The SEC to Coinbase: Crypto Banking Is Still Banking

Coinbase is not the first would-be crypto lender to run into trouble for trying to act like a bank, says our columnist.

CoinDesk Insights
Sep 14, 2021 at 1:00 p.m. UTC
Updated Sep 14, 2021 at 9:18 p.m. UTC

The U.S. Securities and Exchange Commission (SEC) has issued a Wells notice against Coinbase. This is an instruction to the company that the SEC intends to commence legal action against it. It’s like a final warning – get your house in order or we will throw the book at you.

The problem is Coinbase’s forthcoming crypto lending program, known as Lend. The SEC says it is an unregistered securities offering. Coinbase’s executives argue that securities laws devised nearly a century ago shouldn’t apply to crypto products that no one could have even imagined back then. But the principles underlying the 1933 and 1934 Securities Acts were designed to catch products that hadn’t yet been invented. Is Coinbase’s product really so innovative that these laws should no longer apply?

Frances Coppola, a CoinDesk columnist, is a freelance writer and speaker on banking, finance and economics. Her book, “The Case for People’s Quantitative Easing,” explains how modern money creation and quantitative easing work, and advocates “helicopter money” to help economies out of recession.

Lend hasn’t been launched yet, but it’s open for pre-enrolment, and Coinbase has been avidly marketing it to its customers. This is how Coinbase’s pre-enrolment web site describes Lend:

We lend your USD Coin to verified borrowers, allowing you to earn 4% APY1 - over 8x the national average for high-yield savings accounts.

It then goes on to say that your principal is safe. But in a footnote it warns depositors that Coinbase is not a bank, the deposits are not high-yield savings accounts and there is no deposit insurance. So the principal is not “safe” as it is in an insured savings account. It is fully at risk. To be sure, the high interest rate compensates you for the risk of loss – but the marketing is more than slightly misleading.

Lend pays you interest for lending out your funds to “verified borrowers.” But there’s no direct connection between the loans to these borrowers and the interest rate you receive. You won’t even know who these borrowers are. So this isn’t peer-to-peer lending.

More likely, your funds will be placed into a pool of deposits, from which Coinbase will lend to its chosen borrowers. Coinbase will pay all depositors the same fixed interest rate. It will pocket any difference between the interest it earns on lending and the interest it pays to depositors.

Borrowing at a fixed rate, lending at a higher (possibly variable) rate and pocketing the difference is the business model of a bank. But there is as yet no specific regulation for crypto banks. As previously noted, the Securities Acts are intended as the catch-all for bank-like services provided by non-banks. Coinbase has fallen foul of the SEC because it wants to do bank-style deposit-taking and lending using cryptocurrency.

It’s not the first crypto lender to run into serious trouble for trying to act like a bank. BlockFi was recently issued with cease and desist orders by several U.S. states for operating an unregistered securities offering. This is how the State of New Jersey’s cease and desist order describes BlockFi’s scheme:

Since March 4, 2019, BFI, through its affiliates BlockFi Lending, LLC (“BlockFi”) and BlockFi Trading, LLC (“Trading”) has been, at least in part, funding its lending operations and proprietary trading through the sale of unregistered securities in the form of cryptocurrency interest-earning accounts. BlockFi refers to these unregistered securities as its “Crypto Interest Account” or the “BlockFi Interest Account” (the “BIAs”).

BlockFi allows investors to purchase the BIAs by depositing certain eligible cryptocurrencies into accounts at BlockFi. BlockFi then pools these cryptocurrencies together to fund its lending operations and proprietary trading. In exchange for investing in the BIAs, investors are promised an attractive interest rate that is paid monthly in cryptocurrency.

Under the 1933 Securities Act, “investment contracts” are deemed securities. Issuers of investment contracts must register with the SEC and comply with disclosure requirements. But “investment contract” is a very broad definition. In the Howey case of 1946, the Supreme Court established criteria for determining whether a product is an investment contract and therefore should be subject to securities regulation. The product must constitute:

  • An investment of money
  • In a common enterprise
  • With the expectation of profit
  • To be derived from the efforts of others

The product must meet all four of these criteria to be deemed a security.

