4D analysis of the fuse and 5 endings of the SEC's encryption war

Author: Matt Levine Compilation: jk, Odaily Planet Daily

Editor’s note: This article was written after the SEC sued Binance; **One of the fundamental differences between the SEC and Binance, and the core argument discussed in this article, is whether cryptocurrency is a security. ** Binance and all other exchanges operating in the United States must register with the SEC the securities offered to investors if they are securities, and do not need to register if they are not securities. None of the exchanges currently operating in the U.S. are registered with the SEC. So, if the court rules that the token is a security, the SEC wins, and vice versa.

SEC Sues Crypto Leader

“There is a basic standard now that all cryptocurrency exchanges are criminal, and if you are lucky, the exchange you use is only criminal in procedure (not in result).” Why? Examples are as follows:

Is your exchange illegally operating a stock exchange in the US? Yes! Indeed! At least according to the SEC’s opinion, every cryptocurrency exchange in the US is illegal. You may not agree with this point of view - many executives of cryptocurrency exchanges do not agree, and we will discuss these arguments in detail below - but from a practical point of view, if you are trading cryptocurrency, you are not completely Thorough compliance with US securities laws.

Is Your Exchange Stealing Customers’ Funds? may be! Some are, but some are not. If you’re a client, this is what you should be most concerned about.

Running a stock exchange illegally and stealing client funds are related, but they are two different things. “Oh, I shouldn’t be entrusting my money to people who violate US laws”: Of course, yes, this is a reasonable position that will save you from a lot of cryptocurrency disasters, but will also prevent you from doing it at all Cryptocurrency transactions. this is your choice!

My rationale for all this is exaggerating a bit – but not too much.

Yesterday, the U.S. Securities and Exchange Commission (SEC) sued Binance, the world’s largest cryptocurrency exchange, and its founder Changpeng Zhao, accusing them of illegally operating a stock exchange. Today, the SEC filed another lawsuit against Coinbase Inc., the largest U.S. cryptocurrency exchange, for illegally operating a stock exchange.

There are basically two ways that cryptocurrency exchanges can get into disputes with the SEC. One good way is to get in trouble for running an illegal stock exchange (i.e. offering unregistered securities). In April, the SEC filed a lawsuit against Bittrex Inc. for allegedly illegally operating a stock exchange; any reasonable reading of the Bittrex case makes it clear that similar cases would also be brought against Coinbase and Binance. In the view of the SEC, as long as it is a cryptocurrency exchange in the United States, it is illegal.

Another bad way to get in trouble for stealing client funds. Last December, the SEC filed a lawsuit against a major cryptocurrency exchange, FTX Trading Ltd. This is the SEC’s allegation against FTX. I can say with absolute certainty that the SEC believes that FTX is indeed operating a stock exchange illegally in the United States. But that’s not mentioned in the indictment – because there are so many other issues to deal with. **FTX allegedly stole all of customers’ funds; when exchanges steal funds, the SEC will focus on this. When not all funds are stolen, the SEC is concerned with the problem of illegal stock exchanges. **

So with these cases this week, the question is: Is the SEC suing Coinbase and Binance because they are crypto exchanges, or because they are nefarious crypto exchanges? Is the charge here “you allow people to trade cryptocurrencies, which we consider illegal” or “you entice people to trade cryptocurrencies and steal their principal”?

For Coinbase, I think the answer is obvious. Compared to other cryptocurrency exchanges, Coinbase is very legally compliant. It is a US public company registered in Delaware and listed on NASDAQ. It went public by going public in 2021, filing an exhaustive disclosure document with the SEC. Its financial statements are audited by Deloitte. Its business model appears to be to receive funds from customers, use those funds to purchase cryptocurrencies, and hold the cryptocurrencies securely in accounts named after the customers. I dare not make any bold assertions about any cryptocurrency player, and I’ve been wrong before, but I don’t think Coinbase is stealing customers’ funds.

In fact, the SEC’s charges against Coinbase are pretty frivolous and focus entirely on the fact that Coinbase is not registered as a securities exchange. Again, in the eyes of the SEC, every cryptocurrency exchange violates U.S. securities laws. But relatively speaking, Coinbase’s breach was polite and relatively harmless. Not entirely harmless — the SEC said, “Coinbase’s unregistered conduct deprived investors of important protections, including SEC inspections, recordkeeping requirements, and safeguards against conflicts of interest.” But the impact was relatively minor.

