Coinbase Wells Notice

On March 22nd, Brian Armstrong posted a tweet announcing that the SEC had issued a Wells Notice to Coinbase regarding staking and asset listings. A Wells Notice is a letter indicating that the SEC intends to take enforcement action against a person or firm following an investigation. This notice suggests that the SEC's staff has made an initial decision to recommend enforcement action against the firm for alleged violations of federal Exchange and Securities Act regulations. Several aspects of Coinbase's business are under the regulatory microscope, including digital asset listing, staking services, institutional custody and trading solutions, and self-custodial wallets.

While specific details about the investigation are not yet available, the broad scope of products under scrutiny is cause for concern. Although Coinbase has not received explicit information on which cryptocurrencies the SEC considers securities, it is likely that digital assets mentioned in SEC v. Wahi, such as Rari and Ampleforth governance tokens, are included.

Coinbase's attempts to modify the terms of service for its Earn platform have not appeased regulators. It appears that the SEC may be focusing on "pooled" rewards models and could potentially seek to impose fines on Coinbase for past misconduct. A more alarming scenario involves the SEC attempting to classify staking as a security, with the intention of setting a legal precedent in court.

Interestingly, the Wells notice lists Coinbase Prime and Coinbase Wallet as products under investigation. This is the first instance of a regulatory inquiry targeting a licensed institutional custody solution and a smart contract wallet. If Coinbase fails to defend these products in court, it could result in further obstacles for both institutional and retail access to cryptocurrency markets.

All products under investigation were included in Coinbase's Form S-1 registration filing with the SEC, a necessary step for listing a publicly traded company in the United States. The reason behind the SEC's sudden decision to raise questions remains unclear. If the SEC succeeds in its case against Coinbase, it could establish a harmful precedent and hinder cryptocurrency adoption in the US. The outcome of this case will undoubtedly have far-reaching implications for the future of the cryptocurrency industry and its regulation.

Brian noted that the SEC had thoroughly reviewed Coinbase's business prior to its IPO and that the S1 document provided extensive information on the company's asset listing process, with 57 references to staking. He expressed his expectation that the upcoming process will be fair and open and that Coinbase will have the opportunity to demonstrate that the SEC's engagement on digital assets has not been reasonable, fair, or serious.

The Coinbase team has stated that they plan to defend the rule of law by taking the issue to court. This legal battle will have significant implications for the future of cryptocurrency in the United States.

Coinbase generated ~$3 billion in 2022 and has 98 million users worldwide and nine million people actively exchange every month.

Binance and the CFTC

Binance holds a significant lead as the world's largest cryptocurrency exchange. Since its inception in 2017, the platform has experienced steady growth, with its remarkable rise to dominance becoming particularly evident in 2020. At that time, Binance claimed around 25% of the spot volume market share. Its market share then surged to nearly 50% during the final stages of the 2021 bull market before experiencing a temporary dip and eventually reaching an all-time high of over 70% this year. However, these numbers have come down after its stablecoin, BUSD, received legal scrutiny in 2023. We wrote about that here. Unfortunately, that wasn't the end of Binance's legal troubles.

Binance and its founder CZ have been sued by the US Commodity Futures Trading Commission (CFTC) for offering unregistered crypto derivatives products to US customers. Binance has reportedly been under investigation by multiple US agencies, including the CFTC, IRS, and federal prosecutors, for suspected violations of Anti-Money Laundering regulations and allowing US traders to access unregistered securities. The CFTC alleges that Binance has been engaging in unregistered trading activity in the US since 2017, despite publicly stating its intention to block or restrict US customers.

Binance is accused of using a complex web of corporate entities to obscure the ownership, control, and location of the platform and directing employees to use VPNs to spoof their locations. The CFTC also cites internal chats between Binance employees, including Samuel Lim, the exchange's Chief Compliance Officer. Despite the lawsuit, Binance has pledged to cooperate with regulators. This move comes as the US government continues to target major players in the crypto space in an effort to send a clear message.

Binance boasts approximately 670,000 users in the United States as of February 2023. The platform operates a dedicated website for the US market, Binance.US, which attracted around 2.18 million visitors during the same period. The recent lawsuit could potentially impact over half a million American retail crypto investors. As the legal battle with the CFTC unfolds, it remains uncertain whether Binance will retain its market share in the US, with the possibility of users opting for alternative exchanges.

This is not Binance’s first skirmish with regulators. The company has a long history of playing “fast and loose” with the rules. Binance has moved headquarters from country to country to avoid regulation, most recently seeming to indicate there is not a headquarters after Malta denied Binance under its jurisdiction, the last known location of Binance’s headquarters. This represents a regulatory risk as businesses must fall under some jurisdiction. It is unprecedented for a legitimate business not to submit to some regulation scheme.

Binance is currently under investigation by the U.S. Internal Revenue Service as well as the Department of Justice for money laundering as well as dealing with inquiries from the Commodity Futures Trading Commission (CFTC) over whether Binance allowed U.S. residents to trade on its exchange. It is important to note that of Q2 2022, "[t]he federal agencies haven’t accused Binance of wrongdoing." However, over the course of 2021, Binance hired a slew of high-profile individuals to join its regulatory advisory team, including former U.S. senator Max Baucus as a regulatory advisor and two former members of the Financial Action Task Force (FAFT) to its advisory team. Announced in July 2021, Binance is also seeking a new CEO, one with a regulatory background, to replace Changpeng Zhao (CZ). This change may have been spurred by the onslaught of recent regulatory backlash or that the US subsidiary of Binance is planning to IPO, most likely sometime in 2022.

Binance's legal issues are not isolated to the US. in 2020, Binance faced regulatory pushback in Europe for providing stock token trading on its exchange. Additionally, in June 2021, the UK's lead financial regulator announced that Binance's UK division is not permitted to conduct operations related to regulated financial activities in the country. This order followed a similar one from Japan, stating that Binance isn't registered to do business in the country. Binance's regulatory troubles again intensified in late July 2021 when Malaysia's Securities Commission ordered the company to cease operations in the country.

However, as of May 2022, Binance is officially a fully regulated digital asset service provider (DASP) in France. This regulatory breakthrough for the often "marooned" exchange makes Binance the first major global exchange to legally operate in France. A Digital Asset Service Provider (DASP) designation aligns with the Crypto-Asset Service Providers guidelines set forth by the EU commission under MiCa (Markets in Crypto Assets), a proposed regulatory framework for crypto businesses operating in the EU. The DASP designation permits Binance to custody digital assets, exchange digital assets for legal tender, and operate a trading exchange.

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