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Blockchain Bites: Regulation by enforcement; Stablecoins lead regulation race; Barclays sees gold in Copper; SEC investigates Coinbase – Fin Tech



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Michael Bacina, Steven Pettigrove, Luke Misthos and
Jordan Markezic of the Piper Alderman Blockchain Group bring you
the latest legal, regulatory and project updates in Blockchain and
Digital Law.

‘Regulation by enforcement’ by US SEC meet with
criticism from crypto industry and other regulators

Late last week the US Securities and Exchange Commission announced
insider trading charges against a former Coinbase employee, his
brother, and their friend, while the indictment claims that some of
the tokens which were part of the alleged scheme were securities
under US law, including POWR, issued by Australian based Power
Ledger.

The regulatory development of crypto-assets has been ongoing for
many years and unfortunately the “regulation by
enforcement” approach of the SEC is a distraction and
potential impediment to considered and sensible regulation.

The facts surrounding the alleged wrongdoing are relatively
straightforward. The SEC alleges that the former employee in
question was a part of a group at Coinbase who had prior knowledge
of which tokens would be made available for trading on the Coinbase
exchange. All Coinbase employees were warned not to trade tokens on
the basis of any information gained during their employment. The
former employee in question allegedly tipped off his brother and a
friend to upcoming token sales, making profits of USD$1.1M by front
running listings in over 25 tokens. When called in for a meeting
with Coinbase, the former employee bought a one way ticket to India
and sought to flee the country, but was stopped at the airport.

On the token classification side, the SEC
Complaint
opens with the assertion that the insider trading
involved “crypto asset securities” and goes on to
say:

A digital token or crypto asset is a crypto asset security
if it meets the definition of a security, which the Securities Act
defines to include “investment contract,” i.e., if it
constitutes an investment of money, in a common enterprise, with a
reasonable expectation of profit derived from the efforts of
others. … [the defendant] provided material, nonpublic
information about, and [the other defendants] traded in, at least
nine crypto asset securities that meet this definition.

The complaint continues [at 90]:

… each of the nine crypto asset securities were offered
and sold by an issuer to raise money that would be used for the
issuer’s business. In the offerings, the issuers directly sold
crypto asset securities to investors in return for consideration
(most commonly Bitcoin, Ether, U.S. dollars, or other fiat
currency, or processed through the use of smart contracts). The
crypto asset securities then were issued and distributed to the
investors’ blockchain addresses.

As alleged in greater detail below, the issuers and their
promoters solicited investors by touting the potential for profits
to be earned from investing in these securities based on the
efforts of others. These statements focused on, among other things,
the value of the token at issue and the ability for investors to
engage in secondary trading of the token, with the success of the
investment depending on the efforts of management and others at the
company.

the issuers and promoters emphasized the ability for
investors to resell these tokens in the secondary markets, on
platforms such as Coinbase, which was a crucial inducement to
investors and essential to the market for these crypto assets
securities. Investors were told, explicitly or implicitly, that
they could sell their securities in the secondary markets and that
the liquidity available in the secondary markets could drive up the
value of their crypto asset securities.

The Complaint cites the key US decision as to whether something
is an “investment contract”, SEC
v Howey
, only once, and provides no further legal
analysis under US law for the assertions put concerning the nine
tokens. Instead, reference is made to various marketing from the
token issuers referring to the benefits of users buying tokens or
sharing in revenues of the project.

Importantly none of the issuers of those tokens have been
prosecuted by the SEC, nor has Coinbase, which traded in the
tokens. If the assertion as to these token’s status is correct,
there could be very serious consequences for those who were
involved in the projects and for Coinbase and other exchanges which
traded in the tokens.

The SEC has previously made vague assertions that parties were
dealing in securities when conducting enforcement (such as in the
Ether
Delta
and Tokenlot
cases), and has a string of settled enforcement actions which had
never reached a finding of fact or appellate review on the question
of token status, so it is unusual to have this level of factual
allegation as to the status of tokens in this Complaint.

On one view this approach remains consistent with the SEC as a
regulator pressing their point of view as to certain tokens being
securities, and taking a form over substance approach. However, an
extremely well funded regulator, which has a key position of
messaging seen (and followed) not just in the US but around the
world, should be expected to consider their allegations actions and
messaging in such a rapidly evolving space carefully. Further, the
application of securities law is nuanced and complex, and a
sweeping assertion that marketing of a token renders it a security
under US law is not determinative.

That point was take up by an unusual rebuke from a Commissioner
of the Commodities and Futures Trading Commission,
who commented
that the case is a “striking example of
‘regulation by enforcement'” and that:

Major questions are best addressed through a transparent
process that engages the public to develop appropriate policy with
expert input… Regulatory clarity comes from being out in the
open, not in the dark.

