Are crypto currencies Pokémon cards or Stocks? And why does the classification matter to investors?
US SEC v/s Coinbase showdown will determine crypto's future
Hi there,
On 6th June 2023, the US Securities and Exchange Commission (SEC) sued Coinbase, a crypto exchange, for listing tokens which the SEC considers securities.
The big question raised by the case is: Are certain crypto tokens securities?
The answer to this legal question will determine how the crypto industry, worth around $900 billion, progresses. This figure, which represents the market cap for altcoins (coins other than Bitcoin), is equal to USA’s annual national security budget.
Regardless of whether you are a crypto skeptic, a believer, or are confused by it (like me!), it’s fascinating to understand what is happening and what will happen to the industry. The way I see it, four things can happen:
The SEC wins, and tokens are now considered securities; securities law then applies to the industry.
The courts rule that tokens are commodities, falling under the purview of the commodities regulator.
Coinbase wins, and tokens are considered collectibles—no one governs crypto.
The SEC wins, and crypto is now considered a security, but the legislature (Congress) writes new laws governing crypto.
Time will tell what will happen.
The case is central to the SEC’s quest to oversee the crypto market and its biggest gatekeepers, such as Coinbase.
I want to lay out what are the arguments the SEC and Coinbase are using to further their case and use it to understand the incentives behind actions taken by SEC, makers of tokens and Coinbase and most importantly what does that mean for investors.
Buckle up, for it's a bit of a long-winding journey. 🛣️
At the Ritz-Carlton, Bitcoin intrigues tech elites
In March 2013, Wences Casares, a Bitcoin enthusiast and then CEO of the digital wallet company Lemon, was attending an exclusive, invitation-only tech conference at Dove Mountain Ritz-Carlton in Arizona. Surrounded by a tableful of movers and shakers, he thought it was the perfect time for a little show-and-tell.
He asked his tablemates to download a Bitcoin wallet onto their phones and proceeded to generate a QR code, which was linked to his wallet holding 6,390 bitcoins—worth $250,000 at the time.
He asked the person seated next to him to take a picture of his QR code and proceeded to transfer the bitcoins to his tablemate. From seat to seat, with just a few taps on their phones, $250,000 in bitcoins was transferred along the table, ending with the bitcoins back in Casares' wallet, all within a few minutes.
Everyone at the table got a taste of how dead-simple and fast bitcoin could be.
At that time, payment processors such as PayPal already made it easy to transact online. However, they took a cut from merchants, held the money for a few days before releasing it to the merchant, and international transactions were cumbersome, filled with paperwork and complications.
Frictionless payment—meaning without a middleman, such as a bank or money transfer agent, at your fingertips, within a few minutes, to and from anywhere in the world—was unheard of.
But there was a small problem - How do non-techies buy Bitcoin?
Enter Brian Armstrong
Brian Armstrong aspired to be a tech entrepreneur since his high school days.
He got his first taste of entrepreneurship in college when he built an online marketplace that connected students with tutors. He earned a bachelor's degree in economics and computer science, followed by a master's degree in computer science, which he completed in 2006.
Armstrong believed he had missed the opportunity to build an internet company but while working at Airbnb, he noticed an opportunity to make bitcoin accessible to all.
Armstrong developed the concept of a wallet which would hold bitcoins and applied to the Y Combinator startup incubator program. There, he secured a $150,000 cash infusion from Y Combinator in exchange for an equity stake in Coinbase.
In June 2012, he co-founded Coinbase with the aim of making it easier for non-technical users to transact in bitcoin, which at the time was valued at around $6.
He created an online wallet that was user-friendly and later added functionality allowing people to link their bank accounts and buy bitcoin directly from the wallet.
The company would act as both an exchange and a custodian, taking a cut anytime a user converted dollars to bitcoin or vice versa.
With the combination of a digital wallet and payment-processing services, the vision was that you could pay a Kashmiri artist directly for a Pashmina shawl — assuming they have a wallet— using bitcoins while sitting in the US via your smartphone.
