Explaining the response and impact of the cryptocurrency market under the high-pressure regulation of the US SEC

Author: @jinzejiang0x0, LD Capital

Summary:

The U.S. Securities and Exchange Commission (SEC) has filed formal lawsuits against cryptocurrency exchanges Binance and Coinbase, which has triggered a series of chain reactions such as massive market sell-offs and the delisting of tokens that involve securities definitions.
The charges against Binance are more serious, including fraud, cross-entity mixing of assets, and trading against customers.
The market has reacted strongly, with an average price drop of 28.8% for the 18 tokens defined by the SEC as “securities,” compared to a 7.4% drop in BTC during the same period. However, even though it was first sued by the SEC, the proportion of BNB’s market value has even slightly increased, showing that its price has relative resilience.
The tokens defined as securities by the SEC in this case are largely public chains, accounting for 13/18, followed by entertainment and metaverse tokens, accounting for 4/18, with the latter experiencing a larger drop.
The report predicts possible future scenarios for the SEC lawsuit, including possible legal implications and market reactions, and also discusses the progress of legislation in the cryptocurrency industry.
The report summarizes precedents in cryptocurrency cases, including illegal token issuances and unregistered investment and financial management cases.

The U.S. Securities and Exchange Commission (SEC) has sued cryptocurrency exchanges Binance and Coinbase on June 5th and 6th respectively, alleging that 19 tokens are securities, which triggered a sharp sell-off in the entire market.

SEC’s Charges

The SEC accused Coinbase of operating an unregistered securities exchange, broker-dealer, and clearing agency, as well as unregistered crypto asset collateralized lending services. However, the charges against Binance are quite different. In addition to being accused of operating an unregistered securities exchange, broker-dealer, and clearing agency like CB, the SEC also accuses it of engaging in more FTX-like activities such as deception, cross-entity mixing of assets, and trading against customers, which the SEC has not charged against Coinbase.

The SEC has warned the financial markets that most crypto assets are securities, and this stance may impose strict regulatory requirements on crypto asset exchanges.

Since Gary Gensler was sworn in as SEC chairman in 2021, the industry has predicted stricter cryptocurrency regulation. When Gensler was a blockchain professor at MIT, he mentioned that many cryptocurrencies are likely securities, meaning they should be subject to SEC regulation and under the jurisdiction of the U.S. government.

The SEC has taken enforcement actions against some industry companies and projects, such as Ripple Labs, LBRY, Kraken, and Bittrex. Now, it seems that SEC is likely to take aim at smaller companies before going after the two largest exchanges.

Chain Reaction

These lawsuits and their subsequent effects have triggered a chain reaction in the industry. Binance.US announced the suspension of USD deposits and withdrawals in response to SEC’s action. Binance claimed that SEC’s challenges to its banking partners led to the interruption of fiat currency deposits and withdrawals.

Prominent broker Robinhood decided to delist cryptocurrency tokens classified by SEC as unregistered securities. After June 27, the platform will no longer support tokens such as Cardano (ADA), Polygon (MATIC), and Solana (SOL). It is said that before SEC took action, Robinhood held tokens worth $583 million in MATIC, SOL, and ADA.

Crypto.com announced the closure of its institutional exchange, citing insufficient demand due to the US market landscape. This decision reflects the challenges faced by cryptocurrency companies as institutional investors, including pension funds, mutual funds, and university endowments, become cautious in turbulent market environments and regulatory scrutiny.

On June 16, Binance was under investigation by French authorities for allegedly providing illegal digital asset services and engaging in severe money laundering. On the same day, Binance also announced it would withdraw from the Dutch market. Binance said it would stop providing services to users based in the Netherlands because it could not register there.

