Explain in detail the reaction and impact of the encryption market under the high-pressure supervision of the US SEC

Author: @jinzejiang0x0, LD Capital

Summary:

• The United States Securities and Exchange Commission (SEC) filed formal lawsuits against cryptocurrency exchanges Binance and Coinbase, which triggered a series of chain events such as a large-scale sell-off in the market and the delisting of tokens involving securities definitions;
• The SEC’s charges against Binance are more serious, including fraud, mixing assets across entities, and counterparty trading with customers;
• The market reacted violently to this. The prices of 18 tokens defined as "securities" by the SEC fell by an average of 28.8%, compared with a 7.4% drop for BTC over the same period. However, even after being sued by the SEC for the first time, the proportion of BNB’s market value even increased slightly, showing that its price is relatively resilient;
• This time, the token industry defined by the SEC as securities is mostly on the public chain, accounting for 13/18, followed by entertainment and metaverse, accounting for 4/18, and the latter has a larger decline;
• The report predicts the possible future scenarios of the SEC lawsuit, including possible legal impact and market reaction, and also discusses the progress of encryption industry legislation;
• The report summarizes precedents for crypto cases, including illegal token offerings and unregistered investment and wealth management cases.

The U.S. Securities and Exchange Commission (SEC) accused 19 tokens of being securities in nature in lawsuits against cryptocurrency exchanges Binance and Coinbase on June 5 and 6, respectively, sparking a sharp market-wide sell-off.

SEC charges

The SEC accused Coinbase of operating an unregistered stock exchange, brokerage, and clearing agency, as well as unregistering its encrypted asset pledge interest-earning service. But the charges against Binance are very different, and in addition to being accused of operating an unregistered stock exchange, broker, and clearing agent like CB, the SEC also accused it of more FTX-like activities: deception, mixing assets across entities, and collaborating with Customers conducted counterparty trades, and the SEC did not bring similar charges against Coinbase.

The SEC has warned financial markets that most encrypted digital assets are securities, a stance that could impose strict regulatory requirements on digital asset exchanges.

Since Gary Gensler was sworn in as SEC chairman in 2021, the industry has been predicting stricter cryptocurrency regulation. When Gensler was a professor of blockchain at the Massachusetts Institute of Technology, he mentioned that many cryptocurrencies are likely to be securities. Should be regulated by the SEC and subject to US government jurisdiction.

The SEC has already taken enforcement actions against some industrial companies and projects, such as Ripple Labs, LBRY, Kraken, Bittrex, etc. Looking at it now, it seems likely that the SEC will “practice” with small companies before taking action on the two largest exchanges.

Chain Reaction

These lawsuits and their aftermath have set off a ripple effect across the industry. In response to the SEC's action, Binance.US announced the suspension of USD deposits and withdrawals. Binance said the SEC’s challenges to its banking partners had disrupted access to fiat currency deposits and withdrawals.

Well-known brokerage firm Robinhood has decided to delist cryptocurrency tokens classified as unregistered securities by the SEC. After June 27th, tokens such as Cardano (ADA), Polygon (MATIC) and Solana (SOL) will no longer be supported on the platform. It purportedly held $583 million worth of MATIC, SOL, and ADA prior to the SEC’s action.

Crypto.com announced the closure of its institutional exchange, citing a lack of demand due to the U.S. market landscape. and regulatory scrutiny.

On June 16, Binance was under investigation by French authorities for suspected illegal provision of digital asset services and serious money laundering. On the same day, Binance also announced that it would withdraw from the Dutch market. Binance stated that it will stop providing services to users living in the Netherlands due to the inability to register in the Netherlands.

Changes in the market

Table 1: Brief introduction and price change comparison of tokens mentioned as possible securities in the SEC lawsuit in June. Source: Coinmarketcap, Coingecko, TrendResearch

Figure 1: The total market value of 18 tokens defined as "securities" by the SEC compared with the total market value of cryptocurrencies, Altcoins (excluding the total market value of BTC), and the total market value of Defi tokens in 2023. Source: Coinmarketcap, Coingecko, TrendResearch

Figure 2: The total market value of 18 types of tokens defined by the SEC as "securities" compared with the total market value of cryptocurrencies, the total market value excluding BTC, and the total market value of Defi tokens in 2022. Source: Coinmarketcap, Coingecko, TrendResearch

