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The US Securities and Exchange Commission has threatened to sue the crypto exchange Coinbase if it launches its planned lending product [from Global Risk Regulator].

Following a string of crypto-related enforcement actions, the US Securities and Exchange Commission (SEC) is now going after the country’s largest crypto exchange, Coinbase, over plans to launch a lending product.

Coinbase Lend envisages its customers earning 4% on their USDC, a dollar-backed stablecoin, holdings. In a blog post dated September 8, Coinbase said it had been engaging with the SEC for nearly six months, noting that there are already similar products on the market. “We could have simply launched the product but we chose not to,” wrote Paul Grewal, Coinbase’s chief legal officer. “Coinbase believes in the value of open and substantive dialogue with our regulators. So we took [Coinbase] Lend to the SEC first.”

However, on September 1, Coinbase learned that the SEC was threatening to sue if it launched its loan product and also issued subpoenas demanding more information.

And though there are already similar products on the market, those crypto exchanges which are offering them are attracting scrutiny from state regulators, due to concerns over their riskiness. One train of thought is that the SEC homed in on Coinbase due to its size and profile, so as to send a powerful message to all the others currently offering or considering launching similar products.

Coinbase Lend was announced in June with a waiting list opened for interested customers pending regulatory approval. This may have triggered the SEC’s missive and it also wants to know who is on the waiting list. The company said it has delayed the launch until at least October and is resisting handing over customer details.

Trailblazer

It is widely recognised across the industry that Coinbase, a Nasdaq-listed company, is a trailblazer in terms of regulatory compliance and in making crypto mainstream.

According to Mr Grewal, the SEC told Coinbase that it considers Coinbase Lend to be a security, but refuses to state why. This is a familiar complaint about the SEC across the industry over its lack of concrete guidance and clear definitions on whether a token is a security or a commodity for regulatory purposes. Bitcoin and ether are classified as the latter.

“Coinbase isn’t the first company to fail to get clear and transparent guidance from the SEC. That’s just how the SEC works and it isn’t new or unique to Coinbase,” says Richard Smith, a Berkeley mathematician and fintech entrepreneur.

He explains that the SEC has its hands full trying to apply decades old securities rules to rapidly advancing new technologies and financial engineering. “Cryptocurrencies, of course, present the biggest head scratcher to the SEC – and now cryptocurrencies have branched off again into NFTs [non-fungible tokens], stablecoins and cryptocurrency lending programmes.”

Mr Grewal argued that Coinbase Lend is not a security, as customers would not be investors. He said Coinbase would be obliged to pay interest regardless of its broader business activities and that customers’ principal would be secure and repayable on request. Basically, he believes it to be a loan product, or maybe even a type of savings account; however, the former can be classified as securities if they do not fall into certain categories.

Loans can be securities

For example, the 1990 Reves case, which the SEC cited to Coinbase alongside the Howey Test, stipulated that loan notes redeemable on demand can be considered securities partly because they do not have a clear redemption date. The SEC is saying that Coinbase Lend is more akin to an unsecured perpetual bond that can be cashed at the owner's convenience. And the product, which would not have the backing of the Federal Deposit Insurance Corporation (FDIC), would carry some risk and is offering a much higher interest rate than FDIC-insured bank accounts.

Under US law, to be a security, an instrument must satisfy the Howey Test, which states that it is an investment in a common enterprise with a reasonable expectation of profits to be derived from the efforts of others.

The SEC’s position might not be entirely surprising as it considers most cryptoassets to be securities. In August, Gary Gensler, the SEC’s chair, suggested at the Aspen Security Forum that people buy cryptoassets hoping to make a profit on the back of the efforts of people working on an underlying project – usually a blockchain. He also warned then that stablecoins could also be considered securities and investment companies.

“Cryptocurrencies and their derivatives are particularly challenging for the SEC because the cryptocurrency community continues to insist that even though their financial products walk like a duck and quack like a duck, they are not like other ducks,” says Mr Smith. “By ‘duck’ I, of course, mean ‘securities’.”

Some lawyers believe that Coinbase is trying to argue for special guidance or exemptions for crypto products because they use new technology, which they think is ultimately futile due to volumes of existing case law for defining securities. They also think that Coinbase making its grievances so public could backfire in terms of its relationship with the SEC.

While Mr Smith feels deep sympathy with the cryptocurrency community, he explains that the only way they will get what they want is if Congress mimics what it did for internet companies back in 1996 with Section 230 exemptions. These provided civil liability immunity to web firms, such as Facebook and Google, with regards to third-party content so they would not be treated as publishers.

“[But] given that both Democrats and Republicans have recently been hammering on the drawbacks of Section 230, that doesn’t seem highly likely,” he says.

However, US regulatory uncertainty over crypto, volatile cryptocurrency prices and fierce competition led Moody’s Investors Service to give Coinbase a debt issuance credit rating of just Baa2, which is speculative or non-investable, despite the firm being highly profitable.

This article first appeared in The Banker’s sister publication Global Risk Regulator.

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