This episode is sponsored by NYDIG.
Today on “The Breakdown,” NLW briefly covers yesterday’s bitcoin price crash and why it was driven by market structure more than news. The main topic focuses on revelations from Coinbase that after months of engagement around its upcoming Lend product, the SEC is now threatening to sue. NLW examines the controversy from five dimensions:
- The argument for and against lending as a security
- The SEC’s pattern of regulation by litigation
- How the SEC is rewarding bad actors by punishing compliance
- The concerning surveillance implications of one of the SEC’s requests
- Why these strong-arm tactics are doomed
Should Coinbase take the battle to court?
“The Breakdown” is written, produced by and features NLW, with editing by Rob Mitchell and additional production support by Eleanor Pahl. Adam B. Levine is our executive producer and our theme music is “Countdown” by Neon Beach. The music you heard today behind our sponsor is “Only in Time” by Abloom. Image credit: Alex Wong/Getty Images News, modified by CoinDesk.
What’s going on, guys, it is Wednesday, September 8. And first of all, thank you to everyone who shared nice birthday wishes yesterday. I really appreciate it. I woke up this morning to near universal consensus on what we needed to cover on today’s show. That, of course, is Coinbase going on the offensive after what they call the SEC’s “really sketchy behavior.” Now, there are a ton of other things that happened yesterday that I’d love to give some coverage to. There is the first day of reactions to El Salvador’s Bitcoin law. How did everything go? Did the infrastructure hold? Did people actually use Bitcoin? If you were on Twitter at all yesterday, you’ll also know that President Bukele reinforced his Bitcoiner “one of us” bona fides when he made fun of the IMF and bought the dip in a single tweet. There was also new crypto legislation introduced in Panama that has a lot worthy of consideration.
And, of course, there were yesterday’s wild markets and flash crash. Udi Wertheimer tweeted a little while ago: “No one will be talking about NFTs when we get our daily $10,000 bitcoin candle very soon.” He was right, although the wick was down and not up. I really do think it deserves more discussion that I’m going to give it here and maybe I’ll dig in deeper on a future show. For now, I want to point to one tweet and one thread to help explain. The tweet comes from Alex Krüger. And he writes: “Journalists are desperate to build a narrative for today’s correction. Stop. Sometimes there is no narrative.” I’ve discussed this quite a bit this year. News people look for news explanations for market moves when market structure often has much more to do with it. Given that, as has become the habit, we’ll just let Alameda co-CEO Sam Trabucco explain it.
He writes: “Today was the first time I’ve been woken up because the market was moving in a while -- it’s the biggest move we’ve seen in months! What happened? A thread about history. They say that those who do not learn from history are doomed to repeat it. Who remembers what earlier this year? When crypto rallied a ton to $65k pretty quickly, futures were at high premia, and open interest of all the important contracts was up? Here it is:” And then he shares a picture of a crash. “And what about May? When crypto had recovered some to $50k or so -- again with high premia and OI -- but then it dipped a bit? Right.” He shares another graph with a drop.
“The set-up is the same every time: - futures are at really high premia -> this suggests aggressive buying - OIs going up -> this suggests the buyers are opening positions - number go up -> this means there’s *net* buying And “number go up” important sets up the opportunity for people to buy at “high” prices -- this matters because of the next stage of the set-up: - number go down. Each time it’s happened, it’s been for a different reason -- maybe bad news from China, maybe bad news from Elon, maybe nothing that’s easy to point to. But in each case, it happened -- and it was slow at first. And as prices crashed, some of those aggressive net buyers who bought near the top get liquidated, and then more of them get liquidated, and then -- well, you know, BTC crashed an extra 10% over the course of a few minutes. Like clockwork. The past week looked a lot like this! - high premia, all across the board - OIs of big perps (especially Binance) growing quickly - all while the market rallies. And last night, number started going down. Not sure why -- probably something like “someone sold” or “BTC = $50k?” and then during Eastern morning the stock market was also falling, and crypto sometimes follows those things. Regardless, the market started to slowly fall... until it wasn’t slow anymore. Liquidations of course took over on the quick descent, like they always do -- as we said, just like clockwork. Billions got liquidated earlier! And honestly? I was caught a *bit* off-guard this time. I didn’t think the rally had lasted long enough, and in particular I didn’t think the initial draw-down was significant enough (yet) vs. the peak to cause a lot of liquidations.”