This technology had the potential to enable people to participate in the global economy without any barriers.
Armstrong asserts, "Financial services are really holding back innovation in the world and human progress because people lack the freedom to participate in the global economy due to all the barriers to innovation."
I share these concerns about our financial system—it's fundamentally flawed.
For those of us with stable lives, the cracks may not show. We enjoy the comforts of a home, the convenience of technology like laptops or smartphones, a reliable internet connection to read this newsletter, and the security of growing savings in bank accounts.
But consider those without these luxuries—who lack banking services, access to credit, or reside in regions afflicted by narcotics trafficking (Ecuador), authoritarianism (Russia), conflict (Ukraine/Palestine), or economic mismanagement (Argentina). How do they receive payments? How can they leverage the global economy when cut off from international finance?
Cryptocurrency isn't necessarily the magic fix, but it highlights the cracks in monetary systems around the globe, which are deeply dysfunctional.
In 2013, Coinbase started gaining traction leading to Andreessen Horowitz, a venture capital firm famous for its tech investments, investing $25 million. Bringing the total raised by Coinbase to $31 million.
Coinbase by the end of 2013 had 600,000 consumer wallets and was becoming a force to be reckoned with.
Evolution of the Crypto Ecosystem: 2014-2020
The period between 2014 and 2020 was marked by significant events in the cryptocurrency space, as evidenced by the dramatic fluctuations in cryptocurrency prices driven by investor sentiment worldwide.
Here are a few milestones:
Mt. Gox, a leading Bitcoin exchange at the time, reported a massive theft of bitcoins in early 2014, leaving many investors with substantial losses.
Silk Road, an infamous online marketplace for illicit goods ranging from drugs to hacking tools and hitman services, utilized bitcoin for transactions. This association tarnished cryptocurrency's reputation as a medium for illegal payments.
Despite the FBI's shutdown of Silk Road in 2013, where it had processed over nine and a half million bitcoins (worth roughly $1.2 billion then), the cryptocurrency endured. Contrary to predictions of its downfall, Bitcoin's price and trading volume surged, as enthusiasts welcomed the separation from criminal activities.
Luck plays a big part in every story - it is an additional bonus if luck comes with a big purse.
The Bitcoin Foundation was set up to promote the use of bitcoin with an initial endowment of bitcoins worth $55,000. As bitcoin's value climbed, the Foundation grew into a multi-million dollar lobbying powerhouse.In August 2013, as federal investigators probed bitcoin's connections to the Silk Road, the Foundation held a series of meetings with staffers at the US Justice and Treasury departments and the FBI. The months-long lobbying effort culminated in a pair of bitcoin-friendly congressional hearings with bitcoin advocates emphasizing that excessive regulation in the United States would merely push the Bitcoin economy overseas.
Consequently, bitcoin continued to operate with minimal official oversight.
Ethereum's 2015 launch introduced a blockchain capable of executing smart contracts, enabling developers to build applications that solve specific real-world problems, such as streamlining insurance payouts. This expanded the scope of the crypto ecosystem.
The broader market saw the emergence of more blockchains such as Solana, Litecoin, and Cardano, each addressing unique issues. Fueled by investments from venture capital and private equity funds, the shareholding structure and thus the power dynamic shifted from large-regulated banks to less transparent private entities.
Read my earlier piece about it here- Crypto has some issues...The NFT craze spiked and dissipated in 2021. Mirroring the volatility of crypto prices which correlated with the fluctuating ease of borrowing money.
Coinbase transformed into a centralized exchange, facilitating the trading of various tokens.
While cryptocurrency has seen significant growth, it has not yet fully delivered on its promise to solve real-world problems or become widely used as a currency. Developments like programmable smart contracts show potential to simplify complex systems and improve our day-to-day transactions.
Despite setbacks from scams and speculation, there is hope that with time and increased maturity, the industry will evolve and fulfill more of its practical applications. It is important to give this evolution the time it needs to unfold.
