To be regulated or not to be regulated? The Coinbase question
Coinbase is resisting, on principle, almost every regulatory encroachment. How long can this go on?
There was a lot of discussion this week about Coinbase CEO Brian Armstrong’s tweetstorm. Armstrong used Twitter to announce that the SEC plans to file an enforcement action against Coinbase related to its product, Lend.
That’s a very innovative way to do a product launch!
In Part 1 today, free for all subscribers, I’ll run down the debate, some sources for good information about it, and how you could have predicted it, in part based on what I have written previously.
In Part 2 tomorrow, for paid subscribers only, I’ll talk about the two dormant SEC-registered broker-dealers Coinbase already has and why what happens next is so important for investors.
Armstrong’s tweets, and a subsequent statement from its Chief Legal Officer, say that Coinbase has been in discussion with the SEC about the Lend product for a while.
Coinbase came out recently and said we would be launching our own version.
We were planning to go live in a few weeks, so we reached out to the SEC to give them a friendly heads up and briefing
They responded by telling us this lend feature is a security.
Chief Legal Officer Paul Grewal serves the tray of chasers:
Coinbase has been proactively engaging with the SEC about Lend for nearly six months… In June, we announced our Lend program publicly and opened a waitlist but did not set a public launch date… Despite Coinbase keeping Lend off the market and providing detailed information, the SEC still won’t explain why they see a problem… The net result of all this is that we will not be launching Lend until at least October.
There are a lot of great tweet threads on the debate regarding the SEC’s contention that the Lend product is a security. Those include Georgetown Law Professor Adam Levitin’s tweets, which leave no doubt what he thinks, and a couple more posts here and here.
The Coinbase 10-Q for period ending June 30, filed with the SEC one month ago on August 11, 2021, emphasizes that Coinbase considers products like Lend the key to its future.
Across the industry we see immense innovation with new crypto projects addressing a broad range of issues from scaling (to improve transaction speed and lower cost) to developing novel ways for borrowing and lending. New market entrants are joining the crypto economy from all corners, as we saw with the first Sotheby's auction settled in crypto this quarter.
Coinbase is also courting institutional clients as a one-stop shop. It’s even created a Prime Brokerage product for them. Look at those prestige clients!
On the institutional side, we now have over 9,000 financial institutions using Coinbase. Several important themes have developed with our institutional business…In addition, in recent months, we have formed partnerships with industry leaders including Elon Musk, PNC Bank, SpaceX, Tesla, Third Point LLC, and WisdomTree Investments…
Increasingly, our institutional customers see Coinbase as a one-stop shop for the services they need including trading, custody, lending, yield generation, data, and more across a broad spectrum of crypto assets.
We launched the beta of Coinbase Prime, our prime brokerage, an integrated solution that includes trading, secure custody, financing, yield generation, data, and more for our institutional clients. We are continuing to onboard customers and plan to expand our offering in coming months.
[Its] business may be adversely affected if the markets for Bitcoin and Ethereum deteriorate or if their prices decline, including as a result of the following factors…regulatory or legislative restrictions or limitations on Bitcoin or Ethereum lending, mining or staking activities…
What is the Lend product that’s got everyone in a huff? Levitin writes about it, and the about debate over the “security” designation, in longer form for Creditslips:
How Lend Works
My understanding of the proposed Lend product comes from Coinbase website. The details here matter, and the technical legal documentation isn't public, but I am assuming that Coinbase is accurately describing its own product.
Here's the situation: suppose you're a consumer who wants to buy some cryptocurrencies. You go to a crypto broker-dealer like Coinbase and buy some crypto. But because crypto is all digital, you need a "wallet" where you can keep it. Coinbase provides that service as well. It's not just the broker-dealer, but also the custodian. Now remember that when you deposit funds with someone (an "ordinary deposit"), you have made them a loan: there's a debtor-creditor relationship.
In contrast, if you put money into a safe deposit box, that's a "specific deposit", and is not a loan, but a bailment, where you have a right to get the specific asset back, and the bailee has no right to use it (see this old Abraham Lincoln case where the bailee rides the horse put in bailment--a 19th c. Ferris Buehler parking valet).
(Levitin is great. I’ve followed his writing quite closely over the years since the financial crisis, in particular when he wrote about the foreclosure crisis.)
The Coinbase first draft registration statement filed October 9, 2020, refers to Lend as part of its current suite of non-investing products.
Retail users are now engaging with multiple products — across the four quarters ended June 30, 2020, on average, 13% of retail users who invested also engaged with at least one non-investing2 product per quarter.
2 Non-investing products include our Distribute, Stake, Save, Spend, and Borrow & Lend products.
The Coinbase 10-Q filed on August 11, 2021 refers to Lend as a current product.
