Coinbase, Binance, and the SEC - Newsletter #214
You likely heard that the SEC sued Coinbase this week. And maybe you’ve heard that the SEC also sued Binance.
The United States Securities and Exchange Commission effectively tore off crypto’s bandage this week, handing down enforcement against two of the largest digital assets platforms, Binance and Coinbase.
Today, we want to take a step back from our regularly scheduled programming, and instead talk about what’s happening with the SEC and ponder what may happen next.
Coinbase, Binance, and the SEC
By Elliot Koss & Harrison Smith
Technical Level: 🛠️
From the top.
On Monday, June 5th, the U.S. Securities and Exchange Commission (SEC) sued crypto exchange Binance, the operating company for Binance.US and Binance founder and CEO Changpeng "CZ" Zhao for alleged violations of multiple federal securities laws.
In a press release, SEC Chair Gary Gensler said, "Through thirteen charges, we allege that Zhao and Binance entities engaged in an extensive web of deception, conflicts of interest, lack of disclosure, and calculated evasion of the law."
The SEC alleged that Binance allowed for commingling of customer funds.
The SEC also alleged that a number of other tokens with staking, including the native coins for the Solana (SOL), Cardano (ADA), Polygon (MATIC), Coti (COTI) and Algorand blockchains (ALGO), Filecoin network (FIL), Cosmos hub (ATOM), Sandbox platform (SAND), Axie infinity (AXS) and Decentraland (MANA) are securities.
Binance, Binance.US and CZ allegedly offered unregistered securities to the general public in the form of the BNB token and Binance-linked BUSD stablecoin.
Binance's internal chat logs were revealed, including a 2018 exchange where former Binance compliance lead Sam Lin was quoted saying "we are operating as a fking unlicensed securities exchange in the USA.”
Claimed that CZ was "secretly" controlling Binance.US and that a CZ-owned and operated entity was inflating Binance.US's trading volume.
CZ has also allegedly evaded restrictions, and has further plans to do so. The SEC cited the "Tai Chi" documents for this claim, which Forbes originally reported on in 2020, which appeared to be a plan for Binance to officially exit the U.S. while still maintaining a presence through an affiliate.
The SEC asked a court to grant a temporary restraining order to freeze assets tied to Binance.US.
That’s a lot of allegations, and it may be a little confusing. Let’s talk about the 2 biggest ones, in our opinion.
First is the commingling of funds. This is the most serious allegation, and if true, it’s a massive problem for Binance. Commingling funds means that there is no separation between one customer’s money and another. It’s one of the foundational principles of any company that is entrusted with customer’s money. You MUST have strong record-keeping and keep money separate. For instance, if I have 100 ETH, then my 100 ETH should be accessible to me. If the 100 ETH is commingled, then my 100 ETH may not actually be available when I want to cash out.
The commingling allegation is one that could indicate Binance is committing fraud in some manner and acting similar to FTX with dubious loans. Combined with a few other allegations about inflating trade volume, there is legit reason to think Binance is acting similarly to FTX.
The second key allegation is related to the specific tokens and staking that the SEC claims are securities. There’s a test established by the Supreme Court to determine if something is a security, and it’s called the Howey Test. To be fair, securities lawyers have generally noted that while crypto operates in a gray area, staking does not. Staking, the mechanism where you lock up your crypto in exchange for an interest rate, very likely makes that token a security.
Depending on the evidence for the commingling of funds (and the SEC has a strong track record of winning their lawsuits), Binance could be shut down for and fined out of existence.
For the allegations related to tokens that are securities, it’s not clear what the remedy could be (registering doesn’t seem to be an option for any crypto exchange despite what the SEC says - see below). Stopping the sale of these securities is likely one outcome.
What strikes me as odd are two things.
1) Ethereum wasn’t listed as a staking token, yet it’s arguably the most well-known staking token. The entire Proof of Stake concept outlines exactly how staking works. The SEC has been careful about how it defines Ethereum, so this was likely intentional to give them space to change their mind. But it’s frustratingly convenient for the SEC to make a serious allegation but not appear to apply the law consistently.
2) The exchanges were sued and not the issuer of the token. We have not seen individual lawsuits against the individual tokens, and that is arguably the source of the confusion for the exchanges. While Binance hasn’t necessarily been the most forthright player in the space, others have made good faith efforts to gain clarity, but the SEC has explicitly ignored them and refused to issue guidance.
In response to the SEC's lawsuit, Binance said it would defend its platform vigorously. As a user myself with <$500 in my account, I had serious challenges trying to withdraw my funds. It eventually did process, but I cannot honestly say that I believe Binance is operating in good faith. Many other people weren’t able to withdraw with bogus fraud and KYC claims, and I suspect the only reason I did is because their software is buggy and they accidentally let me withdraw after I attempted to do so like 20 times at different times over the course of 3 days. Just this morning, customer support told me that because I’m currently in Texas (an unsupported state) that they wouldn’t let me withdraw until my IP address was in a supported state. Ironically, the funds had already cleared into my bank account, so clearly they didn’t intend to let me withdraw. I, personally, do not trust Binance.
Whether or not these claims prove to be true, there are pivotal implications that immediately stem from these charges.
Up until this point, the SEC has been very careful on how they labeled Ethereum and other blockchain tokens. Just last month, Gensler declined to say if Ether is a security while testifying before the House Financial Services Committee. Now that other tokens with similar characteristics have been labeled, the question is when (not if) the SEC goes after Ethereum directly.
The outright declaration that Solana, Cardano, Polygon, and a handful of other coins are securities is shocking, and undoubtedly spelled bad news for Coinbase. Even the Coinbase stock reflected the trepidation in the waters. And I began preparing plans to move all my funds off Coinbase, which is where I previously felt they were safest.