Market Changes

Table 1: An introduction to tokens that may be defined as securities in SEC lawsuits in June and a comparison of price changes. Source: Coinmarketcap, Coingecko, TrendResearch

Figure 1: Comparison of the total market value of 18 tokens defined by SEC as "securities" and the total market value of cryptocurrencies, Altcoins (total market value excluding BTC), and DeFi token total market value from 2023 to the present. Source: Coinmarketcap, Coingecko, TrendResearch

Figure 2: Comparison of the total market value of 18 tokens defined by the SEC as "securities" with the total market value of cryptocurrencies, the total market value of cryptocurrencies excluding BTC, and the total market value of DeFi tokens from 2022 to the present. Source: Coinmarketcap, Coingecko, TrendResearch

Figure 3: Comparison of the total market value of 18 tokens defined by the SEC as "securities" with the market value of BTC and ETH. Source: Coinmarketcap, Coingecko, TrendResearch

Figure 4: Comparison of the market value changes of 18 tokens defined by the SEC as "securities". Source: Coinmarketcap, Coingecko, TrendResearch

We have compiled the price changes of encrypted tokens mentioned by the SEC as securities this month over a period of time, except for BUSD. Out of the 18 tokens named, it can be seen that:

Table 1 shows that there are mostly public chains in the industry, accounting for 13/18, followed by entertainment and metaverse, accounting for 4/18, and asset management and lending, accounting for 2/18;

Figure 4 shows that BNB has accounted for over 50% this year, even though it was first sued by the SEC, but its market share has even slightly increased, showing that its price has relatively strong resilience; since the beginning of June, the average price has fallen by 28.8%, compared to BTC’s 7.4% decline during the same period, indicating a significant decline;

Figure 3 shows that the market value peak of the 18 tokens occurred in September 2021, exceeding $300 billion, and the market value trough occurred after the SEC regulation was implemented this month, with only $70 billion;

Since the beginning of June, the top three declines are FLOW (-37.1%), SAND (-37.4%), and CHZ (-35.0%), indicating that the decline of entertainment-related tokens seems to be relatively large;

Since the beginning of June, the smallest decline is NEXO (-8.4%), ATOM (-21.1%), and BNB (-22.2%). NEXO has paid fines and reached a settlement with the SEC at the beginning of the year, so it is affected the least. BNB is the largest token in terms of market value among the charged tokens (with a market value of nearly $50 billion before the decline), and its low volatility can be understood, but ATOM’s market value is only over $3 billion, and the limited decline shows its resilience.

Since their respective all-time highs, these tokens have fallen an average of 91%, with the smallest declines being BNB (-58.4%), MATIC (-78.6%), and ATOM (-81.0%), BNB and ATOM were also among the coins with lower declines since early June, indicating their price resilience has continuity;

Since their respective all-time highs, the biggest losers have been ICP (-99.5%), FLOW (-99%), and FIL (-98.5%), with ICP down only 5.6% this year and FIL up 14.6%, indicating that the downward momentum has slowed significantly after a large adjustment;

Figure 1 shows that before the regulatory events in June, the performance of 18 tokens within 2023 lagged behind the broader market, and after the regulatory events, the lag widened and all gains for the year were reversed into losses;

Figure 2 shows that since the beginning of 2022, the performance of the 18 tokens has still lagged behind the broader market, but has outperformed Defi tokens for most of 2022.

Figure 5: 30-day rolling beta value of 18 tokens defined as "securities" by the SEC versus BTC+ETH. Source: Coinmarketcap, Coingecko, TrendResearch

Figure 6: 30-day rolling correlation of 18 tokens defined as "securities" by the SEC versus BTC+ETH. Source: Coinmarketcap, Coingecko, TrendResearch

Beta represents the systematic risk or market risk of a security token relative to a benchmark index. If Beta is greater than 1, the price fluctuations of the security token may exceed the benchmark index; if Beta is less than 1, the price fluctuations of the security token may be lower than the benchmark index.

Rolling beta values show that the market volatility of these “security” token combinations is actually lower than that of blue chips based on BTC and ETH benchmarks, which is not surprising, mainly considering that under diversified allocation, the rise and fall cycles of each token due to project factors are not completely coincident, which also depresses the Beta of the entire portfolio relative to the benchmark index.

