Coinbase Contests the SEC’s Regulatory Authority over Crypto Exchanges, Staking

The crux of the SEC complaint is that as a crypto exchange listing certain digital assets and providing certain services that constitute securities, Coinbase must register—and has not—pursuant to the Securities Act of 1933 and the Securities Exchange Act of 1934. Since at least 2017, the SEC has taken the view that a digital asset (such as cryptocurrency) will be deemed a “security” subject to the registration requirements of these laws if it is an “investment contract” under the four-part test established by the U.S. Supreme Court in SEC v. W.J. Howey Co. (1946). Under the Howey test, a digital asset will constitute an investment contract if there is (1) an investment of money; (2) in a common enterprise; (3) with an expectation of profit; (4) relying on the efforts of others. The SEC asserts that Coinbase’s activities relate to digital assets that are securities under Howey—and that Coinbase deliberately ignored applicable securities laws to earn “billions” at the “expense of investors by depriving them of the protections to which they are entitled.”

The SEC separately argues in its complaint that the “staking” services offered by Coinbase are themselves investment contracts under Howey. “Staking,” or “proof of stake,” is a mechanism used to validate certain cryptocurrency transactions on the blockchain. Blockchain transactions are not subject to centralized verification in the same way that financial institutions verify traditional currency transactions; rather, they require a decentralized mechanism for verification. A proof-of-stake protocol allows holders of certain cryptocurrencies to pledge, or “stake,” their digital assets, which locks up the assets for a certain period during which the holder’s machine can be used to validate blockchain transactions. Validators are selected randomly to confirm transactions and validate block information, and selected validators earn additional cryptocurrency as a reward. The SEC claims that by pooling and staking customers’ digital assets, earning rewards on customers’ behalf, and returning those rewards to customers, Coinbase is offering and selling investment contracts subject to SEC regulation.

The SEC further alleges that Coinbase has operated as an unregistered broker through two services provided to investors on its platform. The first is Coinbase Prime, which the SEC alleges Coinbase refers to as a “prime broker for digital assets” and which is used to route orders for crypto assets to the Coinbase platform or to other third-party platforms. The other service mentioned in this charge is Coinbase Wallet, which routes orders through third-party digital asset trading platforms as a means to access liquidity off the Coinbase platform.

The Coinbase Answer
Coinbase filed its answer on June 29, 2023. The answer denies that any of the Coinbase services identified in the SEC complaint are or involve securities. Challenging the SEC’s overall interpretation of Howey in the context of digital assets, Coinbase asserts that the digital assets traded on its exchange are not “an ongoing business enterprise whose management owes enforceable obligations to investors.” Rather, their value “inheres in the things bought and traded rather than in the businesses that generated them.” If the assets’ value is inherent rather than a product of managerial activity, the “efforts of others” prong of Howey cannot be met and the assets are, as a matter of law, not securities subject to SEC regulation.

The Coinbase answer asserts that the SEC and its Commissioner, Gary Gensler, have acknowledged for years that a “regulatory gap” prevented the Commission from policing digital asset exchanges. By bringing this enforcement action against Coinbase, rather than engaging in notice-and-comment rulemaking, Coinbase claims that the SEC is abusing its discretion. The SEC had declared Coinbase’s IPO registration statement effective in April 2021, for example, without ever suggesting that Coinbase was obligated to register its operations or was in violation of any securities laws. Given the SEC’s role of protecting investors, Coinbase asserts, the registration statement and offering should not have been allowed to go forward had Coinbase been in violation of securities laws at the time of its IPO. Coinbase thus accuses the SEC of changing its position and adopting a completely new interpretation of its regulatory authority “by decree, arbitrarily, and without congressional mandate.” This interpretation is allegedly without basis in federal securities laws, subject to formal rulemaking requirements unmet by the SEC, lacking in due process and, under the so-called major questions doctrine, an impermissible encroachment on Congress’s ongoing consideration of how best to assign regulatory authority over cryptocurrency.^[1]