New Jersey’s cease and desist order says that BlockFi’s crypto lending scheme meets all four criteria: Depositors are investing money in the form of cryptocurrency; their deposits are pooled, so are in a “common enterprise”; they expect to receive interest on their deposits and the interest is earned by BlockFi lending their funds out to others.

The description of BlockFi’s product in New Jersey’s cease and desist order is remarkably similar to the way Lend appears to work. So if BlockFi’s BIAs meet the Howey criteria, it is likely Coinbase’s Lend deposits do too. It is now clear that this is the SEC’s view.

It would surely have been sensible for Coinbase to pause its plans to launch what looks like a carbon copy of BlockFi’s product. And Coinbase certainly should have pulled the product when the SEC indicated that it intended to regard it as an unregistered securities offering. But instead, it opted for defiance.

For a publicly listed company with millions of customers to defy securities laws in plain sight is wholly unacceptable. No wonder the SEC issued a Wells notice. And no wonder it refused to explain to Coinbase’s executives why it was throwing the book at it. In the SEC’s eyes, such a company is perfectly capable of understanding and complying with the law.

Coinbase’s executive team nevertheless pleaded innocence. In a trenchant blog post, Paul Grewal, Coinbase’s chief legal officer, reiterated his view that Lend was not an investment contract and lambasted the SEC for failing to explain its reasoning. And on Twitter, Coinbase’s CEO Brian Armstrong asked how lending could be considered a security. This turned out to be a rather foolish question. In response, the investor John Hempton sent Armstrong a screen image of the front page of the 1933 Securities Act. And in a (perhaps unintentional) exhibition of gold standard trolling, the SEC tweeted a 30-second video explaining “what bonds are and how they work.” Bonds are, of course, securitized lending.

But Armstrong and Grewal have a point. What Coinbase is really offering is bank-like deposit-taking and lending, but in USDC instead of U.S. dollars. No-one says U.S. dollar bank deposits are securities, so why should USDC deposits be considered securities?

The answer is, once again, in New Jersey’s cease and desist order against BlockFi:

The BIAs are not protected by Securities Investor Protection Corporation (the “SIPC”) or insured by the Federal Deposit Insurance Corporation (the “FDIC”). The BIAs are subject to additional risk, compared to assets held at SIPC member broker-dealers, or assets held at banks and savings associations, almost all of which carry FDIC insurance. Nor are they registered with the Bureau or any other securities regulatory authority, or exempt from registration.

Coinbase is offering bank-like services but is not subject to bank regulation – indeed, there is at present no “bank regulation” for crypto deposit-taking and lending. USDC deposits in its Lend scheme are not protected by FDIC insurance. And since Coinbase has not registered with the SEC as a securities broker-dealer, its deposits are not protected by SIPC insurance either. It is marketing Lend as a safe alternative to high-yielding savings accounts, when in reality Lend is considerably riskier than savings accounts or regulated securities investments. That’s why the SEC is throwing the book at it.

Grewal argues that the Securities Acts are far too old to apply to crypto products. But this is, I fear, to misunderstand the nature of the Acts. Although the 1933 Act includes a comprehensive (for its time) list of financial products, the products are not the point. The Acts aim to ensure that lending and investment products offered by non-banks are regulated to protect those investing in them. Coinbase’s Lend product solicits deposits with promises of attractive returns and uses those deposits to fund risky lending. That’s exactly the sort of activity that the Securities Acts were intended to catch.

The business model of banking is eternal. Whenever you see something borrowing at interest, lending at higher interest, and pocketing the difference, it is doing banking, whether or not it is covered by existing bank regulations. And although unregulated banks can survive for a while, regulators eventually catch up with them. Crypto lenders are merely the latest type of unregulated bank. The SEC is currently catching up with them. Banking regulators will follow.

Eventually, crypto lenders will be subject to bank-like regulation specifically designed for them, and have their own version of FDIC insurance. Today’s unregulated crypto lenders will become tomorrow’s regulated banks. The tragedy of crypto is that rather than disrupting the existing system, it seems destined to re-create it in a digital form.

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