From the data, we can see that the values of Beta and correlation change significantly at different time points, which may be related to market conditions, token fundamentals, or macroeconomic factors. When Beta is high, it indicates that the price changes of security tokens are more influenced by the market, and when industry sentiment is extremely optimistic or pessimistic, correlation and Beta tend to increase, which means that the utility of diversified allocation is weakened.

Overall, if invested in a market-cap weighted way, such a portfolio has underperformed BTC and ETH over the last two years, showing that the price resilience of altcoins is weaker than that of BTC and ETH during bear markets.

What is a security?

According to US regulations, whether something is a security primarily depends on whether it resembles shares of stock issued in company fundraising. The SEC currently mainly applies the Howey Test, which is the 1946 Supreme Court ruling. Under this framework, assets may fall within the SEC’s jurisdiction when investors invest money with the intent of profiting from the efforts of the organization’s leaders.

What are the implications of being defined as a security?

Calling a token a security will make running a cryptocurrency trading platform more expensive and complex. According to US rules, this label imposes strict investor protection requirements on platforms and issuers. This means that exchanges will face ongoing scrutiny from regulatory bodies, which may result in penalties, and, in the worst-case scenario, criminal charges if criminal authorities are involved.

Classifying a large number of cryptocurrencies as securities would fundamentally change the way the cryptocurrency industry operates. Compliance with securities law becomes crucial, requiring these altcoins and their issuers to comply with strict regulatory requirements. This includes registering with the SEC, providing necessary disclosures, and complying with reporting obligations.

In addition, classification may lead to potential trading restrictions. If most altcoins are considered securities, they can only be traded on registered securities exchanges subject to specific rules and regulations. This may limit the liquidity and accessibility of these assets to retail investors and introduce additional barriers to market participation.

For POS public chains like Polygon or Binance Smart Chain, wearing the hat of a security can create many problems, such as financial accounting for user payment of transaction fees, KYC for validators, taxation, and whether any DeFi applications on the chain are legally authorized. These labels can be said to be more destructive to the long-term health of the industry than the closure or exit of several exchanges from the US market.

Future scenarios of SEC litigation

The lawsuits against Binance and Coinbase reflect the increasingly tense relationship between the government and the cryptocurrency industry. SEC Chairman Gary Gensler has made it clear that more digital currencies are not needed and emphasized that the US already has a digital currency called the US dollar. US Treasury Secretary Janet Yellen has also expressed support for the SEC’s actions, approving the use of regulatory tools to protect consumers and investors. This reflects regulators’ clearer stance against cryptocurrencies or becoming a fundamental principle of the traditional financial system.

In the future, we may see the following four trends:

Expansion of regulatory enforcement against more blockchain projects, especially large-cap public chains, with direct lawsuits. Recently, the SEC has mainly targeted exchanges for lawsuits. The 19 tokens mentioned in the relevant documents, except for BUSD and NEXO, have not yet issued direct warnings or lawsuits, which may indicate that there may be more law enforcement actions in the future.
From civil to criminal charges. Since the SEC and CFTC do not have the authority to bring criminal charges, relevant charges may not yet be forthcoming. Criminal charges against cryptocurrency exchanges or projects typically involve fraud, money laundering, or other illegal activities. Such cases are usually handled by law enforcement agencies such as the FBI or the US Department of Justice. For example, last year, the DoJ announced criminal charges against six defendants in four cryptocurrency issuance cases, on suspicion of involvement in fraud related to cryptocurrencies. For example, in the case involving FTX and Alameda, Sam Bankman-Fried (SBF) faces 12 criminal charges, including conspiring to commit bank fraud and operating an unlicensed remittance business, as well as wire fraud against FTX customers, securities fraud against FTX investors, and conspiring to make illegal political donations and defraud the Federal Election Commission.
The authority of the SEC or Gensler may be revoked. Many US politicians do not approve of the SEC’s tough regulation.

For example:

US Senator Bill Hagerty wrote on Twitter, “The SEC is using their role to kill an industry. Allowing a company (Coinbase) to go public and then blocking them from registering as a compliant exchange.”

