The SEC has recently charged Coinbase with unlawfully exchanging crypto asset securities. The SEC alleges that Coinbase’s integration of four functions – listing, exchange, clearing, and settlement – violates conflict of interest rules.
How stocks are traded:
First, let’s look at how these 4 functions work with stocks and compare coinbase to the Nasdaq or NY Stock Exchange
- listing
- you as a company can list your stocks on the NY-Stock
- no normal person can do it, you need to register, have disclosures
- Exchange
- a trading platform has access to trade stocks
- these platforms also have their own requirements to operate
- clearing
- on the end of a day, it should be clear who owns the stock (because there are different platforms, but one exchange)
- settlement
- stocks have to be actually exchanged, not only in the books
Coinbase does all of these functions by themselves. SEC claims they violate conflicts of interests by doing that and they should be licensed anyways.
Counterarguments by Coinbase:
Coinbase counters that with crypto, clearing and settlement occur via blockchain, and the absence of a central entity necessitates that companies handle listing and exchange themselves. On Purpose! Otherwise, a blockchain wouldn’t be necessary.
Because of that, Coinbase said they simply cannot operate the same way like the stock market.
Uncertain Business model
The last counterargument might be critical, because Prometheum gives a counter example (not for retail, but still Finra regulated).
But the SEC approved Coinbase IPO in 2021, why do they question the business model now? Coinbase didn’t change much of how they operate, but thats not the focus of the SEC. They want the finances to be right, have disclosures, etc.
Even in the S1 risk disclosure from coinbase says that the business model might not be legit, so maybe they already knew something like this might happen.
What counts as a security?
SEC named a list of coins that are allegedly securities. According to that, Bitcoin and Ethereum are not securities. But how are these classifications decided?
Securities traditionally include stocks and bonds, but the U.S. lacks a clear definition for digital assets. In contrast, Singapore labels them as Digital Payment Tokens (DPT), Europe uses the term MIKA, and several countries refer to them under the Virtual Asset Licence (VASP).
The “Howey test,” almost a century old, is a key determinant. This test originated from a case involving Mr. Howey, who sold oranges as an investment before their harvest. While Howey claimed the oranges were a commodity, the SEC argued they were securities, based on four criteria:
- The investment deal was offered in exchange for cash.
- There was an expectation of profit.
- The investment was tied to the work of others, requiring no additional effort from the investor.
- The investment originated from a business.
All four criteria must be met for an asset to be classified as a security. This puts cryptocurrencies that had an Initial Coin Offering (ICO) at risk of being labeled securities due to the fourth criterion. The third criterion also poses challenges, given that coin holders often rely on the work of developers and miners. Furthermore, virtually all coins carry an expectation of profit.
Especially point 2 depends not only on the blockchain itself, but also how it’s wrapped/offered. For example, Ethereum had also an ICO. So at the beginning, you could easily say they are a security. But at the current state? Unlikely. One key factor is the marketing of ethereum which is rather done for its technical innovation than the ability to earn dividends through staking.