As SEC brings charges against Binance and Coinbase, Consider these 3 red flags

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Last year, Bitcoin tumbled from its 2021 perch — and 2022 ended with the implosion of the cryptocurrency exchange FTX.

This week, the Securities and Exchange Commission sued two other major exchanges — Binance and Coinbase. Though the lawsuits contain different allegations, both contend the companies ran unregistered securities exchanges.

The SEC charged Binance, the world’s largest crypto exchange and founder Changpeng Zhao with mishandling customer funds, and illegally serving U.S. investors. The SEC also charged Coinbase, the only publicly-traded crypto exchange company, with illegally operating an unregistered securities exchange.

They both denied the charges.

A cloud of uncertainty hangs over the regulation of crypto exchanges, and has helped to push down cryptocurrency prices. Will this dissuade retail investors and scare off potential crypto investors?

“The future of crypto-asset regulation in the U.S. is not fully predictable,” said Yuliya Guseva, a law professor at Rutgers University and head of the school’s blockchain and fintech program.

Law professor cites three red flags

1. The SEC also alleges that Ripple Labs Inc., a San Francisco-based cryptocurrency payment company, sold unregistered securities with its native coin, XRP. In April, Ripple denied the SEC allegations that XRP has traded and used as a digital currency. Analysts are closely watching the outcome of this case — and await an answer to the question as to what and when digital assets are considered securities.

Ripple’s chief legal officer Stuart Alderoty, meanwhile, responded to the SEC’s allegations with the following statement: “Even if true, this only shows that the SEC’s unelected bureaucrats believe they have unchecked power to issue indiscriminate closed door edicts under pain of punishment to those who don’t blindly obey. We have crossed from regulation by enforcement to hubris most foul.”

2. As lawmakers introduce more bills, some analysts are wondering if Congress can cobble together some sort of statutory reform for crypto markets. The prospect of this happening is “highly improbable,” Guseva said. The SEC’s enforcement division “has been covering an ever-increasing swath of the crypto industry,” she noted.

3. The outcomes of the Binance and Coinbase cases are also of paramount importance.

Binance, Coinbase and Ripple fired back

Binance said in a blog post this week: “The SEC’s real intent here, instead, appears to be to make headlines.” The crypto exchange added: “All user assets on Binance and Binance-affiliate platforms, including Binance.US, are safe and secure, and we will vigorously defend against any allegations to the contrary.”

The SEC is asking a judge to grant a temporary restraining order that would freeze assets tied to Binance.US. A hearing on the motion is scheduled for Tuesday in Washington D.C. District Court, according to the case’s court docket.

The SEC is asking a judge to grant a temporary restraining order that would freeze assets tied to Binance.US.

Paul Grewal, Coinbase’s chief legal officer and general counsel, said this week that “the SEC’s reliance on an enforcement-only approach in the absence of clear rules for the digital-asset industry is hurting America’s economic competitiveness, and companies like Coinbase that have a demonstrated commitment to compliance.”

Legislation, instead of litigation, is the solution, he said. “In the meantime, we’ll continue to operate our business as usual,” Grewal added.

Rutgers law professor Guseva said the outcome of the Ripple case is also crucial. “There is a progression of SEC enforcement actions,” she said. “The SEC started with primary markets, namely unregistered [initial coin offerings].”

“Ripple is one of the last cases of this generation,” Guseva added. “The primary question in these cases is whether crypto assets are securities. The outcome of the Ripple litigation, therefore, will be a major win or loss for the SEC.”

What does the SEC want to happen?

SEC lawyers want to claw back alleged “ill-gotten gains” from Binance and Coinbase, court papers say.

But the government is not after users’ money and assets, said Oleg Elkhunovich, a partner at Susman Godfrey. “Disgorgement is a remedy that goes after improperly-gotten gains. Those would not be user assets. User assets should be separated,” he said.

The SEC complaint is alleging Changpeng Zhao, Binance’s founder known as “CZ”, controlled customer assets and commingled them with personal holdings and company holdings.

The SEC is also pressing for the court to appoint a receiver, usually a lawyer or third party who would take over control of the company. If the court agrees, the extent of that control will depend on the judge’s order, Elkhunovich said.

For Binance and Coinbase, however, the disgorgement attempt is serious, Guseva said. “This is a massive remedy that may destroy companies.”

FTX is in bankruptcy proceedings and while its co-founder and former CEO, Sam Bankman-Fried, has pleaded not guilty to criminal charges. Bankman-Fried is facing charges including fraud and conspiracy. The trial is scheduled to start in October.

What do these lawsuits mean for crypto?

The lawsuits do not present “existential risks” to crypto prices, according to some analysts. For example, Bitcoin prices had an initial plunge after news of the Binance lawsuit, but the price has largely rebounded to where it was.

Bitcoin
BTCUSD,
+0.94%

was over $26,300 and ethereum
ETHUSD,
+0.89%

was over $1,800 on Thursday morning. Exchanged-traded funds focused on bitcoin have dropped lower for the week.

The SEC actions have sowed “even more doubt” from people eyeing cryptocurrency as a potential investment, said Shabana Nathoo, a principal at Navigo Wealth Management in Southlake, Texas.

When clients have asked about crypto investments, “I’ve always made the caveat this is a new innovative idea and I would not put more than you can afford to lose.” Nathoo’s rule of thumb: It should be less than 1% of their net worth.

Coinbase
COIN,
-2.95%

shares are down 15% in the last five trading days, but are up more than 52% year-to-date. The Dow Jones Industrial Average
DJIA,
+0.13%

is up 1.7% and the S&P 500
SPX,
+0.11%

is up more than 11% from the start of the year.

Who exactly is investing in cryptocurrency?

The sharp 2022 downturn for cryptocurrencies may have spooked some, but crypto isn’t a fringe investment – especially for younger investors.

Just over half of people aged 18 to 25 who invested said they were primarily invested in cryptocurrencies, according to recent research from the FINRA Investor Education Foundation and the CFA Institute.

For comparison, 41% of these Generation Z investors said they owned individual stocks and 35% said they owned mutual funds.

A different poll also shows crypto’s presence. Some 22% of people said they owned some form of cryptocurrency as of April, according to Morning Consult. That’s up from 19% in January.

In the wake of the Coinbase lawsuit, Brian Armstrong, the exchange’s CEO and co-founder made the same point about the risks for cryptocurrency.

“I always tell people the same thing: Don’t invest money you are unwilling to lose,” he said in a CNBC interview on Wednesday. “This is a new field of technology. It’s one of the most important technology fields in the world. But don’t speculate with assets that you are unwilling to lose.”

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