US Senator Cynthia Lummis also wrote on Twitter, “The SEC has failed to provide a path for digital asset exchanges to register, and worse, has failed to provide adequate legal guidance to distinguish what is a security and what is a commodity.”

On June 16, two Republican congressmen, Warren Davidson and Tom Emmer, proposed a bill called the “SEC Stability Act” to reshape the SEC and remove current chairman Gary Gensler. The bill proposes to increase the number of SEC commissioners, increase directors to oversee the commission, and avoid regulatory policies being influenced by the personal ideas or political struggles of the SEC chairman.

4. Legal tug of war or quick rectification and fines. The sued team or individual actively defends themselves, leading to a lengthy legal battle that can last for years. For example, the lawsuit between Ripple and SEC that started in December 2020 is still ongoing as of now. Of course, if the sued team or individual quickly compromises, makes business changes, and accepts fines, the case can be quickly settled. For example, Kraken and SEC only took less than a month to settle earlier this year.

Progress in cryptocurrency legislation

Congress may pass a cryptocurrency regulatory framework that provides clearer rules for the operation of cryptocurrency and related businesses in the United States. This clarity may stimulate further development and innovation in the industry. A legislative proposal initiated by Representatives Blockingtrick McHenry and Glenn Thompson in the House Financial Services Committee is considered the most feasible legislation. This legislation attempts to clarify the jurisdiction of various agencies over certain digital assets and “strike an appropriate balance” between protecting consumers and encouraging responsible innovation.

This 162-page proposal was released in early June, which initially considered digital assets that were originally securities to eventually be regulated as commodities. Whether it is a security or a commodity depends largely on the degree of decentralization of the underlying blockchain network.

The proposal suggests that if a network meets certain requirements, the network will be considered decentralized, and tokens that meet commodity conditions will be regulated by the Commodity Futures Trading Commission (CFTC).

The specific criteria include that no one has the unilateral right to “control or substantially change” the functionality or operation of the network in the past 12 months, and no token issuer or affiliate owns more than 20% of the outstanding tokens, etc.

However, this proposed bill is expected to face significant opposition from the Democratic Party in Congress. SEC Chairman Gary Gensler and some Democrats believe that most digital assets should be classified as securities and that existing regulations are sufficient.

It is not yet clear when this bill may enter the congressional voting agenda, but it is an important step in the ongoing discussion of cryptocurrency regulation.

Precedents for cryptocurrency cases

Ripple (XRP): In 2020, the SEC filed a lawsuit against Ripple Labs Inc. and its two executives, accusing them of conducting an unregistered securities offering of $1.3 billion through a digital asset called XRP. The SEC’s claim is that although Ripple positions XRP as a cryptocurrency, its issuance process is closer to traditional securities issuance, and therefore should be subject to securities law. This is the largest cryptocurrency-related lawsuit that the SEC has filed to date. As of my knowledge update (September 2021), this case is still ongoing without a final decision.

Block.one (EOS): In 2019, the SEC announced a settlement with Block.one, which agreed to pay a $24 million fine to resolve the SEC’s allegations that Block.one’s initial coin offering (ICO) for EOS conducted between 2017 and 2018 violated securities laws. This was an important case because it demonstrated that the SEC may levy substantial fines for ICOs that violate securities laws.

Telegram (Grams): In 2020, the SEC successfully halted Telegram’s Grams token offering. The SEC’s claim in this case was that the Grams tokens were unregistered securities, and therefore their offering violated securities laws. Ultimately, Telegram agreed to pay a fine and return funds to investors.

Kik (Kin): In 2020, the SEC successfully brought a lawsuit against Kik Interactive Inc., which conducted an unregistered securities offering through a digital asset called Kin. Kik ultimately agreed to pay a $5 million fine to resolve the SEC’s allegations.

BlockFi: The SEC believes that investors lending cryptocurrency to BlockFi in exchange for the company’s promise of variable monthly interest payments constitutes securities under applicable law; additionally, the SEC believes that BlockFi issued securities and had more than 40% of its assets (excluding cash) invested in securities, and failed to register as an investment company in violation of the registration provisions of the 1940 Investment Company Act. BlockFi will ultimately pay a $50 million fine directly to the SEC and an additional $50 million in fines to 32 U.S. states in the form of fines to settle similar allegations. The settlement represents the largest recorded fine suffered by a crypto company at the time.