The biggest takeaway for me was just how familiar today’s move still feels. It’s been a few months, but it was really just the same thing with a slightly different spin. History repeats again, and I’ve got a feeling we’ve not seen the last of it. The point here is just how much these big moves are about market structure. They’re about the positions that people have put on much more than the catalysts that make the initial move up or down.
But, with that, let’s move back to our main topic: Coinbase and the SEC, WTF is going on and what does it mean? First of all, let’s take a moment to give a little bit of background context from a different company. In July, New Jersey’s Bureau of Security sent BlockFi a cease and desist letter around their flagship product, their interest bearing accounts, or BIAs as BlockFi calls them. They claimed that the BIAs were violating securities laws by not being registered with the securities division of that state. The head of New Jersey’s Bureau of Security said: “Our rules are simple. If you sell securities in New Jersey, you need to comply with New Jersey security laws. No one gets a free pass simply because they’re operating in the fast-evolving cryptocurrency market.”
Since then, states including Alabama, Kentucky, and Texas have all brought similar cases against BlockFi. In Texas, the director of the enforcement division at the Texas State Securities Board said: “What we as regulators saw was a company promising to pay investors high rates of return in a largely unregulated environment. We were not convinced that a federal regulator in the near future was going to do anything to help protect the clients of these firms. We felt we needed to act.” Bloomberg offers some more insight around what these regulators might be concerned with: “Some regulators say they’re concerned that investors aren’t always told what their deposits are used for, in what circumstances they could lose some or all of their principal, and how the crypto firms are making money themselves. The whole point is we need to know what they’re doing with everybody’s bitcoin, and where the money is going and to have some regulation that accounts for it.” So, Joseph Borg, who heads the Alabama Securities regulator, and says the state is looking into several other firms with similar activities. “You know, what happens if one of these things fails? People are going to be calling my office and asking ‘why didn’t you do something?’”
At this point, I’ll take a quick pause and offer perhaps a slightly unexpected opinion. These states don’t strike me as ideologues acting in bad faith to strike at the heart of crypto. They look instead like local regulators who see returns that are being promised at 100x the national average rate for savings accounts of 0.06%. What’s more, so far, they seem like they’re engaging with BlockFi, New Jersey has delayed its cease and desist three times as they’re in discussions. That doesn’t seem to me like an office that’s just out to get someone. Now, all that said, I’m not privy to what’s going on behind the scenes, so I could be way off and these could be Elizabeth Warren-esque attack dogs, but that’s the optimistic take.
The SEC, on the other hand, when it comes to these lending products, does not seem to be acting in super good faith. At least if we’re to take Coinbase and Brian Armstrong’s recent accounts at face value. A couple of things we have to read to get this story, Coinbase published a tweet thread and a blog post. So, let’s read Brian Armstrong, Coinbase CEO’s tweet thread first. “Some really sketchy behavior coming out of the SEC recently. Story time… Millions of crypto holders have been earning yield on their assets over the last few years. It makes sense, if you want to lend out your funds, you can earn a return. Everyone seems happy. A bunch of great companies in crypto have been offering versions of this for years. Coinbase came out recently and said we would be launching our own version. We were planning to go live in a few weeks, so we reached out to the SEC to give them a friendly heads up and briefing. They responded by telling us this lend feature is a security. Ok - seems strange, how can lending be a security? So we ask the SEC to help us understand and share their view. We always make an effort to work proactively with regulators, and keep an open mind. They refuse to tell us why they think it’s a security, and instead subpoena a bunch of records from us (we comply), demand testimony from our employees (we comply), and then tell us they will be suing us if we proceed to launch, with zero explanation as to why.”