Assets on Platform also represent our monetization opportunity for subscription products and services, including current products such as Store, Stake, Save, Borrow, and Lend. Assets on Platform generate fees that are recorded as subscription and services revenue when customers engage with these products.
That‘s despite the fact that Coinbase is saying now in its 8-K filing on September 8, 2021, and its CEO and Chief Legal Officer are writing now, that Lend was only announced on June 29, 2021, is only open for pre-enrollment, but has not yet been launched.
CEO Brian Armstrong’s Vision
I don’t think anyone would have been surprised at the Coinbase point of view regarding the SEC’s scrutiny if they had been reading the filings. The 10-Q precisely previews the Coinbase approach to regulators and regulation that Armstrong preached:
Our business is subject to extensive laws, rules, regulations, policies, orders, determinations, directives, treaties, and legal and regulatory interpretations and guidance in the markets in which we operate…
Many of these legal and regulatory regimes were adopted prior to the advent of the internet, mobile technologies, crypto assets, and related technologies. As a result, they do not contemplate or address unique issues associated with the cryptoeconomy, are subject to significant uncertainty, and vary widely across U.S. federal, state, and local and international jurisdictions. These legal and regulatory regimes, including the laws, rules, and regulations thereunder, evolve frequently and may be modified, interpreted, and applied in an inconsistent manner from one jurisdiction to another, and may conflict with one another.
Moreover, the complexity and evolving nature of our business and the significant uncertainty surrounding the regulation of the cryptoeconomy requires us to exercise our judgement as to whether certain laws, rules, and regulations apply to us, and it is possible that governmental bodies and regulators may disagree with our conclusions.
Coinbase hints that maybe they are in constant discussion with regulatory authorities.
Because we have offered and will continue to offer a variety of innovative products and services to our customers, many of our offerings are subject to significant regulatory uncertainty and we from time to time face regulatory inquiries regarding our current and planned products.
This next paragraph is an admission that something is up with the Lend product and maybe also the staking and other yield-generating and “reward” products:
We also offer various staking, rewards, and lending products, all of which are subject to significant regulatory uncertainty, and could implicate a variety of laws and regulations worldwide. For example, there is regulatory uncertainty regarding the status of our staking, lending, and other yield-generating activities under the U.S. federal securities laws. While we have implemented policies and procedures designed to help monitor for and ensure compliance with existing and new laws and regulations, there can be no assurance that we and our employees, contractors, and agents will not violate or otherwise fail to comply with such laws and regulations.
I told you when I wrote about the SEC’s comments on the Coinbase S-1 that SEC questions about staking, air drops and forks took the longest to resolve sufficiently to move forward with the direct listing.
The SEC’s original question #5 in the General section says:
Please provide us with your legal analysis as to why your activities supporting staking are executed in compliance with the federal securities laws.
…There is a lot more to this but, basically, staking is like a permanent chastity belt for your crypto. Not for the faint of heart…
The SEC’s question #54 wants to know how Coinbase recognizes the revenue it earns from staking services provided to customer. I have to give the SEC staff a lot of credit. I would have thrown up my hands after Question #5 but they soldiered on, treating staking like any other product or service and getting Coinbase, or likely its auditors Deloitte, to fit the square peg of crypto staking into the round hole of ASC 606.
So, what if a traditional bank asked you to lock up money in an account for an indefinite period of time, let’s say until Elon Musk lands on Mars. In exchange for participating in the monetary system indefinitely and enabling the bank to conduct fractional banking, on your behalf, the bank will give you some of the interest income it receives from the Federal Reserve Bank for holding the excess reserves, but after taking its cut.
Sounds innovative, no?
…On March 17, a week before Coinbase finally put out its last S-1/A and got the approval to move ahead, the company finally put together some answers to the SEC’s questions. In its response Coinbase says it believes that it does not have to account for crypto assets that come to customers as a result of forks and airdrops or give those customers credit for the assets.
I also warned you that the Coinbase Save product sounds a lot like taking bank deposits.
The SEC’s question # 37 highlights some text in the Our Products, Retail, section of the October 9, 2020 original draft registration statement. This is a really interesting discussion that feels to me like Orwellian, crypto-lingo used to describe Coinbase activities that are similar to routine well-known activities of broker-dealers and banks.
This is how Coinbase described the Save product in its original draft registration:
Save. Providing opportunities for our retail users to put their crypto asset investments to work and earn a yield, which we call rewards, has been a priority for us. All eligible retail users are automatically opted into available rewards programs. Today, our Save product supports two stablecoins, USDC and Dai, crypto assets that track the value of the U.S. dollar.