2021: Coinbase goes public
In April 2021, Coinbase went public, debuting with a market capitalization of $85.8 billion on a fully diluted basis.
Its valuation was fueled by a surge in transaction fees, propelled by the dramatic increase in the prices of Bitcoin and Ether, which soared by more than 800% and 1,300% respectively in 2020.
By 2021, Coinbase's user base had grown to 56 million, a significant increase from the 43 million recorded at the end of 2020.
During its last private funding round in 2018, Coinbase was valued at $8 billion. Upon listing, in a time span of 3 years, its value skyrocketed to ten times that amount.
2023: SEC sues Coinbase for listing “securities”
In mid-2023, the SEC filed a lawsuit against Coinbase, accusing the company of operating an illegal exchange. The SEC classifies certain crypto tokens as securities and claims that Coinbase functioned as a broker-dealer, securities exchange, and clearing house without registering for any of these capacities, thus circumventing disclosure obligations designed to safeguard investors.
Well, there are many things to unpack here, let’s go one by one:
If the activities Coinbase was doing were illegal why did the SEC permit Coinbase to go public?
Coinbase went public following a meticulous six-month review by SEC staff, who scrutinized the company's risk disclosures and financial reporting.
This thorough examination allowed the SEC to gain insight into Coinbase's core operations and assess its readiness for public listing.
The SEC asserts that its primary objective during the listing process is to ensure companies are disclosing potential risks to investors. This includes verifying whether Coinbase has been clear in its prospectus and marketing materials about the uncertain legal status of certain tokens.
However, the SEC is not responsible for determining the legality of a business. Even enterprises operating in industries considered illegal at the state level, such as cannabis firms, have managed to list on stock exchanges.
Why now? The SEC could have targeted exchanges at any time in the past decade
As per Matt Levine in Money Stuff, Bloomberg
When crypto is popular and exciting and going up, if you are a regulator who says “no, we must stop this,” you look like a killjoy. Investors want to put their money into stuff that is going up, and they are mad at you for stopping them. Politicians like the stuff that is going up, and hold hearings about how you’re stifling innovation. Crypto founders are rich and popular and criticize you on Twitter and get a lot of likes and retweets. Your own regulatory employees, who have an eye on their next private-sector jobs, want to be leaders in crypto innovation rather than just banning everything.
When crypto is going down and so many projects are evaporating in fraud and bankruptcy, you can kind of say “I told you so.” There is just a lot more appetite to regulate, or I guess just to shut everything down. “You are stifling innovation,” the indicted founder of a bankrupt crypto firm can say, but nobody cares.
Why cryptocurrency exchanges? Why not the makers of the tokens?
A foundational principle of cryptocurrency is "decentralization," meaning no single entity has control. The allocation of governance tokens, which gives holders a voice in managing a blockchain - varies widely. Ownership of these tokens ranges from being concentrated among a select few to being broadly distributed across thousands of holders.
This presents a challenge for the SEC. It could target entities like Solana Labs, Inc., the creator of the Solana blockchain and its associated currency, SOL. However, taking legal action against numerous companies would be complex, and the outcomes uncertain.
The SEC's ultimate aim is to oversee the crypto industry.
Targeting exchanges is a strategic move, as they are central yet fewer in number within the ecosystem.
By regulating exchanges, the SEC can effectively extend its reach across the entire crypto ecosystem.
What is the point of contention between Coinbase and SEC?
The SEC alleges 13 altcoins are in fact securities and hence Coinbase has been operating an illegal exchange. The tokens mentioned are:
Solana (SOL)
Cardano (ADA)
Polygon (MATIC)
Flow (FLOW)
Internet Computer (ICP)
NEAR Protocol (NEAR)
Filecoin (FIL)
Dash (DASH)
The Sandbox (SAND)
Axie (AXS)
Chiliz (CHZ)
Voyager Token (VGX)
Nexo (NEXO)
What stands out in the complaint is that quite a few of the tokens on the list use Proof-of-Stake (PoS) technology (1-6 above). Filecoin and Dash (7 & 8) use a combination of other technologies while the rest (9-13) are tokens that run on the Ethereum blockchain.