“Look….we’re committed to following the law. Sometimes the law is unclear. So if the SEC wants to publish guidance, we are also happy to follow that (it’s nice if you actually enforce it evenly across the industry equally btw). But in this case they are refusing to offer any opinion in writing to the industry on what should be allowed and why, and instead are engaging in intimidation tactics behind closed doors. Whatever their theory is here, it feels like a reach/land grab vs other regulators. Meanwhile, plenty of other crypto companies continue to offer a lend feature, but Coinbase is somehow not allowed to. Gensler in his confirmation hearing: “It’s important for the SEC to provide guidance and clarity,” Gensler said. “Sometimes that’s a clarity that will be a thumbs up, but even if it’s thumbs down, it’s important to provide that.” March 2, 2021. If you don’t want this activity, then simply publish your position, in writing, and enforce it evenly across the industry. Ostensibly the SEC’s goal is to protect investors and create fair markets. So who are they protecting here and where is the harm? People seem pretty happy to be earning yield on these various products, across lots of other crypto companies. Shutting these down would arguably be harming consumers more than protecting them, and by preventing Coinbase from launching the same thing that other companies already have live, they’re creating an unfair market.”
“In May of this year I traveled to DC to meet with every regulator and branch of government I could. The SEC was the only regulator that refused to meet with me, saying “we’re not meeting with any crypto companies”. This was right after we became the first crypto company to go public in the U.S. Gensler had been confirmed just a month prior, so I brushed it off as the SEC still getting its feet under it. Now I’m not so sure. Now, I’m not so sure. We’ve always tried to be good actors in the space - leaning in to sensible regulation even when it is difficult or expensive. We try to think about what products we would want for ourselves, and what risks we would want our families to be aware of, before launching products. We will keep following this approach. Yet here, we’re being threatened with legal action before a single bit of actual guidance has been given to the industry on these products. If we end up in court we may finally get the regulatory clarity the SEC refuses to provide. But regulation by litigation should be the last resort for the SEC, not the first. Our door remains open. Hopefully the SEC steps up to create the clarity this industry deserves, without harming consumers and companies in the process. America could really use us all working together to figure this out right now.”
A hell of a threat and you can understand why it has about 30,000 people who have liked it and shared it at this point. There’s also a Medium post from Paul Grewal, Coinbase’s chief legal officer, but I’m going to intersperse that with sections of this analysis. So, five things stand out to me about this. The first is the actual security designation of lending and whether this sort of lending product is a security. You’ll see most in crypto immediately saying, “of course lending isn’t a security” and that would be my first instinct as well. However, I’m not a lawyer so I have no real ground to stand on. I’m going to read Coinbase’s argument for why it’s not but here’s the counterpoints first, from Anderson Kill partner Preston Byrne, he writes, “yield products are securities. They differ no material respect from an unsecured bond, they just don’t use the name. Other countries like England have debt crowdfunding rules, U.S. companies should check that out. And we should emulate those rules here. If you happen to run a U.S. company and have a nearly fully-baked yield offering and you’re not immediately calling up English council to talk about U.K. debt crowdfunding rules, now would be the time.”
Preston also points to a reframing from a Brit, Simon Taylor, who writes: “The argument the other ways that it’s not savings or lending, it’s bond buying and selling, which is a security.” Coinbase, of course, has a different view. From their blog: “Coinbase’s lend program doesn’t qualify as a security or to use more specific legal terms, it’s not an investment contract or a note, customers won’t be investing in the program, but rather lending the USDC they hold on Coinbase’s platform in connection with their existing relationship. And although lend customers will earn interest from their participation in the program, we have an obligation to pay this interest regardless of Coinbase’s broader business activities. What’s more, participating customers’ principle is secure and we’re obligated to repay their USDC on request. We share this view and the details of lend with the SEC. After our initial meeting, we answered all the SEC’s questions in writing and then again in person, but we didn’t get much of a response. The SEC told us they considered lend to involve a security but wouldn’t say why or how they’d reached that conclusion. Rather than get discouraged, we chose to continue taking things slowly.”