For Binance, the answer is more interesting. As far as cryptocurrency exchanges go, Binance has a little level of compliance with the law, but not much — it’s notoriously opaque and has an uncertain headquarters, designed to avoid a tangled web of regulations. (The SEC quotes its chief compliance officer as saying in 2018, “We never want [Binance] to be regulated.”) Similar to FTX, it has its own token — BNB; it has its own affiliate trading company; Separate platforms for US customers (Binance.us) and customers in the rest of the world (Binance.com). It was sued by the U.S. Commodity Futures Trading Commission in March for allowing large U.S. clients such as high-frequency market makers such as Jane Street and Tower Research to trade on its Binance.com exchange through its offshore affiliates, and The CFTC indictment also mentioned the source of terrorist financing.

Likewise, the **SEC’s complaint against Binance claims to have seized some evidence of wrongdoing by Binance. ** Binance has a number of affiliated market makers, including companies such as Sigma Chain AG and Merit Peak Ltd., which are said to be controlled by Changpeng Zhao and trade on Binance’s Binance.com and Binance.us. The SEC hints at suspicious activity:

For example, in 2021, at least $145 million will be transferred from BAM Trading (i.e., Binance.us) to Sigma Chain accounts, and another $45 million will be transferred from BAM Trading’s Trust Company B account to Sigma Chain accounts. Sigma Chain spent $11 million from the account to purchase a yacht. (Suggestion only, no actual evidence)

Moreover, from September 2019 to June 2022, Sigma Chain AG (hereinafter referred to as “Sigma Chain”), a trading company owned and controlled by Changpeng Zhao, conducted shuffled transactions, artificially exaggerating the value of encrypted asset securities on the Binance US platform. transaction volume.

In addition, the SEC alleges that Changpeng Zhao and Binance exercised control over client assets on the platform, allowing them to mix or transfer client assets at will, including to Sigma Chain, a company owned and controlled by Changpeng Zhao.

However, the SEC did not place too much emphasis on these allegations, and most of Binance’s allegations are the same as those of Coinbase: Binance is accused of operating open to U.S. customers and listing some of the identified exchanges without registering as a U.S. stock exchange. Cryptocurrency exchange for crypto tokens for securities. I tend to see yesterday’s lawsuit as an endorsement of Binance by the SEC. The SEC, as well as the previous CFTC, conducted a careful investigation of Binance and wrote a 136-page indictment * (Odaily Planet Daily’s in-depth interpretation of the prosecution document)*, **But they can The only problem found was that Binance was only operating a cryptocurrency exchange. **

While most of the arguments in the two indictments are the same, Coinbase and Binance take very different stances. The key legal question (which we discuss below) is whether crypto tokens listed on Binance and Coinbase are securities. If they are identified as securities, chances are that Coinbase and Binance (and Bittrex and every other exchange) are running illegal stock exchanges; if they are not securities, then everything is fine. Coinbase recognizes this as a potential risk and has established committees and procedures to think through and mitigate this risk. A description from the SEC’s complaint against Coinbase:

Given that at least some cryptoassets are offered, sold, and distributed by an identifiable group of persons or promoters, Coinbase publicly released the “Coinbase Cryptoasset Framework” around September 2018, which includes a framework for cryptoasset issuers and An application form for promoters to apply to list their crypto assets on the Coinbase platform.

Coinbase’s listing application requires issuers and promoters to provide information about their crypto assets and blockchain projects. It explicitly asks for information relevant to performing a Howey analysis on crypto assets.

Additionally, around September 2019, Coinbase and other crypto asset businesses created the “Crypto Asset Rating Council” (CRC). The CRC then released a framework for analyzing cryptoassets that “distills a concise set of yes-or-no questions designed to answer unambiguously the four elements of the Howey test,” assigning cryptoassets a scale of 1 to 5. A score where 1 means “the asset has few or no characteristics consistent with an investment security” and 5 means “the asset has multiple characteristics that are strongly consistent with a security.”

