Center for Technology and Innovation

Reason: Secur⁠i⁠⁠t⁠⁠i⁠es Regula⁠t⁠⁠i⁠ons Shackle U.S. Cryp⁠t⁠ocurrency Indus⁠t⁠ry

By: Andrea O’Sullivan / 2021

Andrea O’Sullivan


Center for Technology and Innovation


September 14, 2021

Cryptocurrency is far from unregulated. In the United States, it is often overregulated. This is a big enough problem when the rules are too numerous or onerous. But to make matters worse, the rules can also be vague. And as a cherry on top, regulating agencies may be slow or even refuse to clear things up.

Who wants to deal with this kind of headache? Not cryptocurrency entrepreneurs, those mobile millionaires whose businesses are global by design. Many of them pack up their packets and move to more hospitable climes. It is for this reason that Americans have become accustomed to the screens informing them that “this service is not available in your country.” While this doesn’t stop dedicated Americans with bitcoins burning a hole in their wallets, it does put up walls for less savvy Yankees that may be more in need of financial opportunity.

But some projects do want to make it work in America. Whether chasing patriotism or profit, they train with their lawyers to jump through all the hoops. This often involves asking a lot of clarifying questions. As we will see, maybe it is better to ask for forgiveness than permission.

Last week, the popular cryptocurrency exchange Coinbase published a blog post accusing the Securities and Exchange Commission of dirty tricks. The company has been planning to issue a new product, Coinbase Lend, for some time. Like the name implies, this product would allow users to earn interest—starting with an almost mythical (for contemporary Americans) 4 percent annual percentage yield (APY)—on cryptocurrency assets that are lent out to borrowers. It would be like if you had a savings account that actually earned money.

To make sure everything was on the up and up, the company says it proactively reached out to regulators while it readied its waitlist and promoted the service. Coinbase has something of a reputation for being compliance-focused, perhaps even to a fault in the opinion of the famously government-allergic cryptocurrency world. They surely hoped their good faith dialogue would be returned in kind.

That didn’t happen. According to the blog post, the company was shocked when it was told not only that Coinbase Lend would be considered a security, like a stock, and subject to all the according regulations but also that the SEC was in the process of suing the company and that it wouldn’t divulge the reasoning behind this decision.

There were plenty of “well, ackshuallys” to go around. Obviously Coinbase Lend is a security, since it promises a return. Err, or maybe it’s obviously because the first asset that could be lent out would have been Coinbase’s own stablecoin, or dollar-backed cryptocurrency, USDC, which Coinbase obviously … promotes? And anyway, this is obviously an investment in a common enterprise. No, no, no. No 4 percent APY for you, America.

If this all sounds a bit pedantic you may be fortunate enough to not have to think about the Howey test for a living. This is one of the court-created precedents that the SEC uses to determine when an investment contract is considered a “security” under the Securities Exchange Act of 1934 and therefore subject to registration and regulation. If something involves the 1) investment of money in a 2) common enterprise with the 3) expectation of profit thanks to the 4) effects of the promoter, then the SEC considers it a regulated security.

Of course, Coinbase disagrees that Lend is a security. It maintains that “customers won’t be ‘investing’ in the program, but rather lending the USDC they hold on Coinbase’s platform,” that the company has “an obligation to pay this interest” regardless of Coinbase’s promotion, and that Coinbase is “obligated to repay” secured USDC on request.

Let’s grant the ackshuallys their point for a moment: maybe this is all some fancy motivated reasoning to skirt securities regulations. Setting aside the dumb implied tactics, from a procedural perspective, is it really that much to ask for a clear explanation of why you are being regulated and sued? Especially since this company seems to have tried to play by the rules, a little clarity seems warranted.

From the perspective of some securities experts, this is just part of the process. Coinbase is not entitled to special treatment because they have questions. Well, maybe the process stinks, then.