What does that sound like to you? Sounds to me like retail customers deposit stablecoins such as USDC and Dai, which are intended to be 1:1 U.S. dollar equivalents, in an account at a Coinbase, a broker-dealer. The customer can earn a yield on that deposit which Coinbase likes to call “rewards” but anyone else would call interest.
But the SEC accepted the Coinbase answer to those questions — basically that the numbers were not yet material— and let the IPO fly.
The SEC is approving listings for companies that have active civil and criminal investigations pending and has been satisfied in the past with companies’ promises to disclose questionable accounting or business practices and legal woes, rather than telling them to just “Stop it” or you can’t go public.
Once a not-ready-for-prime-time company is public the SEC is held hostage.
There’s even more acknowledgment in the recent 10-Q of the huge risk of asking for forgiveness instead of permission from regulators. It must be that that potential short-term rewards are considered worth the hassle.
Our industry has been characterized by many rapid, significant, and disruptive products and services in recent years. These include decentralized applications, DeFi, yield farming, lending, staking, token wrapping, governance tokens, innovative programs to attract customers such as transaction fee mining programs, initiatives to attract traders such as trading competitions, airdrops and giveaways, staking reward programs, and novel cryptocurrency fundraising and distribution schemes, such as “initial exchange offerings…our ability to adapt and compete with new products and services may be inhibited by regulatory requirements and general uncertainty in the law…
Businesses under intense legal and regulatory scrutiny typically avoid using the word “scheme” in filings.
Coinbase has an extensive risk section in its 10-Qs devoted to whether some crypto assets will be classified as securities by the SEC. In general, Coinbase is dismissive of what the SEC has already said or done on the subject, suggests nothing is final and may even change as administrations change. Counting on politicians rather than reason and rules is quite risky for a company that wants to survive and thrive in the financial services environment over the long-term. That’s because you’ve established a business model that’s reliant on getting the politics to go your way all the time.
The SEC and its staff have taken the position that certain crypto assets fall within the definition of a “security” under the U.S. federal securities laws. The legal test for determining whether any given crypto asset is a security is a highly complex, fact-driven analysis that evolves over time, and the outcome is difficult to predict. The SEC generally does not provide advance guidance or confirmation on the status of any particular crypto asset as a security.
Furthermore, the SEC’s views in this area have evolved over time and it is difficult to predict the direction or timing of any continuing evolution. It is also possible that a change in the governing administration or the appointment of new SEC commissioners could substantially impact the views of the SEC and its staff…though the SEC’s Strategic Hub for Innovation and Financial Technology published a framework for analyzing whether any given crypto asset is a security in April 2019, this framework is also not a rule, regulation or statement of the SEC and is not binding on the SEC.
The bottom-line is that Coinbase does not want the assets it helps cryptonauts trade to be regulated by the SEC nor does it want the products its exchange offers as a full-stop shop to be regulated as a bank. That would be anathema to a mission that sings a libertarian anthem:
The Coinbase implementation of a libertarian philosophy via its business model is threatened not just by the SEC designating more crypto assets as securities. It’s also not going to work for them if regulators may decide Coinbase is a bank.
In addition, although we are not a bank holding company for purposes of United States law or the law of any other jurisdiction, as a global provider of financial services and in light of the changing regulatory environment in various jurisdictions, we could become subject to new capital requirements introduced or imposed by the United States. and international regulators…we are subject to strict rules governing how we manage and hold customer fiat currency and crypto asset. We maintain complex treasury operations to manage and move customer fiat currency and crypto asset across our platforms and to comply with regulatory requirements.
Coinbase has already decided that if a jurisdiction decides to treat it as a bank and forces it hold reserves for deposits of crypto assets from customers, it will shut down in that jurisdiction.
However, it is possible we may experience errors in fiat currency and crypto asset handling, accounting, and regulatory reporting that lead us to be out of compliance with these requirements. In addition, regulators may increase the amount of fiat currency reserves that we are required to maintain for our operations, as has happened in the past. For instance, in 2017, the Hawaii Division of Financial Institutions imposed a new policy whereby digital currency businesses are required to maintain cash reserves in an amount equal to the aggregate face value of digital currency funds held on behalf of customers, making our operations in Hawaii impracticable and forcing us to shut down operations in the state. Any similar events can lead to sanctions, penalties, changes to our business operations, or the revocation of licenses. Frequent launch of new products and services, including Earn campaigns, margin trading, lending functions, and the addition of new payment rails increase these risks.
It makes you wonder why Coinbase ever went public!
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If you like what you see, please subscribe to the paid version of this newsletter to read tomorrow’s reporting. Part 2 will focus on Coinbase’s two SEC-registered broker dealers and its role as both a broker and a custodian of crypto assets.
© Francine McKenna, The Digging Company LLC, 2021