This brings us to the next frame for analysis. The next way to look at all of this, which isn’t about differing opinions about what is or isn’t a security, but an unwillingness on the part of the SEC, the body with the authority to make that argument to actually make the argument. Going back to Simon Taylor’s reframing of this as bond buying, the problem is that the SEC isn’t saying to Coinbase “we actually see this as bond buying” or any other reframing for that matter. They’re just saying, “nope, it’s a security because we say so.” Mark Cuban responded to Brian Armstrong’s thread saying, “Brian, this is regulation via litigation. They aren’t capable of working through this themselves and are afraid of making mistakes and doing so they leave it to the lawyers, just the people you don’t want impacting the new technologies. You have to go on the offensive.” Investor Adam Cochran agrees, saying: “Part of me wonders if the SEC’s unwillingness to provide Coinbase guidance on why they’re blocking their lead program is because they can’t. Like, maybe they realized that things they think are a security may not all be accounted for in the act from 1933. They don’t like it. They have concerns it feels to them as if it should be a security. But under the Howey Test and Exchange Act, they know it wouldn’t really stand up in a court and they don’t want to set a precedent that would make this industry harder on them.” Chainlink God put it more poetically: “So the SEC is pushing people through a minefield without telling anyone where their mines are and yet at the same time telling them to not step on any mines or you’ll die. This makes zero logical sense.”
A third analysis or way to look at this is rewarding bad actors by penalizing compliance, the offshore dimension in that blog post again, Coinbase gives this as background: “Coinbase has been proactively engaging with the SEC about lend for nearly six months, we’ve been eager to hear their perspective as we explore innovative ways for our customers to gain more financial empowerment on Coinbase. Specifically for lend, we’re seeking to allow eligible customers to earn interest on select assets on Coinbase starting with 4% API on USD coin USDC. We could have simply launched the product but we chose not to. This is far from the norm in our industry, other crypto companies have had lending products on the market for years. And new lending products continue to launch as recently as last month. Coinbase believes in the value of open and substantive dialogue with our regulators. So, we took lend to the SEC first.”
Joe Weisenthal from Bloomberg picks up one of the central problems here and tweets: “This seems like the general problem with the state of crypto regulation right now, any company that tries to make a point of being a good player automatically falls behind. This isn’t about sympathy with Coinbase per se, but new lending products built by anonymous teams are being spun up every day. They’re a little different than something like lend but it still creates essentially two different tracks with one being at a major disadvantage.” Jesse from Kraken adds, “Ask Coinbase why they shut down margin yet it’s still widely offered by competitors. U.S. regulators are beating down good actors because it’s convenient. Meanwhile, actual scams are unabated for years, who’s behind the effort to drive domestic businesses and consumers offshore.”
Now, regulators could point to this and say that’s exactly the problem. It’s regulatory whack a mole. So we have to be aggressive with those we can regulate. The issue is one of strategy, to some extent regulating crypto or it should be said any future tech industry that sets up in an anonymized decentralized way, it’s like trying to squeeze a fistful of ocean, it’s just going to flow away. But the response to that isn’t just to try to squeeze harder. It’s to create a scenario in which the actors that do want to comply, can create network effects in the market around their compliance. Put differently, there are a ton of people who want to work with regulated exchanges, and a ton of people who net net would prefer that versus not but aren’t willing to handicap themselves entirely. The net effect then of this approach to regulation is that actors that demand compliance simply don’t engage at all. And the ones that are more neutral use the tools at their disposal to flow away to less regulated venues just like that water. In other words, it’s a bad strategy, unless your strategy is to kill the thing through legal pressure, which is something I think we at least have to consider as a possibility here, given how aggressively the SEC has been digging in.
A fourth layer of analysis around this has to do with the truly messed up levels of surveillance. This is where I perhaps have the biggest WTF moment of this entire escapade. Let’s read what happened when Coinbase tried to engage. “The SEC told us they consider lend to involve a security but wouldn’t say why or how they’d reach that conclusion. Rather than just get discouraged, we chose to continue taking things slowly. In June, we announced our lend program publicly and opened up a waitlist but did not set a public launch date. But once again, we got no explanation from the SEC. Instead, they opened a formal investigation, they asked for documents and written responses that we willingly provided them. They also asked us to provide a corporate witness to give sworn testimony about the program. As a result, one of our employees spent a full day in August providing complete and transparent testimony about lend. They also asked for the name and contact information of every single person on our lend waitlist. We have not agreed to provide that because we take a very cautious approach to requests for customers’ personal information. We also don’t believe it is relevant to any particular questions the SEC might have about lend involving a security, especially when the SEC won’t share any of those questions with us.”
