Why The SEC’s Coinbase Lawsuit Is Great For Bitcoin (BTC-USD)

Thesis

The SEC’s lawsuits could cause serious long-term damage to exchanges including Coinbase (NASDAQ:COIN) and Binance (BNB-USD), as well as many alt-coins including Cardano (ADA-USD), Solana (SOL-USD) and Polygon (MATIC-USD). However, Bitcoin (BTC-USD) can likely emerge from the drama with an improved long-term outlook and wider moat because the SEC has made it clear that it considers Bitcoin a commodity (and thus outside its regulatory scope).

The SEC’s Argument

The SEC sued Coinbase, claiming that Coinbase is operating as a securities broker (e.g., Charles Schwab), exchange (e.g., NYSE), and clearinghouse (e.g., NYSE) but has not registered as any of them. Registration is legally mandated and would enforce requirements such as record keeping and inspection that would allow the SEC to better safeguard investors against potentially illegal/harmful operations.

The SEC’s lawsuit against Binance is more damning, essentially accusing them of alleged price manipulation, but I won’t cover this lawsuit further since the impact is mostly on Binance and is unlikely to change long-term regulatory practices for other cryptocurrency exchanges/tokens.

Coinbase’s Argument

Coinbase argues that the SEC’s current guidelines are not complete enough to allow Coinbase to properly register with the SEC.

A critical part of their argument is that they only list cryptocurrencies which are commodities rather than securities (commodities and currencies are regulated by the Commodity Futures Trading Commission instead of the SEC).

The definition of a security was determined by a 1946 Supreme Court ruling, which requires a security to involve all of:

1. An investment of money.
2. In a common enterprise.
3. With the expectation of profit.
4. To be derived from the efforts of others.

Coinbase argues that most cryptocurrencies don’t meet these requirements because they can function in a transparent and decentralized way. Cryptocurrencies typically allow peer-to-peer transactions, and all transactions are automatically recorded on a public blockchain. In other words, there is no expectation that profits will come from the efforts of others, so the 4th requirement fails. As their name implies, cryptocurrencies are more like currencies than securities.

Who’s Right? A Thought Experiment

There’s no doubt that Coinbase’s argument is correct for some cryptocurrencies, namely Bitcoin, which even the SEC concedes is a commodity.

But imagine a cryptocurrency that copied Bitcoin’s technical design, but was created and initially sold by a company selling smartphones, which promised to pay 2% of its profits every year to holders of this cryptocurrency.

While Coinbase would still be correct that this cryptocurrency could be bought and sold in a decentralized way with a record of transactions available on a public blockchain, there’s clearly an expectation of future profit to be derived from the smartphone company’s earnings. Investors should be protected (likely by the SEC) if the company fails to pay out its earnings as promised. In this case, I would argue that this theoretical cryptocurrency should be regulated as a security.

In reality, most cryptocurrencies are somewhere between Bitcoin and the theoretical currency described above, which arguably places them in a gray area between securities and commodities. That’s what makes this regulatory issue so difficult to solve, and I can’t say that I have a perfect solution to offer. Lawyers could – and likely will – argue for days about which cryptocurrencies are securities and whether Coinbase could realistically have registered properly with the SEC under its current guidelines.

Neither party is 100% right in my view; I think that some cryptocurrencies are securities, but not all of them. But, I do agree with Coinbase that this issue is complicated enough that is should be handled by an updated regulatory framework which at least mentions cryptocurrency explicitly. Many other countries have done this already with legislation like the EU’s MiCA. Hopefully this lawsuit will help to define that framework in the USA, and in doing so clarify when a cryptocurrency is a security.

Alt-Coins Under Fire

Coinbase offers 212 assets, and the SEC only explicitly called out 13 (6%) of them as securities: Solana, Cardano, Polygon, FileCoin (FIL-USD), Sandbox (SAND-USD), Axie Infinity (AXS-USD), Chiliz (CHZ-USD), Flow (FLOW-USD), Internet Computer (ICP-USD), Near (NEAR-USD), Voyager Token (VGX-USD), Dash (DASH-USD), and Nexo (NEXO-USD). They provided evidence such as these coins’ promotion and development by a management team and their use of initial coin offerings to raise funds.

I think it will be difficult for the SEC to argue that the current regulatory framework is clear enough that Coinbase could have identified these specific 13 offerings as securities, especially when Coinbase has already made a concerted effort to not list many other crypto assets which it believed may be securities.

Further, the SEC’s decision to only provide evidence that these 13 assets are securities arguably contradicts its prior claim that all cryptocurrencies besides Bitcoin are securities. There are alt-coins like Bitcoin Cash (BCH-USD) and Litecoin (LTC-USD) which are extremely similar to Bitcoin, and I think it will be very difficult to argue that these are securities when Bitcoin is not. So far, the SEC has not provided evidence to support this argument. Notably, the SEC’s claim also contradicts statements from fellow regulator CFTC, which has stated that it views Ethereum (ETH-USD) as a commodity.

When the dust settles, I hope that the more centralized alt-coins (likely including some of the ones flagged by the SEC) will ultimately be classified as securities. But I hope that less centralized alt-coins including Ethereum will be classified as commodities.