It especially stinks that the SEC decided to try their hand at a little financial surveillance while they were at it. According to Coinbase, the agency asked for the “name and contact information of every single person on our Lend waitlist.” Excuse me? What does that have to do with assessing a possible securities offering? Coinbase says it told the SEC to pound sand, but good to know that collecting lists is standard practice these days. Was this the first time? It surely won’t be the last.

Coinbase may be the most well-known cryptocurrency company to become ensnared in U.S. securities law, but it is far from the only one. Really, Coinbase may be particularly well poised to handle these problems because it is so well-capitalized and lawyered. Plenty of small projects sweat about when the securities sword of Damocles will fall on their heads each day.

Take LBRY, a project for censorship-resistant video sharing and monetization. LBRY allows creators to post videos using a blockchain that cannot be censored on the protocol level. Developers can then build explorers that allow users to view those videos, and on which content moderation can be built. The idea is that while no one can remove a video from the underlying blockchain, third-party built explorers can compete on what moderation they want to provide. Viewers and creators can be paid in the native cryptocurrency, LBC, instead of relying on a byzantine ad reward monetization scheme favored by incumbents like YouTube.

Well, the SEC says this is an illegal unregistered security since LBC will be used to fund the LBRY ecosystem. The agency has moved to quash this viable competitor to controversial centralized video platforms like YouTube through the flexible arm of the Howey test. Now LBRY faces the unenviable task of fighting through a thicket of mostly unworkable securities rules for decentralized cryptocurrency projects. Just like Coinbase, LBRY says it has repeatedly asked the SEC for guidance, only to be told that what it is doing is illegal and they can’t tell them why.

If the goal is to “protect investors,” as is part of the SEC’s mission, it is hard to see why it has pursued enforcement the way that it has. There are tons of obvious scams in the cryptocurrency world. Coinbase Lend and LBRY are not among them. Yet it is these projects that aim to provide accounts with actual interest and a censorship-resistant communications platform that are on the top of the chopping block. Kinda weird.

It’s almost like SEC securities enforcement isn’t really about enforcing securities law. But while the SEC may be able to temporarily hold back financial and technological alternatives in this country, it cannot stop the global tide.

Many cryptocurrency projects have already gotten the hint and moved overseas to proceed unmolested. Americans who know how to do such things can get around geofencing intended to keep them out. Some may decide to make it meatspace official and just leave the U.S. altogether. These folks tend to be pretty financially sophisticated. Meanwhile, the people who desperately need things like an actual savings account will be stuck with no options. Some protection!

There are ways for the SEC to provide oversight of cryptocurrency projects that fit awkwardly on the Howey test that wouldn’t outright kill the industry. One of them comes from the SEC itself: my former Mercatus Center colleague Commissioner Hester Peirce has proposed a “Token Safe Harbor Proposal” that could give the LBRY’s of the world a three-year grace period to operate before being assessed as a regulatable security.

With the Safe Harbor, if the project is sufficiently decentralized and functional, like LBRY claims to be, it could continue as such after the grace period has expired. If not, the project will have at least had three years’ time to get their financial and legal ducks in order to register as a proper security.

Such a plan wouldn’t solve all the problems surrounding things like Coinbase Lend, and it would first take enough of the SEC to get on board with the plan to implement it. But it is exactly the kind of innovation-friendly thinking that we need agencies to embrace so that they, well, don’t kill much of the cryptocurrency industry in America.

But SEC enforcement is far away from the promise of a safe harbor. Right now, America has the worst combination of inconsistent and overbearing enforcement. And securities law is only one problematic U.S. domain. Issues surrounding taxation, money transmission, and financial surveillance mandates present more headaches for cryptocurrency ventures. These projects won’t go away. They will just become harder to access with traditional means in the United States. Do regulators know this?

ANDREA O’SULLIVAN is the Director of the Center for Technology and Innovation at the James Madison Institute in Tallahassee, Fla. Her work focuses on emerging technologies, cryptocurrency, surveillance, and the open internet.

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