Understanding Proof-of-Stake (PoS) Technology
PoS is a consensus mechanism used to validate transactions on the blockchain.
In this system, validators lock-up ("stake") a specified amount of the tokens as collateral, to get a chance to authenticate transactions. The greater the stake a validator commits, the more likely they are to be chosen to record transactions on the blockchain, earning rewards in the native tokens.
This structure motivates validators to act honestly and maintain the network's integrity since any malicious actions could lead to their stakes being reduced or seized.
However, to become a validator and earn rewards, one needs to hold a substantial amount of the cryptocurrency initially. This requirement can result in a concentration of validation power among a limited number of parties, potentially leading to centralization within the blockchain.
So why does this centralization matter? It opens the door for the interpretation of these tokens as securities.
The case for PoS native tokens to be treated as a security
To be classified as security, the transaction must pass the four criteria laid out in the “Howey Test”. This precedent was set by a ruling made in a 1946 case called SEC v. Howey Co.
Is the transaction-
(1) an investment of money
(2) in a common enterprise
(3) with an expectation of profits
(4) to come solely from the efforts of others.
A share certificate is a security as it satisfies the four Howey Test criteria.
The SEC believes that Proof of Stake (PoS) coins meet the criteria for securities, given the technology's nature. Coin holders anticipate returns from staking, and a relatively small circle of entrepreneurs and early adopters tend to dominate the network. More on this later.
Is Bitcoin a security also?
Bitcoin is not a security for multiple reasons,
It fails to meet criteria #2, "a common enterprise." The coin itself is distinct from the underlying technology.
It operates on a Proof-of-Work method, where the coin serves as a reward for solving a cryptographic puzzle; there is no inherent utility in the coin itself. Unlike PoS tokens, which needs validators to stake the tokens to run the network.
Therefore, the holder is not investing in the underlying technology or, simply put, a company (common enterprise); rather, they are investing in an asset comparable to a Pokémon card.
Even if that Pokémon card is valued at $52,000, it doesn't alter these facts.
It fails criteria #4, "solely from the efforts of others." The protocol that governs the Bitcoin blockchain is unchanging, and there is no central entity actively working to improve, drive, or repair it should issues arise.
This is why bitcoin is not classified as a security, but is considered as a commodity.
So, what is the difference between cryptocurrency and stocks?
The SEC primarily cares about protecting retail investors.
They do this by ensuring companies disclose all the relevant risks required for decision making and the financial statements show a fair picture of the company’s health.
One way to determine what disclosures are relevant is to look at the way investors access tokens and what actions they can take with them.
Let’s consider Solana
Solana is a blockchain and SOL is its native token (“coin”). It follows the PoS method, wherein validators will stake their holdings of SOL and earn rewards in SOL.
SOL tokens are also used to pay for transaction fees on applications built on the Solana blockchain, such as Helium.
Helium's goal is to enable global wireless connectivity. Users of Helium interact with the network by trading Helium tokens. Purchases of Helium tokens are recorded on the Solana blockchain, resulting in transaction fees being paid in SOL.
Therefore, SOL serves a functional purpose within the Solana ecosystem.
An analogy would be how Apple’s app store (Solana) works. Instead of paying for Spotify in USD you are paying in hypothetical Apple dollars (SOL). The value of these Apple dollars is determined by market dynamics, much like stock prices, where buyers and sellers agree on their worth, thereby making it an investment vehicle.
This underscores the difference between cryptocurrencies and stocks whereby crypto tokens have both utility and speculative-investment aspects. Stocks only have an investment aspect - you can’t really take Reliance shares and use them as a currency to pay for Spotify.
The argument against native tokens/coins such as SOL being declared securities
In 2017, Solana labs raised money from professional accredited investors such as VC/PE firms to build out their blockchain, the instrument (usually done through a SAFT agreement) which lays out the conditions of the fundraising is a securities contract.