Just for those keeping track at home, maybe you were distracted, maybe you were having a conversation, maybe you just had to take a sharp right turn, let’s read that line again: “They also asked for the name and contact information of every single person on our land waitlist.” Jerry Brito from Coin Center sums this up perfectly for me when he writes: “This creeps me out, but I’ll go farther. What sort of insane un-American witch hunt bulls**t is this, where you can be made known and targeted for entering your email to sign up for a new financial product? That’s absolutely insane.” Qiao Wang wrote: “Apparently, in order to determine whether or not Coinbase’s lend is a security, the SEC needs the name and contact information of every single customer.”
And this, of course, gets to our last piece of analysis, which is just the tactics as a whole. Coinbase’s blog starts with: “Last Wednesday after months of effort by Coinbase to engage productively, the SEC gave us what’s called a Wells notice about our planned Coinbase lend program.” A Wells notice is the official way a regulator tells a company that it intends to sue the company in court. This is the wild thing to me, that the SEC went straight to a lawsuit for an unreleased product. That’s not engagement with an industry, that is straight-up strong arm tactics.
Going back to their requests for all customer information, Ryan Selkis from Messari has a different theory about it that connects the dots back to the Treasury Department: “SEC is abusing its authority to assist Treasury and fully surveilling crypto investors. Regulation is important but mafia intimidation tactics further undermine confidence in regulators.” So, let’s talk about where we go from here and what’s to be done. Here’s how Coinbase’s lawyer concludes: “Despite Coinbase keeping lend off the market and providing detailed information, the SEC still won’t explain why they see a problem. Rather, they have now told us that if we launch lend, they intend to sue. Yet again, we asked if the SEC would share their reasoning with us and yet again, they refused. They’ve only told us they are assessing our lend product through the prism of decades-old Supreme Court cases called Howey and Reves, the SEC won’t share the assessment itself, only the fact that they have done it. These two court cases are from 1946 and 1990. Formal guidance from the SEC about how they intend to apply Howey and Reves tested products like lend would be a big help to regulating our industry in a responsible way. Instead, last week’s wels notice tells us that the SEC would rather skip those basic regulatory steps and go right to litigation, they’ve offered us the chance to submit a written defense of lend, but that would be futile when we don’t know the reasons behind the SEC’s concerns. The SEC has repeatedly asked our industry to talk to us, come in. We did that here. But today, all we know is that we can either keep lend off the market indefinitely without knowing why we can be sued. A healthy regulatory relationship should never leave the industry in that kind of bind without explanation. Dialog is at the heart of good regulation. The net result of all of this is that we will not be launching lend until at least October. Coinbase continues to welcome additional regulatory clarity, mystery and ambiguity only serve to unnecessarily stifle new products that customers want and that Coinbase and others can deliver safely. We will also keep our customers informed at every step as things progress.”
Jerry Brito, again from Coin Center, sums up where I tend to land pretty well. He writes, “If true, this is pretty underhanded. I know it’s easy for me to say, but Coinbase should go ahead and launch its product. Let the SEC sue and go to court. Let the SEC make its case and let a judge decide what the law is. Coinbase should go to court because the alternative is that the SEC will enforce against a small provider, settle with them out of court and hold up the scalp as guidance. Enough with guidance Howey and Reves or judge-made law. We need court decisions to get clarity here.” Dan from CMS Holdings agrees, saying: “Somebody’s finally taking the fight to the SEC over lending, of all things. But I’ll take it, we need this to move forward.” I particularly resonate with Jerry’s second point that if the fight doesn’t come from a well-capitalized player with the resources to actually mount a fight, it will become a precedent with some tiny little player that’s forced to settle.
Look, I don’t know how many times exchanges have to say “it’s not that we don’t want regulation. It’s that we want guidance and then fairness and consistent application” for that message to get through. But when regulators keep refusing to provide that actual guidance, not just threats to sue and Wells notices, it makes one suspicious that regulation integration into the system are not, in fact, the goal that regulators have in mind, that the goal is, in fact, something much more aggressive, hostile and existential. Until tomorrow, guys, be safe and take care of each other. Peace!