With respect to staking, Coinbase denies that staking constitutes an investment contract under Howey. It argues that it merely offers its customers a platform on which to stake, i.e., to participate in a particular token’s protocol when that protocol allows for staking. Coinbase argues that the staking process does not involve investment, but merely an agreement by customers to participate in a staking process where digital assets held in a customer account are used to stake in return for rewards. Coinbase further claims that the staking services it provides are merely IT services and not the managerial effort required for an investment contract under Howey, and moreover, that staking on the Coinbase platform does not involve any potential risk of loss. Coinbase also denies that Coinbase Wallet and Coinbase Prime constitute broker services.

Comment
The ongoing Coinbase litigation highlights the significant gap between recent SEC enforcement actions and market participants’ hopes for a more clearly defined regulatory structure. Such participants—including Coinbase^[2]—have publicly pleaded for more formal SEC rulemaking or for Congress to pass legislation that clarifies when U.S. securities laws apply to digital assets. The SEC has instead brought a flurry of litigation pursuant to rules they claim are already clear. “Crypto markets suffer from a lack of regulatory compliance,” SEC Commissioner Gary Gensler stated during an April 2023 hearing before Congress, “not a lack of regulatory clarity.”

No matter one’s position on how crypto is or ought to be regulated, the SEC seems unlikely to abandon its current preference for litigating such questions. Market participants might prefer formal SEC guidance or new legislation, but recent SEC actions against Coinbase, Binance, Kraken, Genesis, Gemini, and others suggest that the Commission is seeking to define SEC jurisdiction over digital assets as aggressively as courts will allow. In June 2023 remarks, former SEC Chairman Jay Clayton criticized the SEC’s current position, which he summarized as: “If we’re not losing cases, if we’re not getting pushed back on by the courts, we’re not doing enough.”

An SEC win in the Coinbase litigation could grant the SEC expansive jurisdiction over the services provided by cryptocurrency exchanges. Moreover, the impact of this litigation is likely to reverberate far beyond just crypto exchanges. A finding that Coinbase’s staking services are “investment contracts,” for example, and therefore regulated securities, could increase the likelihood that the SEC also will pursue similar claims against the cryptocurrency issuers that offer unregistered staking programs. Conversely, a win by Coinbase on the basis of its interpretation of Howey and the application of the major questions doctrine would be a major setback for the SEC, potentially depriving it of its most effective tool in regulating digital assets. In that event, and without new legislation by Congress, much of the spot digital assets industry would be largely unregulated.

Conclusion
While the United States has yet to adopt a comprehensive regulatory and enforcement framework for digital assets, the SEC is aggressively pursuing litigation against unregulated market participants that the SEC believes put U.S. investors at risk. Crypto issuers, exchanges, and other industry players may hope for more guidance from the SEC and Congress, but in the near term, further litigation seems more likely.

^{[1]   In the U.S. Senate, Senators Cynthia Lummis (R-Wyoming) and Kirsten Gillibrand (D-New York) are crafting bipartisan legislation that would create a broad regulatory framework for digital assets and give the CFTC the bulk of the responsibility for oversight. Senator Debbie Stabenow (D-Michigan) has introduced another bill that would grant the CFTC broad jurisdiction over digital assets and trading platforms. In the U.S. House of Representatives, a bipartisan group has introduced legislation that would allow for the regulation of digital commodity exchanges by the CFTC and establishes conditions for the sale of digital commodities and the registration of exchanges, among other requirements. These bills overlap but do not fully align. Moreover, they are just three of over fifty bills and resolutions introduced so far in Congress that relate to the regulation of digital assets.}

^{[2]   See Coinbase, Petition for Rulemaking – Digital Asset Securities Regulation (July 21, 2022) (requesting that the SEC “propose and adopt rules to govern the regulation of securities that are offered and traded via digitally native methods, including potential rules to identify which digital assets are securities”).}