Coinbase’s Chief Legal Officer, Paul Grewal, issued a strong
statement titled: “
Coinbase does not list securities. End of story.
” pointing
out:-

Seven of the nine assets included in the SEC’s charges
are listed on Coinbase’s platform. None of these assets are
securities. Coinbase has a rigorous process to analyze and review
each digital asset before making it available on our exchange
— a process that the SEC itself has reviewed.

Mr Grewal summarized the key issue for the US, which also
applies to many other jurisdictions:

…instead of having a dialogue with us about the seven
assets on our platform, the SEC jumped directly to litigation. The
SEC’s charges put a spotlight on an important problem: the US
doesn’t have a clear or workable regulatory framework for
digital asset securities. And instead of crafting tailored rules in
an inclusive and transparent way, the SEC is relying on these types
of one-off enforcement actions to try to bring all digital assets
into its jurisdiction, even those assets that are not
securities.

A core, and repeated, problem for the entire cryptocurrency and
digital currency exchange industry is that existing financial
services frameworks were not designed for a decentralised world and
are unworkable in many ways for crypto asset issuers, even in the
event they want to issue a token which is a security, or in
Australia, a financial product.

Coinbase had coincidentally just
petitioned the SEC
to request clearer rules for crypto asset
securities, so as give certainty for issuers seeking to innovate,
and to provide clear boundaries between when a product would be
within the regulatory perimeter (or not).

That petition summarised present issues as including:

  • An ongoing lack of clear regulation for the subset of
    crypto-assets which are securities/financial products;

  • A plethora of steps and intermediaries which prevent real time
    settlement of crypto assets which are securities;

  • An impossibility for individual investors to trade directly
    without using a broker; and

  • Blockchain technology not being able to be used as a record of
    transactions under current US rules, even though that is precisely
    what makes the technology so powerful.

Important other questions are left unanswered by this case,
including:

  • Will other exchanges delist the tokens in questions (as
    occurred when the SEC sued Ripple)?

  • Are the issuers of the tokens in question, Coinbase or other
    exchanges which listed the tokens going to intervene in the case to
    argue the securities point?

  • Will the defendants argue that the tokens aren’t securities
    to challenge the SEC’s jurisdiction?

  • Given this prosecution arose from Coinbase itself
    referring the matter to the SEC
    , what incentive does this give
    to people in the crypto-industry to self report wrongdoing, if the
    SEC response is to respond in the manner it has?

As
Miles Jennings
of A16Z noted “[the] biggest takeaway
is that it’s remarkable how little new information/guidance can
be taken away from the allegations…”

For Australian projects, many of the same regulatory grey areas
as are faced in the US remain the same down under. There are great
difficulties in bringing any crypto asset financial products to
market, and those grey areas create great risks around token
issuances which are not intended to be financial products.

This action by the SEC serves as a reminder of the importance of
taking great care when a business considers issuing crypto asset
tokens.

Stablecoins lead the regulation race

It is a momentous time for global financial markets. Interest
rates continue their ascent followed swiftly by inflation and
business costs while the stock and crypto markets, as well as
consumer spending, have all dropped.

Despite the crypto industry being hit with a flurry of bad news,
namely the
Three Arrows liquidation
,
Terra/Luna meltdown
and
Celsius bankruptcy filing
, stablecoins are emerging from the
storm with a range of potential regulatory frameworks.

Following years of lobbying for considered regulation into
crypto assets, the UK Treasury has unveiled a proposed digital
asset legislation, the Financial Services
and Markets Bill.
The bill, which aims to retake the UK’s
status as a global financial leader, includes a regulation piece
for stablecoins.

In a
speech
, the newly appointed UK Finance Minister, Nadhim Zahawi
said the bill:

reinforces the U.K.’s position as a leading center for
technology as we safely adopt crypto assets.

The bill extends the scope of the Banking Act 2009 and
the Financial Services (Banking Reform) Act 2013 to
include digital settlement assets (DSAs) which are
a digital representation of value or rights“.
The bill would authorise the Treasury to regulate DSAs, DSA service
providers and DSA insolvency arrangements.

Regulations will be made in consultation with the Bank of
England and the Financial Conduct Authority (FCA)
but won’t become law until it passes two more readings in the
House of Commons and passes the House of Lords.

Across the Atlantic, the United States are flirting with
stablecoin regulation in a different way. Speaking at
Consensus 2022
, Sen. Pat Toomey, who put forward his own bill
on stablecoins this year, told attendees:

I’m going to go out on a limb and say we get stablecoins
done this year…I know the [Biden] administration is interested in
doing something in this space.

Senior Democratic and Republican officials on the House
Financial Services Committee are progressing a draft bill,
the Responsible Financial Innovation Act
, that is likely to
impose stringent regulation on collateralised stablecoin
issuers.