Centralized assets carry more risk of scams/rug pulls, which many alt-coins have taken advantage of, and in doing so harmed the entire crypto industry’s reputation. Centralized regulation of centralized assets helps prevent this, which makes it a good thing that has existed for a long time.

Of course, this doesn’t mean that all centralized alt-coins have been useless scams. For example, Polygon’s layer 2 on Ethereum has made transactions much more scalable, to the point where Ethereum developers were able to de-prioritize planned layer 1 scaling work. Similarly, Flow and its easy walletless onboarding has been critical to the launch and growth of NBA Top Shot and other sports NFT platforms. One unfortunate but necessary side effect of this lawsuit could be that these useful alt-coins end up facing stricter regulations and/or get de-listed from exchanges. On the other hand, they may re-examine their operating models to become less centralized, which would be a good outcome.

As described in previous sections, the question of exactly which alt-coins should be considered securities is difficult to solve. Personally, I wouldn’t want to hold the alt-coins the SEC flagged until the question of whether they’re securities is resolved in courts.

As for other alt-coins, many now carry the unfortunate risk that this lawsuit results in centralized regulation of decentralized alt-coins. That makes them higher risk but higher reward, which may be appealing to some investors. Personally, the only alt-coin that I’m comfortable holding while this lawsuit is pending is Ethereum, and even that carries some risk.

Coinbase’s Staking Mistakes

Another caveat in the lawsuit is Coinbase’s staking program, in which it stakes users’ cryptocurrencies in order to earn a percentage yield on them, and then returns this yield to users after taking a cut of about 25-35%. Staking has been a great way for people to earn a higher return on their crypto investments, and I think it’s great that Coinbase has made it easier to stake assets.

However, the SEC believes that Coinbase’s staking service itself is a security. In this case, I think the SEC actually has a strong argument because Coinbase is performing this service on behalf of users, and users expect to earn a profit. Note that this differs from users staking their assets themselves, in which case they’re securing a network and being compensated for their own work.

Personally, I fail to see how registering this service as a security would adversely impact the overall crypto space and I think it was a mis-step by Coinbase to not attempt registration of its staking service. One possible reason why they didn’t want to register is because they didn’t want to lose flexibility, for example, the ability to change their percentage cut at any point and the ability to lose users’ staked coins without consequence.

If Coinbase’s staking program is ruled a security and that ultimately makes the program less lucrative to investors, it could hurt all proof-of-stake coins including Ethereum (but notably excluding Bitcoin). Of course, this would also hurt Coinbase itself. The impact on investors is mixed, since it would make coins harder – but ultimately safer – to stake.

Bitcoin: The Biggest Winner

It’s difficult to find many winners from this lawsuit at this point. As the previous sections highlighted, Coinbase and other exchanges may be forced to remove or update some offerings, including their staking programs. And all cryptocurrencies besides Bitcoin are now at risk of being regulated by the SEC as securities, although I do expect some alt-coins to be classified as commodities when the lawsuit is resolved. User and investor sentiment across the industry has also been harmed by the lawsuit.

Even the SEC doesn’t come off as great here. They look incompetent in light of their inconsistent statements about which cryptocurrencies are securities, poor communication leading up to this lawsuit, and the fact that they failed to act before FTX collapsed. The SEC’s communication is so comically poor that they’re being represented as trying to kill crypto to protect the US Dollar, when their approach is actually pro-Bitcoin (the crypto that’s closest to replacing the US Dollar as the global reserve currency).

Even without knowing the outcome of the lawsuit, one clear winner is Bitcoin. The SEC has already stated that they view Bitcoin as a commodity, so even if they win the lawsuit, Bitcoin can still be listed on Coinbase and won’t be regulated by the SEC. This would essentially give it a regulatory moat. Meanwhile, a victory for Coinbase would continue business as usual for Bitcoin and the rest of the industry, but with significantly less regulatory concern weighing down the entire industry. Bitcoin also doesn’t rely on staking and isn’t impacted by the staking part of the lawsuit.

A more neutral verdict (which is what I’m hoping for), would be still good for Bitcoin for the aforementioned reasons. It would also be good for alt-coins which are sufficiently decentralized.

For balance, some risks to Bitcoin should be noted. First, there’s the risk that a prolonged lawsuit harms sentiment in this sentiment-driven industry and drags Bitcoin down with everyone else, at least in the short term. Further, a (very unlikely) bankruptcy of Coinbase caused by the lawsuit could also make it more difficult to buy Bitcoin and increase short-term selling pressure during liquidation.

Conclusion

Overall, the SEC’s lawsuit against Coinbase will have a complicated and mixed impact on the overall crypto industry.

But it should be good for Bitcoin in the long term. Bitcoin stands to gain from this lawsuit through market share increases, a potential regulatory moat, greater regulatory clarity, and (eventually) improved sentiment.

As a result, I’m upgrading my rating for Bitcoin to Strong Buy from Buy.

Editor’s Note: This article covers one or more microcap stocks. Please be aware of the risks associated with these stocks.