In announcing the formation of the CRC, Coinbase said: “While the SEC has issued helpful guidance, determining whether any given crypto asset is a security ultimately requires a fact-based analysis.” Based on the opinions of the SFC and the court.)

Very responsible, right? Still, the SEC disagreed with Coinbase’s conclusions and took some issue with its process:

Between the end of 2019 and the end of 2020, the number of crypto assets traded on the Coinbase platform more than doubled, and more than doubled again in 2021. During this period, Coinbase offered crypto assets with high scores under the CRC framework on the Coinbase platform. In other words, in order to achieve the exponential growth of the Coinbase platform and increase its own trading profits, Coinbase made a strategic business decision to add these crypto assets to the Coinbase platform even while recognizing that they have securities characteristics superior.

In the meantime, here’s how Binance’s “brilliant” head of compliance describes fact-based analysis of whether Binance is listing security tokens in the U.S.:

As Binance’s head of compliance candidly admitted to another Binance compliance officer in December 2018, “We’re running a fucking unlicensed stock exchange in the US, bro.”

How clear is this angle! Coinbase hired a lot of lawyers, did a lot of analysis, and wrote a lot of checklists to convince itself that it was legal to operate a crypto exchange in the United States. The attitude of Binance is “maybe this is illegal in the United States, well, it doesn’t matter.” The SEC fully agrees with Binance’s point of view. (i.e. feel both are illegal at the same time)

This could be good news for Coinbase: it may be able to appear in court as a good-faith actor trying to comply with the law, while Binance looks like a malicious actor trying to ignore the law; Coinbase may win its lawsuit with the SEC, while Binance may lose. **But I must say that Binance seems to be doing the smarter thing so far. **Binance notes that operating a crypto exchange in the US is likely to be illegal, but it still does so, but it minimizes and compartmentalizes its US exposure: it has relatively few customers in the US and appears to be Part of the business is located outside the United States. Coinbase is all-in on trying to operate a legal and regulatory-compliant crypto exchange in the U.S., and now the SEC says that’s not possible. If the SEC is right, what’s left for Coinbase’s business?

What exactly are securities?

Alright, let’s discuss the underlying theory the SEC is proposing here, which we’ve discussed before when the SEC sued Bittrex:

1 If you operate an exchange that offers securities trading in the United States, you need to register with the SEC as a securities exchange.

2 Encrypted tokens offered by Binance and Coinbase are securities.

3 They did not register their exchange in the US as a stock exchange.

4 violations!

The first point is a bit more complicated than you might think; for example, there are stock trading venues that are not registered as stock exchanges, they are registered as other forms of organizations under other rules. But from the SEC’s perspective, what matters is that the rules of the stock exchange protect investors. In particular, they often call for a separation of three key functions that are often combined together in cryptocurrencies, including an exchange that matches buyers and sellers, a broker/dealer who trades on the exchange on behalf of clients, and the actual Clearing house for moving money and securities. In the stock market, you place an order on Robinhood’s website to buy shares on the New York Stock Exchange, and the Depository Trust Co. keeps the shares and settles the trade. Whereas in the cryptocurrency market, you place an order on Coinbase’s website to buy cryptocurrency on Coinbase, and Coinbase holds the cryptocurrency and settles the transaction.

But the focus here is on the third point: Are crypto tokens considered securities? **The SEC’s fundamental view is that most crypto tokens — not all, excluding Bitcoin, but most — are securities under U.S. law. **Coinbase apparently doesn’t think many of these are securities. The specific issue at issue here is that of a range of popular crypto tokens, including Solana’s SOL, Cardano’s ADA, Polygon’s MATIC, Filecoin’s FIL, Decentraland’s MANA, Algorand’s ALGO, Axie Infinity’s AXS and Voyager Digital’s VGX, are they listed as securities, the SEC mentions that they are listed on Binance and/or Coinbase.

U.S. securities laws define “securities” to include, but are not limited to, “stocks,” “certificates of interests or shares in profit-sharing agreements,” “pre-establishment or subscription certificates,” “transferable shares, investment contracts, [or] voting trusts, Certificate”. One of the most commonly used terms is “investment contract,” as interpreted by the U.S. Supreme Court in a famous 1946 case, SEC v. WJ Howey Co.

