Published: April 26th, 2023
Coinbase made a formal legal move against America’s Securities and Exchange Commission (SEC) this week, taking action in a US Federal court to force the regulator to reply to an earlier request for clarity on the rules around crypto trading.
The world’s number two cryptocurrency exchange sent the SEC a ‘petition for rulemaking’ in July of 2022, which asked the US financial services watchdog to come up with new rules for digital assets, and definitions for those that qualify as securities. Part of the missive was a list of 50 questions the exchange says will provide ‘clarity and certainty’ to the way regulators in the US treat digital assets.
Coinbase wants the SEC to standardise and publish its classification methodology, which currently sees some tokens defined as securities while others are not. Other questions touch on issues such as trading crypto assets and asset custody.
The US Administrative Procedures Act requires the SEC (and other Federal agencies) to reply to petitions such as Coinbase’s within ‘a reasonable timeframe’. Now that nine months have passed without a response, Coinbase believes the watchdog has a responsibility to act.
The company argues that answering its questions and clarifying the rules related to digital assets would be beneficial for US capital markets and promote ongoing liquidity.
'In the United States right now there is no legally-defined market in digital assets. This is because crypto traders must conduct their affairs without a clear and practical regulatory regime,’ the petition says. ‘New rules that clarify how digital assets can be bought and sold would enable a more efficient capital allocation in American financial markets.’
The SEC is clearly interested in regulating the crypto space, though to date it has chosen baby steps over full stride. In January 2023 the agency warned American crypto firms operating in New York State that they would need to manage their customers' digital assets with greater care.
In the wake of the still-unfolding FTX scandal, the New York Department of Financial Services (NYDFS) published an open letter to the industry outlining how investor assets should be kept separate from company funds. The letter also included guidelines for custodians, and explained the necessary disclosures that firms need to make when keeping custody of digital assets for clients is part of their business model.
NYDFS took the action as federal prosecutors apply more scrutiny to collapsed crypto trading exchange FTX and its controversial founder Sam Bankman-Fried. Bankman-Fried, or ‘SBF’ as he is known colloquially, is accused of misusing billions of dollars in customer assets and funneling them from the exchange to fund dodgy trades at his recently shuttered hedge fund.
‘As stewards of customer assets, crypto companies that act as custodians need to have rigorous processes in place that follow those relied on by traditional financial services firms,’ the NYDFS letter said.
The role of asset custodians in finance is to ‘hold on’ to customer assets for safe keeping. They could be funds, bonds, equities, or cryptocurrencies. In all cases custody has to be executed in a secure and transparent manner.
The new NYDFS guidelines are even more specific and provide detailed guidance on how digital assets should be handled.
Crucially, the agency said custodians must keep customers’ digital assets completely separate from any assets that belong to the custodian itself. In crypto terms this could mean recording the assets both on-chain and on the custodian’s own books, but maintaining appropriate records to avoid double counting.
The agency also said that assets under a custodian’s control should only be held for the purpose of safekeeping. Specifically, there should not be a debtor-creditor relationship between custodian and customer when possession of a digital asset is transferred.
Custodians in New York are also required to give customers written disclosures that clarify what the custodial arrangement means and how the custodian operates. Disclosures should explain how the custodian ‘segregates and accounts for and digital currency held in custody,’ and clarify the customer's ‘retained property interest in it.’
Back in July 2022 the Financial Stability Board (FSB), a G20 entity charged with monitoring financial activity in the world’s top-20 economies, announced a coming proposal that will lay out new 'robust regulation and supervision’ for cryptocurrencies.
A report scheduled for October will be shared with G20 finance ministers with a proposed set of new rules to govern and supervise crypto assets, including so-called stablecoins.
An FSB press release said that digital currencies are evolving rapidly in a tumultuous environment marked by extreme volatility. 'Despite these worries, cryptocurrencies are becoming increasingly integrated into the traditional financial system, exposing investors to new risks.’
The FSB is worried, it says, about the potential for one market failure to negatively impact participants in the wider crypto ecosystem. ‘Investors can suffer huge losses while risks are transmitted to other parts of the system and market confidence is damaged.’
Crypto market watchers saw this as a veiled reference to Terra’s dramatic failure in early May of 2022. The collapse of the Terra ecosystem triggered a liquidity crisis and sent several well-known crypto finance firms and hedge funds into bankruptcy.
Though the organization monitors the financial services industry closely, the October crypto proposal will mark a new chapter for the FSB. Up until now it has played a background advisory role, and any recommendations to G20 ministers and bankers have been made outside the public sphere.
In May 2022, pro-crypto Portugal became the latest country to reboot its financial services rules and clamp down on crypto activity. The shift from pro-crypto to crypto-curious is significant, since Portugal had become a haven for blockchain and crypto innovation.
All that changed when the country's finance ministry did an about-face and announced that all crypto assets in the country would be subject to capital gains taxes.