The bill is narrowly focused on establishing a US oversight
regime for stablecoins, setting a path for nonbanks to issue them
and ban commercial companies from becoming issuers while also
implementing new capital and liquidity standards. It does not cover
‘algorithmic’ stablecoins like Terra so would have little
to prevent a repeat of the Luna / Terra situation beyond
encouraging better capitalised ‘collateralised’
stablecoins.

Negotiations over the particulars of the bill, and in particular
protections to users of stablecoins, is delaying passage through
the committee, and the summer break will further delay debate until
September.

The rise of UK, US and
EU
stablecoin regulatory approaches provides an interesting
opportunity to collaborate and compare differences, and the global
momentum hasn’t escaped the notice of Australia either, with
the
Governor of the Reserve Bank of Australia, Philip Lowe,

identifying stablecoins as “the one piece of the crypto
landscape where I think there is real promise”.

When it comes to regulation, it might just be that stablecoins
enjoy the first truly stable and workable set of rules.

Barclays sees potential gold in Copper Series-C

UK-based banking giant Barclays has reportedly invested millions
into crypto custody firm Copper during its latest capital raise.
Having been in the works since November 2021, the long-standing
talks with investors concluded with Barclays taking a stake in
Copper, which provides custody, prime broking and settlement
services to institutional investors.

The investment comes amid a lash of losses for the crypto
industry as
billion-dollar firms declare bankruptcy
, and
stringent regulation
as a method of response is becoming a real
possibility.

Copper has continued its rise as a serious player in the
crypto-industry announcing its Series-C capital raise in November
2021, six months after closing a $50 million Series-B raise.

Being one of the top-four banks in the United Kingdom, Barclays
is seemingly circling the crypto space once again, having
previously accepted bitcoin as a form of donations to charity in
2015.

While the investment from Barclay’s is small relative to
their total investments, the continued institutional involvement in
crypto-asset providers sends an important message and shows how
blockchain and crypto continues to become more mainstream.

Barclays has not always been accepting of crypto, having denied
banking services to Binance and Coinbase in the past. The
investment could encourage further education and understanding into
the space for Barclays and other institutional investment
companies.

The fundraising is expected to be finalised within the coming
days.

SEC investigating Coinbase for dealing in unregistered
securities

Earlier this week, Bloomberg reported that the US Securities and
Exchange Commission (the SEC) is
probing Coinbase
– a prominent cryptocurrency exchange
– on suspicion that it allowed US consumers to trade
unregistered securities.

The investigation follows the
SEC’s announcement
late last week that it was initiating
proceedings against a former employee of Coinbase and two
associates on insider trading charges relating to nine tokens which
are listed on the cryptocurrency exchange. The SEC claims those
tokens are securities (i.e. investment contracts) under the
Howey test. The SEC Chair, Gary Gensler has
previously said
that he believes Coinbase ought to register as
a national securities exchange by virtue of the nature of some of
the cryptocurrencies they offer.

In response, Coinbase has been critical of the SEC’s
investigation, citing the lack of clear rules for defining
cryptocurrencies as securities. Coinbase’s Chief Legal Officer,
Paul Grewal
said
to Coindesk:

We are confident that our rigorous diligence process –
a process the SEC has already reviewed – keeps securities off
our platform, and we look forward to engaging with the SEC on the
matter.

The latest revelation cast the SEC’s decision to prosecute
Coinbase’s former employee and his associates in a new light.
The decision to pursue insider trading charges had been criticized
by some as an odd way for the SEC to seek to set precedent on what
is or is not a security in circumstances where:

  • The SEC could have left it to the US Department of Justice to
    pursue wire fraud charges (which it has done in parallel with the
    SEC action) rather than filing a securities fraud complaint which
    will require it to establish that one or more of the nine tokens in
    issue are in fact securities;

  • The three individuals charged by the SEC present potentially
    easy targets for the SEC rather than litigating the important
    question of whether certain tokens may be a security against an
    issuer or exchange which would have had to satisfy itself that they
    were not securities before proceeding to issue or list those
    tokens.

It now appears that the SEC’s decision to pursue insider
trading charges against the three individuals could be a prelude to
a broader battle between the SEC and Coinbase over what constitutes
a security under US law.

In Australia, individuals and entities require an Australian
Financial Services Licence to issue or deal in financial products,
which may include digital assets in some circumstances. Significant
civil and criminal penalties may apply for carrying on a financial
services business without an AFSL. ASIC has issued guidance in the
form of
Information Sheet 225
indicating that it expects those involved
in issuing or dealing in digital assets to seek legal advice as to
whether any token they are dealing in may be a financial
product.

The content of this article is intended to provide a general
guide to the subject matter. Specialist advice should be sought
about your specific circumstances.





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