The argument against being declared as a security goes - once the blockchain is built and running, the tokens are something else - they are air miles, Starbucks gift cards, credit card points but not securities.
How can tokens be considered as credit card points?
One aspect of tokens is that they are crucial for the operation and maintenance of a blockchain or application (Helium), serving either as a reward mechanism or to pay transaction fees.
However, possession of a token does not automatically grant the holder governance rights over the project's direction. Solana’s governance power rests with Solana Labs and not with SOL holders. Across the crypto ecosystem governance is handled differently. Some projects launch a governance token which grants voting power to the token holder while others conduct off chain governance via calls and discussions amongst stakeholders.
In contrast, owning shares grants you certain rights such as electing a new board of directors, determining director compensation, and the right to inspect the company's financial records. Such levels of influence are generally not afforded to token holders.
To elaborate on the analogy, just as being a user of Facebook doesn't make one a shareholder of Meta (formerly known as Facebook), holding a project's tokens doesn't equate to claiming ownership of the project itself.
Taking this argument further
Coinbase claims a token holder is not entitled to share in the profits of the underlying enterprise. There is no contractual obligation with the token holder which guarantees any economic upside or distribution of dividends if the network explodes in usage tomorrow.
Thus, failing the third criteria of the Howey test “expectation of profits”, the token is being used for carrying out an action - not held for deriving profits from economic activity. This is the stance Coinbase has taken - not the SEC.
The price swings can be explained as speculative mania such as “a lot of people are buying SOL, let me also buy it and stick it to someone else once the price goes up.” That is not really an expectation of profits derived from the “efforts of others” (4th criteria of Howey test); that’s an expectation of profits derived from a gambling mentality.
As per William Savitt, the lawyer for Coinbase, the difference between tokens and securities is,
“It’s the difference between buying Beanie Babies Inc. and buying Beanie Babies,” Savitt said.
The SEC’s argument - Tokens should be classified as securities
The SEC believes that token holders are effectively investing in the network and anticipating profits from the efforts of developers who are actively working to scale the network, making it faster and cheaper to attract more users to the project.
Additionally, many blockchains such as Solana employ tactics similar to those used by luxury brands to preserve value. For instance, the platform burns a certain % of coins paid as gas fees to reduce the overall supply, a move designed to support SOL’s price, making it attractive for token holders.
These actions make token holders resemble stockholders and hence existing securities laws should apply.
Impact on Retail Investors
At the start of this article, I highlighted 4 ways this case could go
Tokens are securities
Tokens are commodities
Tokens are collectibles
Congress writes new rules governing crypto
Which way it ultimately goes will be decided by the arguments each side makes but I do hope I’ve provided you with a better understanding of what is going on.
Regardless of the decision it will result in clarity on the status of tokens. With clarity, exchanges and token makers can follow rules to divulge relevant information, disclose conflicts of interests and bring more transparency to the industry - positively impacting retail investors.
Coinbase has been publicly asking the SEC to release new rules for crypto companies, but the SEC has been firm on its stance that crypto should follow existing securities law.
Phewwww..😅 I know this was a long read but just stick with me for a little bit longer.
There are a few nuances which are worth mentioning to understand the complete picture,
The SEC is attempting to classify all token holders as investors, similar to shareholders in companies, but there are various reasons why someone might hold cryptocurrency. They could be libertarians seeking greater autonomy over their finances or privacy advocates who appreciate the convenience of digital currency and desire to use it in a more privacy-conscious way.
If the SEC prevails and imposes stringent regulations, it could prompt the entire industry to relocate offshore, beyond the reach of regulators. This move would make it significantly more challenging for the SEC to fulfill its role in protecting retail investors.
Centralized exchanges like Coinbase play a crucial role in making crypto widely accessible. Hampering their innovation might render this technology less available and beneficial to investors.
I would appreciate it if you shared this with others who might find it interesting. It helps the newsletter grow and keeps me motivated.
Filtered Kapi #52
This is a brilliant read.Thanks for going in to the weeds and explaining.