According to the Securities Law, an investment contract means a contract, transaction or scheme in which an individual invests funds in a joint enterprise with the expectation of making a profit purely through the efforts of the promoter or a third party, regardless of whether the shares in the enterprise are formally certificated or issued by Proof of nominal interest in real assets. Such a definition … makes it possible for legal purposes to require “full and fair disclosure of the multitude of instruments that are conventional concepts of securities in our business world” … it embodies a flexible rather than static principle, capable of adapting The myriad and varied schemes devised by those seeking to use other people’s funds for profit on their promises.

Investors provide capital and share in proceeds and profits, and promoters manage, control and operate the business. Therefore, whatever the legal terminology used for the specific arrangement of these investor interests, an investment contract is involved.

The point is whether the scheme involves investing money in a joint venture, with profits derived entirely from the efforts of others. If this test is satisfied, it does not matter whether the business is speculative or non-speculative, whether there are property sales with or without intrinsic value.

**This creates the “Howey Test,” where the court asks whether: (1) the funds invested; (2) a joint enterprise; (3) expected profits; and (4) whether the profits are solely the result of the efforts of others. **The SEC has argued since 2017 that most crypto businesses fit this description.

Take Solana as an example. Solana is a blockchain that runs encrypted applications and its native token is called SOL. Here’s how the SEC explained Solana:

“SOL” is the native token of the Solana blockchain. The Solana blockchain was created by Solana Labs, Inc. (hereinafter referred to as Solana Labs), a Delaware company headquartered in San Francisco by Anatoly Yakovenko (hereinafter referred to as Yakovenko) and Raj Gokal (current CEO and COO) was founded in 2018. According to Solana’s website blockchain is a network on which decentralized applications (dApps) can be built, consisting of a platform designed to increase blockchain scalability and achieve high transaction speeds, employing a combination of consensus mechanisms .

According to Solana’s website, SOL can be “staked” on the Solana blockchain to earn rewards, and a tiny amount of SOL must be “burned” when a transaction is proposed on the Solana blockchain. This is a common feature of native tokens on blockchains, and is used to avoid potential bad actors from “crowding” a blockchain with an infinite number of proposed transactions through a cryptographically distributed ledger.

Solana Labs is selling SOL tokens to raise funds for building the Solana ecosystem:

Solana Labs publicly stated that it will pool the proceeds of private and public SOL sales into a comprehensive encrypted asset wallet under its control, and will use these funds for the development, operation and marketing of the Solana blockchain to attract more users. Blockchain (since those wishing to interact with the Solana blockchain need to provide SOL, which may increase the demand and value of SOL itself). For example, in its private sale of SOL in 2021, Solana Labs publicly stated that it would use investor funds to: (i) hire engineers and support staff to help grow Solana’s developer ecosystem; introduce users to market-ready applications in the crypto space”; (iii) “launch an incubation studio to accelerate the development of decentralized applications and platforms built on Solana”; and (iv) establish a “dedicated Venture Capital Department" and “Trading Department”.

Howey test:

1 Have the investors invested their money? Yes, SOL tokens are sold as currency to raise funds to build Solana.

2 Is there a joint enterprise? Yes, Solana is a business; it’s a blockchain ecosystem competing with Ethereum, Cardano, etc., designed to attract users.

3 Is there any profit expectation? Yes, people bought SOL hoping that its price would go up, and it actually did.

4 Does the profit come from the efforts of others? Yes, the price of SOL increased because its promoters and developers made Solana a popular blockchain, increasing the demand for SOL.

These are often difficult questions to judge. Most large crypto blockchains are decentralized to some degree; Solana’s growth depends not only on the efforts of Solana Labs, but also on the efforts of third-party users and developers who enjoy using it. For some crypto tokens, it can be reasonably argued that people buy tokens not as an investment in anticipation of profit, but to pay for transactions on the blockchain; the SOL token is a way for people to run programs and The “fuel” used in transactions, if SOL is purchased as a pure “utility token”, it can be said that it is not a security. Most crypto tokens have both utility value and speculative investment characteristics, which complicates the analysis.