However, the following day (June 6th), the SEC formally declared charges against Coinbase for violating federal securities law.
The SEC pointed to Coinbase's Prime, Wallet and staking products, as well as the actual tokens it lists, as areas where it violated federal securities laws. Again, the key issue here was staking tokens that the SEC alleges are securities, thus making Coinbase an unregistered securities exchange.
The SEC alleged Coinbase violated the Exchange Act through its failure to register across four different counts, as well as violated the Securities Act, and is seeking to "permanently enjoin" the company - meaning the SEC wants to shut down Coinbase.
Unlike the Binance lawsuit, the SEC did not allege that Coinbase commingled funds, or had any sort of financial mispractice. This is notable since the commingling of funds would put Coinbase squarely into the bad actor space. Once again, Coinbase’s efforts to operate a legit business has shielded it from the most devastating charge.
Let’s not forget that Coinbase has tried many times to get regulatory clarity from the SEC.
The SEC just simply hasn’t granted that luxury.
Shortly after the news broke:
Coinbase traders withdrew over a half-billion dollars from the platform.
COIN shares, along with a lot of cryptos quickly tumbled, before being bought up by big buyers.
Coinbase founder and CEO Brian Armstrong tweeted that the complaint "is exclusively focused on what is or is not a security," while also reiterating the industry wide complaint that the "SEC has taken a regulation by enforcement approach." Coinbase also released a video response.
Robinhood came to Coinbase’s defense: “When Chair Gensler at the SEC in 2021 said, ‘Come in and register,’ we did,” Robinhood Markets' chief compliance lawyer Dan Gallagher, a former SEC commissioner, said. “We went through a 16-month process with the SEC staff trying to register a special purpose broker dealer. And then we were pretty summarily told in March that that process was over and we would not see any fruits of that effort.”
Coinbase met with the SEC 30 times in 2022 alone. The idea that they have been pervasive of regulation in any way is, at best, laughable.
As a personal note, I wound up liquidating my crypto from Coinbase where I had the bulk of my crypto (yes, a taxable event though I’m about even or slightly under in my account so it’s not going to be a nightmare) and transferred the cash to my bank account. The risk that regulators shut down an exchange is simply not something I’m willing to take. I was previously planning to simply move everything to a Ledger this weekend, but the lawsuit gave me significant concerns that the SEC is hellbent on shutting down Coinbase.
In general, I had intended to transfer the large majority of my crypto to a Ledger for cold storage anyway. That is still my intent. I just won’t be leaving any money in a crypto exchange going forward for 2 reasons.
I believe the SEC is going to try to kill crypto exchanges in the short term. This won’t be successful, because as the SEC takes these actions, the courts will require that the SEC establish a path to registering (which they haven’t provided to date), so eventually companies will register in a manner that the SEC won’t have teeth to shut them down.
Crypto isn’t going anywhere. The technology, as we’ve illustrated and discussed for the last 6 months and even before when we were writing about NFT research, is solid and will provide a foundation for the next generation of the internet-based economy.
The SEC’s Actions Show A New Aggression
Gensler was not always so anti-crypto. According to a new filing from Binance’s lawyers, he even offered to be an advisor to Binance in 2019.
Before he started in the SEC hot seat, Gary Gensler was fresh from teaching courses on digital currency at the Massachusetts Institute of Technology and consulting with that school’s Digital Currency Initiative. You can find videos of his lectures on YouTube if you look for it.
Gensler obviously formed a relationship with FTX’s infamous CEO, Sam Bankman-Fried, throughout the past few years. The implosion of that tarnished the reputation of the industry, and put a target on crypto as a whole.
So now, what is the SEC chairman’s position on crypto now, you may ask?
Gensler went on to contend that “promoters of crypto asset securities contend that their token has a function beyond simply being an investment vehicle,” but “some additional utility does not remove a crypto asset security from the definition of an investment contract.”
In many ways, this quote from Coindesk nails it.
While there might be some legitimacy to the Binance claims (commingling of funds is obviously a serious issue), the move towards Coinbase seems to lack basis in anything other than a desire to impede crypto.
As crypto grows increasingly prevalent, it becomes more and more of a threat to everything in the traditional financial world. The SEC understands that, and this is their plan of action.
So where do we go from here?
Coinbase is planning to continue their staking services, double down, and fight the war against the SEC. Trying to win the staking battle is likely going to be difficult, if not impossible. After all, staking does fail the Howey Test. However, the characteristics of crypto mean that staking isn’t just a way to make money. There’s an actual purpose for staking that helps provide stability to the token, and in the case of Ethereum, it is the mechanism that reduces energy consumption by 99%. This is a unique quality that the Howey Test is inadequate to evaluate.
However, Coinbase is trying to stand up for the entire crypto industry. They have consistently led with their heads high. If anyone can succeed here, it’s them.
Remember, Coinbase are the good guys - probably the most compliant company in the entire crypto space. They’re publicly traded, and they have already gone through SEC scrutiny multiple times, including the approval process to become a publicly traded company.
And it’s important to note that crypto isn’t all “hucksters, fraudsters, scam artists” like Gensler may want you to believe. Sadly, trying to convince certain regulators of that may prove to be a fool’s errand. Here’s hoping that the courts appreciate the nuance.
If you want to read the full complaint, here is a link to the SEC filing.
Next week, we’ll return to our general cadence, but this was a fairly big week and we wanted to take a moment to help clarify what’s happening.
I also want to take a moment to disclose that I own, and have owned, Coinbase stock. As always, this is never financial advice.