by Peter Eberle, President & Chief Investment Officer of Castle Funds
In early June, the US Securities and Exchange Commission (SEC) filed separate lawsuits against cryptocurrency companies Coinbase and Binance. The central allegation of both is that the companies were running unregistered securities exchanges. In other words, the SEC believes these companies set up their own exchanges for buying and selling assets, which were in fact, securities under the law, without following the government rules and regulations that generally protect investors.
The Coinbase and Binance cases have consequences and implications that extend far beyond the fates of these two companies. Indeed, it seems the entire crypto industry could potentially be affected by the SEC’s actions.
The SEC’s allegations
The SEC’s suit against Coinbase alleges the company created securities under its program for “staking” or lending crypto assets in return for income, which were then sold to investors without lawful disclosures and registration with the SEC. In so doing, the company “has deprived investors of significant protections, including inspection by the SEC, record-keeping requirements, and safeguards against conflicts of interest, among others,” according to the agency’s complaint.
Binance faces these same charges, as well as additional ones for allegedly misusing customer funds. For instance, the SEC alleges the company and its founder Changpeng Zhao engaged in tactics like “wash trading” to inflate prices and profit off of consumers.
The agency also contends they mixed up funds from investors and transferred them to another Zhao-owned company in an attempt to thwart the authorities. As SEC Chair Gary Gensler states, “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.”
Altogether, the SEC has brought 13 charges against Zhao and his company. These allegations could lead to criminal prosecution for fraud or similar offenses under US laws.
What’s going to happen?
First off, it will take a very long time for these cases to be resolved. They may even stretch on for years. In the meantime, Coinbase and Binance can be expected to continue to operate, and people can still use them to trade.
The likely outcome of the case will be that the core functions of these firms (i.e., running an orderly exchange, helping investors do trades, and clearing/settling those trades) will be split up and brought under similar regulations to those governing financial firms performing the same functions for securities such as bonds, stocks, and mutual funds. To stay in business, Coinbase and Binance will likely need to submit to inspections by the SEC or other regulators, keep books and records as required, and make truthful disclosures to investors.
However, that’s not where the case’s impact will end. The whole world of crypto is likely to change as a result.
Will crypto come under the SEC’s umbrella?
The actions that the SEC has taken against Coinbase and Binance will test whether or not crypto companies fall under the purview of US laws that regulate securities. Crypto companies have long sought to exploit ambiguities in the SEC’s rules and argue that their coins, tokens, and other assets are not securities. These apparent gaps in the rules exclude their activities from investor protections, such as filing audited financial statements and preventing manipulative trading such as “wash sales”.
Indeed, questioning the SEC’s jurisdiction is Coinbase’s most recent defense. “Coinbase just doesn’t list securities, period,” the business’s chief legal officer has claimed, seeking to get the case dismissed.
Whatever decision the court reaches, its ruling can be anticipated to clarify the obligations to investors and regulators that cryptocurrency exchanges incur.
How crypto will change
I foresee other changes as well. For instance, the barriers to getting new digital asset tokens launched will likely become higher as access to pools of US investor capital becomes more limited. Digital asset tokens will also probably need to make financial disclosures, such as ownership and control information, and keep this data up to date.
Any market participants that actively seek to avoid this regulation — as Binance is alleged to have done in the SEC complaint — will likely find that avoidance to be more difficult.
Finally, some investors today rely on personal and firm reputations instead of regulatory safety nets when selecting venues to invest in crypto assets. If these companies are found guilty of malfeasance, investors will become increasingly skeptical of unregulated exchanges and cautious in their decision-making.
Crypto still has a long future
While some may fear that government scrutiny will destroy the crypto industry, my team and I believe these concerns are overblown. From our perspective, the crypto space can be effectively regulated to provide investor protection. In the end, increased transparency and
accountability may even prove a good thing for the industry, making it more trustworthy to everyday investors.
For this reason, we believe that cryptocurrencies and related assets will continue to provide exciting opportunities for investors long into the future.
Peter Eberle, President and Chief Investment Officer of Castle Funds, has extensive experience in portfolio management, derivatives trading, and risk management. He earned his MBA from the University of Pennsylvania’s Wharton School of Business.