Coinbase likely to face SEC action over cryptocurrency product

US regulator also sent warnings to other firms already letting customers earn interest on their digital tokens or contemplating doing so

Coinbase slid 3.2 per cent to $258.20 in New York trading on Wednesday on news of the SEC’s pending enforcement action. Michael Nagle / Bloomberg via Getty Images

US Securities and Exchange Commission chairman Gary Gensler just put the cryptocurrency industry on notice of how far the regulator will to go to tame a market he’s labelled the wild west of finance.

In threatening to sue Coinbase Global if the exchange lets customers earn interest on their digital tokens, the SEC sent warnings to other firms already offering similar products or contemplating doing so. The move is the clearest sign yet that, under Mr Gensler, the regulator will aggressively use its powers to thwart products it’s uncomfortable with – even before they launch.

Privately, ex-SEC officials said they were shocked by the agency’s posture, which Coinbase disclosed on Tuesday in a blog post. The former officials said the SEC typically waits for firms to start selling investments before announcing possible sanctions, indicating the agency has found a forceful way to shut down cutting-edge crypto offerings it fears are putting consumers at risk. Coinbase slid 3.2 per cent to $258.20 in New York trading on Wednesday on news of the SEC’s pending enforcement action.

“The SEC is being aggressive for the first time in a long time,” said James Cox, a professor at Duke University School of Law. “The SEC has been putting a lot of muscle into cryptocurrency. It’s a big, fast-growing market and a fertile area for abuses.”

SEC officials declined to comment.

When Mr Gensler took the reins at the SEC in April, many crypto enthusiasts cheered. That’s because the former Goldman Sachs Group Inc partner knew finance and had taught a class on digital assets at the Massachusetts Institute of Technology – a background far different from most Washington officials, who had a limited understanding of the booming market.

But that optimism has all but faded after Gensler made clear in speeches and congressional testimony that a crackdown was looming. In July, he referred to the industry as “the wild west of our financial system” that “desperately needs rules of the road”. Gensler also said the SEC will step up efforts to hold firms accountable for offering products that may involve securities, including in decentralised financial or DeFi platforms.

At issue is Coinbase’s Lend product, which promises investors they can earn 4 per cent annually by lending out their USDC virtual tokens. USDC, which is offered by a consortium of firms including Coinbase, is a stablecoin – a fast-growing corner of the crypto market that allows traders to easily convert their digital assets into cash and vice versa.

Stablecoins have been the focus of intense scrutiny from top US officials this year, including Gensler and Treasury Secretary Janet Yellen. Watchdogs have raised numerous concerns, including that the tokens should probably be registered with regulators so that they adhere to strict investor protection rules. Officials are also worried about crypto firms promising high-yields without complying with banking requirements, such as deposit insurance.

Coinbase’s tussle with the SEC became public when Paul Grewal, the company’s chief legal officer, said the SEC determined that Lend involved “a security, but wouldn’t say who or how they’d reached that conclusion”. Mr Grewal added that the agency told Coinbase “that if we launch Lend they intend to sue”, prompting the company to shelve the product until at least October. Coinbase chief executive Brian Armstrong later tweeted that the SEC was engaging in “really sketchy behaviour”.

The crypto exchange won support from at least one long-time SEC adversary: Billionaire entrepreneur Mark Cuban. In a series of tweets, he urged Coinbase to fight back to prevent the agency from winning a legal ruling that allows it to assert more authority over tokens and DeFi. Mr Cuban famously prevailed against the SEC in 2013 after it accused him of insider trading.

There are signs the SEC was already scrutinizing Coinbase’s plans. Last month, the company disclosed in a regulatory filing that it had “received investigative subpoenas from the SEC and similar subpoenas and demand letters from various state regulators for documents and information about certain of our customer programs, operations, and intended future products, including our stablecoin and yield-generating products”.

Despite Coinbase’s bewilderment, the SEC has long argued that a range of tokens fall under its jurisdiction. Over the past four years, the SEC has consistently asserted that many digital assets are investment contracts or securities based on a legal theory knows as the Howey Test laid out in a 1940s Supreme Court case. The regulator’s stance is that almost anything that gives investors the expectation of profiting from the work of others can be labeled an investment contract.

The industry has countered that the SEC’s view is too vague and unsuitable for virtual coins. And the SEC’s GOP commissioners, Hester Peirce and Elad Roisman, have routinely admonished the agency for relying on punishments to clamp down on tokens, instead of writing clear rules for the fast-developing market. In a recent public statement, the Republicans said “providing guidance piecemeal through enforcement actions is not the best way to move forward”.

The move is also likely to cause concern among companies like BlockFi, Gemini Trust and Celsius Network that already offer services that let clients earn interest for lending out their tokens. New Jersey is among states that have ordered BlockFi to stop marketing some products. Gemini declined to comment, while BlockFi and Celsius didn’t immediately respond to requests for comment.