Analysis-Coinbase, SEC on collision course for ‘existential’ clash over crypto industry

By Chris Prentice and Hannah Lang

NEW YORK/WASHINGTON (Reuters) -Coinbase debuted on the U.S. stock market on April 14, 2021 – the same day U.S. senators confirmed Gary Gensler to lead the Securities and Exchange Commission (SEC), the country’s top markets regulator.

Gensler, who has called the crypto sector a “Wild West” riddled with fraud, is now embroiled in a battle with the world’s largest publicly-traded crypto firm over a core debate: whether digital assets are investment contracts akin to stocks or bonds that should be regulated by the SEC.

Friction between crypto proponents and the regulator have been brewing under Gensler’s leadership, with both sides growing increasingly loud in their criticisms.

The escalating tension exploded into public view on Wednesday when Coinbase CEO Brian Armstrong and the company’s chief legal officer Paul Grewal posted online that the firm had been told that SEC staff intend to recommend enforcement action, adding that Coinbase was willing to fight it in court.

Coinbase shares have tumbled 12% since Wednesday’s disclosure.

SEC and Coinbase spokespeople declined to comment. For months, the two have been in discussions over regulation and the agency’s investigation into Coinbase, according to two sources.

In July, the firm disclosed an SEC probe into its asset listing processes, staking programs and yield-generating products.

Discussions between the SEC and Coinbase broke down in recent weeks, with one source saying the two sides had moved “further apart.” The SEC appears to be going after Coinbase’s entire business as operating outside of U.S. laws, the source said.

The crypto industry believes it operates in a regulatory gray area not governed by existing U.S. securities laws – and that new legislation is needed to regulate the industry.

“We continue to think rulemaking and legislation are better tools for defining the law for our industry than enforcement actions,” Coinbase’s Grewal said on Wednesday. “But if necessary, we welcome the opportunity for Coinbase and the broader crypto community to get clarity in court.”

Prior to Gensler’s arrival, the SEC engaged in targeted enforcement, but the Democratic chair has ratcheted up focus on crypto platforms themselves. The SEC’s crackdown on crypto gathered pace after November’s collapse of Sam Bankman-Fried’s FTX exchange.

Gensler has raised questions over whether crypto firms rely on a business model that is fundamentally non-compliant with the law, adding that crypto intermediaries provide a range of functions, such as operating as an exchange, broker-dealer, clearing agent and custodian, that should be regulated by the SEC.

“This is probably existential for Coinbase,” said Joshua White, a finance professor at Vanderbilt University. “It’s perhaps existential for the industry, at least in the U.S.”

The SEC on Thursday issued an investor alert warning that firms offering crypto asset securities may not be complying with U.S. laws.

Kristin Smith, the CEO of the Blockchain Association, voiced the crypto industry association’s support for Coinbase, noting: “The SEC doesn’t make the law – it only makes allegations, which ultimately must be tested in the courts.”

The SEC has gone to court against many crypto firms, including a case against San Francisco-based crypto and cross-border payments company Ripple Labs Inc that some say could offer clarity on when a digital asset is considered a security.

But the SEC and Coinbase debate over an “unspecified portion” of its listed digital assets sets the stage for a more expansive and potentially defining courtroom battle. Coinbase’s website lists over 150 crypto assets for trading.

Coinbase flagged potential regulatory risks when it filed to go public in 2021, and noted on Wednesday that its staking and exchange services are “largely unchanged” since then.

“There couldn’t be a more significant development for crypto markets and crypto investors,” said Philip Moustakis, former SEC enforcement lawyer and partner with Seward & Kissel LLP in New York.

(Reporting by Chris Prentice and Hannah Lang; editing by David Gaffen and Nick Zieminski)