Also, even if you’re buying SOL as a speculative investment, it’s not clear that you’re buying it to share in the profits of the underlying business. Your thought process might be “If I buy SOL, a lot of other people will probably buy SOL, its price will go up, and I’ll make money.” That’s not the expectation of profit from “the efforts of others”; The speculative frenzy and the anticipation of profits in online memes. We talked about Dogecoin yesterday, which is a joke crypto token where people openly promise not to do anything to build the ecosystem; people buy Dogecoin because they think other people will buy Dogecoin. Personally, I take this to mean that Dogecoin is not a security; the “efforts of others” involved in a purely meaningless token are not enough to qualify. (Beanie Babies teddy bears, for example, are no doubt not securities.) And even where crypto projects do promise hard work, ecosystems, and hard-working, smart developers, the sheer reason many people buy tokens may not be the same reason they buy Dogecoin Same, that is, for numerical gains.

But I like to think of the relationship between crypto and securities as that most crypto tokens are in some way clearly similar to stocks of some underlying technology business. In Solana (and Cardano, Polygon, etc.), the underlying business is a platform business for building a blockchain ecosystem of applications, primarily financial services applications, primarily for trading cryptocurrencies. Everyone who buys these tokens is, in some loose sense, a quasi-shareholder in the business. **They are rewarded in the same way as traditional shareholders: share repurchases. And a stock buyback in crypto terms is called a “burn.” **

Additionally, Solana Labs promotes its “burning” of SOL tokens as part of a “deflation model.” As Yakovenko explained in an article titled “Solana (SOL): Scaling Cryptocurrency to the Masses” published on gemini.com on April 14, 2021: "Solana transaction fees are paid in SOL, and By burning (or permanently burning) as a deflationary mechanism to reduce the total supply and thereby maintain a healthy SOL price.” As explained on the Solana official website, since the launch of the Solana network, the “current total supply” of SOL has been traded Burning of fees and planned token reductions due to reduced activity. This marketing of the burning of SOL as part of the Solana network’s “deflationary mechanism” gives investors reason to believe that their purchases of SOL have profit potential, as the built-in mechanism reduces the supply and thus increases the price of SOL.

In its complaint against Binance, the SEC cited Changpeng Zhao’s description of Binance’s own BNB token burn mechanism:

In fact, on July 9, 2019, Changpeng Zhao described Binance’s planned BNB burn in an interview posted on YouTube, stating that “the benefit we promised in the white paper is that every quarter we will use 20% of the Profits are repurchased at market value [BNB] …we will buy back and burn these tokens. We will burn up to 100 million BNB. Basically half of all tokens available…financially it’s the same way economically as a dividend. "

I mean, I would say it works the same way as a stock repurchase, but of course, dividends and stock repurchases are essentially equivalent. The point is, in a crypto project, shareholders (sorry, token holders) share in the project’s profits when a portion of the revenue is used by the project to buy back and burn tokens, increasing the value of the remaining tokens, just as stock buybacks do the same way.

One way to understand cryptoeconomics is that cryptocurrencies construct a new way to sell shares in promised promising technology and financial businesses without calling them stocks. For example, if you were launching a cryptocurrency exchange and wanted to raise capital, you could offer investors shares in your business. If the business does well, there will be substantial profits (from transaction fees charged to clients) which you will share with your investors. But there are some problems with this:

1 If selling stock to the public, you will need to register with the SEC.

2 If selling stock to large VCs, they will need to register for resale with the SEC, or otherwise seek an exemption from SEC registration.

3Either way, you will likely need to provide some kind of financial information about the business to investors in order to secure funding.

4 Shareholders may expect voting rights, ongoing financial disclosure, etc., which are customary and often required by law.

Or, if you’re starting a cryptocurrency exchange, you can go to investors and offer them tokens from your business. If the business works well, there will be substantial profits (from charging clients transaction fees) and you will share these profits with investors (by buying and burning tokens). This is very nice:

1 If you sell tokens to the public, you can declare that they are not securities and you do not need to register with the SEC.

2 If you sell tokens to large VCs, they can declare that these tokens are not securities and resell them freely.

3You will write a white paper to sell the tokens, which does not necessarily need to contain a lot of financial or operational details.

