven to have great potential for world-changing and value, but the United States has fallen behind. Alternatively, it has been proven to be a unique financial product that can be traded in Europe but not in the United States, much like binary options or contracts for difference. In any case, it continues to exist abroad, but cannot develop in the United States.


3. SEC wins, and then some existing Crypto companies, new Crypto participants, and traditional financial service companies find Crypto trading channels that comply with US securities regulations. Everyone will work hard and say "Well, Solana will start submitting annual reports and audited financial statements", and people will establish Crypto exchanges registered with the SEC and separate from clearinghouses and brokerage firms. This seems very difficult because the SEC is clearly not interested in accommodating any Crypto projects. I won't sit here and tell you "this is how Crypto companies register their tokens as securities". There is no doubt that Coinbase has been working hard to find a solution - they have been pressuring the SEC to get the regulations they need, but so far, luck has not been on their side. But I think this is always possible.


4. SEC fails, the court will say "what, no, these things are not securities", and Crypto will continue to trade in the United States without too much securities regulation.


5. Congress (or the future SEC) intervenes to change the rules, saying "Well, of course, under current law, all of these things are technically illegal, but stifling innovation like this is too crazy, so we will create new regulations to allow regulated crypto trading in the United States."


I don't know which outcome I will bet on. The last outcome is what the crypto industry hopes to see, and Congress does have the intention to establish crypto regulations.


But what I want to say is that SEC is clearly betting on the first outcome. That's why it's now bringing these cases, after the collapse of FTX and many other large crypto companies and the subsequent drop in crypto prices, venture capitalists have turned to artificial intelligence. For the SEC, these cases against Binance and Coinbase are high-risk cases:


Coinbase and Bitcoin are large, well-funded companies with strong legal and lobbying teams. They have the resources and motivation to fight the SEC to the end, and they do have reasonable legal arguments. The SEC may lose, but it is strategically maximizing its chances of winning. I wrote in February:


When Crypto becomes popular and shows an upward trend, if you are a regulatory agency that says 'no, we must stop all of this', you will definitely be disappointed. Investors want to put their money into something that is rising, and they are angry at your obstruction. Politicians like things that are rising and hold hearings to discuss how you can stifle innovation. Crypto founders are wealthy and popular, and they criticize you on Twitter, getting many likes and retweets. Your own regulatory staff are focused on their next private sector job, hoping to become leaders in Crypto innovation, not just banning everything.


When crypto prices fall and many projects fall into fraud and bankruptcy, you can say "I told you so." People are more eager for regulation or shutdown. The founder of a bankrupt crypto company that has been sued can say "You have stifled innovation," but no one cares.


This is the bet that SEC is currently making, and now we will see if it is correct.


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