NEXO: The SEC accused Nexo Capital of issuing and selling unregistered retail cryptocurrency lending products called Earn Interest Product (EIP). On January 20, 2023, crypto lending platform Nexo reached a settlement with the SEC and state regulators, agreeing to pay a total of $45 million in fines and to cease offering lending products. The SEC agreed to settle with Nexo considering the company’s prompt remedial action and cooperation with Commission staff.

Kraken: In February 2023, the SEC brought securities violation charges against cryptocurrency exchange Kraken, due to opaque concerns over its staking token interest business. The SEC reached a $30 million settlement with Kraken that same month, and Kraken will discontinue its “crypto staking” program that offers investment returns.

Encrypted Interest-Bearing Business

US regulations are not just for the issuance and trading of token securities, but also include financial services, such as BlockFi and NEXO mentioned above.

If a company provides a platform for users to store funds and pay interest, then this business model is closer to a bank or financial institution’s deposit business. In this case, the company needs to register and obtain licenses as a bank or financial institution according to local laws and regulations.

In the United States, such companies may need to obtain licenses from the Federal Reserve System, the Federal Deposit Insurance Corporation (FDIC), the Office of the Comptroller of the Currency (OCC), or state banking regulators. These agencies are responsible for regulating banks and financial institutions to ensure that their operations comply with legal and regulatory requirements.

In other countries and regions, companies may need to obtain licenses from the relevant banking and financial services regulatory authorities. For example, in Europe, this may include the European Central Bank and national banking regulators in each country.

It should be noted that such licenses usually require meeting a series of requirements, including capital requirements, risk management requirements, corporate governance requirements, etc. In addition, companies also need to comply with regulations such as anti-money laundering (AML) and customer identity verification (KYC).

Is Regulation Outdated?

Supporters of more regulation believe that the designation of securities due to applicable SEC disclosure requirements will bring more information and transparency to investors. However, cryptocurrency enthusiasts argue that their projects are somewhat decentralized, making old rules inappropriate. Cryptocurrency exchanges believe that their listed assets should be treated as commodities rather than securities. In the United States, rules regulating commodity and derivative trading focus more on ensuring that companies, producers, and farmers can effectively hedge against commodity price fluctuations.

Despite the strengthened scrutiny of regulatory agencies, the cryptocurrency industry still expects Congress to ultimately pass new laws to legalize the industry. Last year, both Democrats and Republicans introduced several bills that would bring cryptocurrencies under the jurisdiction of the Commodity Futures Trading Commission and legitimize other products, including stablecoins, by specifying what assets the products can hold.

Due to the unique properties of cryptocurrency assets, they can contain multiple sources of value beyond traditional securities. It may be outdated to regulate them only with securities law frameworks that were developed ninety years ago.

Table 2: Classification of the sources of value of encrypted digital assets. Source: TrendResearch

Table 3: Encrypted assets defined as securities by the SEC prior to the June lawsuit filings. Source: SEC, TrendResearch

Reference:

https://beincrypto.com/full-list-cryptos-securities-sec-lawsuit-binance-coinbase/

https://www.bloomberg.com/news/articles/2023-06-13/these-are-the-19-cryptocurrencies-are-securities-the-sec-says

https://www.bloomberg.com/news/articles/2022-07-29/why-crypto-flinches-when-sec-calls-coins-securities-quicktake

https://mp.weixin.qq.com/s/DSytFWfcnlA2FdWhTQt2IQ

https://www.sec.gov/files/litigation/complaints/2023/comp-pr2023-101.pdf

https://www.sec.gov/litigation/complaints/2023/comp-pr2023-102.pdf

https://www.justice.gov/oBlocking/pr/justice-deBlockingrtment-announces-enforcement-action-charging-six-individuals-cryptocurrency-fraud

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