4 You can give the token any rights you want.

I may be a little unfair. I’m describing a pure regulatory arbitrage; Binance’s BNB token or FTX’s FTT token are pure substitutes for shares, issued by a company to raise the capital needed to run a centralized business. This is not quite the case for many projects in cryptocurrencies; in some projects, where people are idealistic about building a decentralized ecosystem that is not owned by any one company, selling tokens can be the way to create and fund ownerless projects, an economic The model is really very different from a shareholder-owned company. But in many cases, the cryptocurrency ecosystem seems to be built by fairly centralized teams, and tokens are seen as shares in a promising new technology company, a promising idea started by a promising team.

You can see why crypto folks love this! It combines regulatory arbitrage with an exciting philosophical novelty. You can also understand why the SEC doesn’t like this situation! The SEC is well aware of “countless and varied schemes that seek to use other people’s funds for the promised profit.” The SEC is the regulator that gets bypassed in arbitrage. And it clearly doesn’t like this.

After the SFC sues, what else will happen?

In principle, here are several possible outcomes:

1SEC wins and cryptocurrencies are more or less banned in the US. Bitcoin, Ethereum, and possibly Dogecoin can still be purchased in the US because they are not securities, but any other crypto item may be considered a security and not be traded in the US. Cryptocurrencies fade and die, and people turn to artificial intelligence. The SEC has killed cryptocurrencies with a slow vengeance as they try to bypass the SEC’s oversight.

2 Same situation, except that cryptocurrencies thrive elsewhere and the US misses out. Cryptocurrencies are proving to be of great world change and value, and the US is left behind in the race. Or cryptocurrencies are proving to be a strange niche financial product that can be traded in Europe but not in the US, like binary options or contracts for difference. Either way, cryptocurrencies have survived abroad but failed to grow in the United States.

3SEC wins, and then some existing crypto companies, new crypto players, and traditional financial services companies work together to find a way to trade cryptocurrencies in compliance with US securities laws. Everyone goes all out and says “well, Solana will start filing annual reports and audited financial statements,” people are going to build crypto exchanges that are registered with the SEC, separate from clearinghouses and brokerages, etc. This seems very difficult since the SEC is clearly not interested in any crypto projects. I’m not going to sit here and tell you “how crypto companies can register their tokens as securities”. No doubt Coinbase has been trying to figure out how to do this, constantly “harassing” the SEC for permissible regulations, but so far, no luck. But I think it’s also possible.

4SEC fails, court says “what, no, none of these things are securities” and cryptocurrencies continue to be traded in the US without much securities regulation.

5 Congress (or future SEC) steps in to change the rules, saying “Of course, all of this is technically illegal under existing law, but it’s insane to stifle innovation like this, so we’re going to make new rules that allow conduct regulated transactions in cryptocurrencies.”

I don’t know which outcome will happen. **This last outcome is what the cryptocurrency industry expects, and Congress seems to have some interest in making cryptocurrency rules. **

But what I’m trying to say is that the **SEC is clearly betting on the first outcome. **Which is why these cases are only now being brought after FTX and many other large crypto companies have collapsed, after crypto prices have fallen, and venture capitalists have turned to AI. For the SEC, these cases against Binance and Coinbase are high-stakes cases: Coinbase and Bitcoin are large companies with sufficient funds, excellent lawyers and lobbying teams. Pretty good legal point. The SEC may lose! But it is strategically maximizing its odds. I wrote in February:

When cryptocurrencies are popular and looking exciting and going up, if you’re a regulator that says “no, we have to stop this,” you look like a poacher. Investors want to put their money in something that’s going up, and you’re holding them back, and they’re angry. Politicians love things that go up and hold hearings on how you stifle innovation. Crypto founders are rich and popular, criticize you on Twitter and get tons of likes and retweets. Your own regulatory staff is eyeing their next private sector job, where they want to be leaders in crypto innovation, not just ban everything.

When cryptocurrencies drop and many projects disappear as frauds and bankruptcies, you can say “I told you so (it’s a scam)”. Back then, people would have preferred regulation, or banning everything altogether. A sued founder of a bankrupt crypto company can say “you stifled innovation”, but no one cares.

That’s the bet the SEC is making now. We’ll see if that bet is correct.