Figure 3: The total market value of 18 tokens defined as “securities” by the SEC compared with the market value of BTC and ETH. Source: Coinmarketcap, Coingecko, TrendResearch

Figure 4: Comparison of market value changes of 18 tokens defined as "securities" by the SEC. Source: Coinmarketcap, Coingecko, TrendResearch

We have counted the price changes of encrypted tokens mentioned by the SEC as securities in the past period of time this month. Except for BUSD, 18 named tokens can be seen:

Table 1 shows that the majority of public chains in the industry are 13/18, followed by entertainment and Metaverse 4/18, and asset management and lending 2/18;

Figure 4 shows that BNB has accounted for more than 50% of the total since the beginning of this year. Even though it was sued by the SEC for the first time, its market capitalization ratio has even increased slightly, showing that its price is relatively resilient; since the beginning of June, the price has fallen by an average of 28.8%, compared with the decline of BTC in the same period. 7.4%, it can be seen that the decline is very considerable;

Figure 3 shows that the peak market value of 18 tokens occurred in September 2021, when it exceeded 300 billion US dollars, and the market value trough occurred after the implementation of SEC regulation this month, which was only 70 billion US dollars;

Since the beginning of June, the top three decliners are FLOW (-37.1%) SAND (-37.4%) and CHZ (-35.0%). It seems that entertainment-related tokens have fallen too much;

Since the beginning of June, NEXO (-8.4%), ATOM (-21.1%), and BNB (-22.2%) have seen the smallest decline. NEXO has paid the fine and settled with the SEC at the beginning of the year, so it has been the least affected, and BNB has received charges It is understandable that the market capitalization of the token with the largest market capitalization (close to 50 billion U.S. dollars before the fall) has low volatility, but the market capitalization of ATOM is only more than 3 billion, and the decline is limited, showing its resilience;

Since their respective price all-time highs, these tokens are down an average of 91%, with the smallest declines being BNB (-58.4%) MATIC (-78.6%) and ATOM (-81.0%), both BNB and ATOM have also fallen less since the beginning of June. Low currency, it can be seen that its price resilience has continuity;

Since their respective price historical highs, the biggest declines are ICP (-99.5%) FLOW (-99%) and FIL (-98.5%), of which ICP has only fallen by 5.6% this year, and FIL has a 14.6% increase. After the range adjustment, the momentum of price decline has slowed down;

Figure 1 shows that before the regulatory event in June, the performance of 18 tokens lagged behind the market in 2023, and after the regulatory event, the lagging range expanded and all gains were lost during the year and turned down;

Figure 2 shows that since the timeline is extended to the beginning of 2022, the performance of 18 tokens still lags behind the market, but outperforms Defi tokens for most of 2022.

Figure 5: Rolling 30-day Beta of 18 tokens defined as “securities” by the SEC versus BTC+ETH. Source: Coinmarketcap, Coingecko, TrendResearch

Figure 6: Rolling 30-day correlation to BTC+ETH for 18 tokens defined as “securities” by the SEC. Source: Coinmarketcap, Coingecko, TrendResearch

Beta represents the systematic or market risk of a security token relative to a benchmark index. If Beta is greater than 1, the price volatility of the security token may exceed the benchmark index; if Beta is less than 1, the price volatility of the security token may be lower than the benchmark index.

From the perspective of rolling Beta values, the market value fluctuations of these "securities" token combinations are actually smaller than the blue-chip fluctuations based on BTC and ETH. This result is not surprising, mainly considering that under the decentralized configuration, each token is due to project factors. The ups and downs cycles of the stocks do not exactly coincide, which also depresses the Beta of the entire portfolio relative to the benchmark index.

From the data, we can see that the beta value and the correlation have obvious changes at different points in time, which may be related to market conditions, fundamentals of the token, or macroeconomic factors. When the Beta value is high, it indicates that the price changes of security tokens are more affected by the market. When the industry sentiment is extremely optimistic or pessimistic, both correlation and beta value tend to increase, which means that the utility of decentralized allocation is weakened.

On the whole, if the investment is weighted by market value, such a combination has not been as good as BTC and ETH in the past two years, showing that the price resilience of altcoins in the bear market is not as good as BTC and ETH.

What are securities?

Under U.S. rules, whether something is a security depends largely on whether it looks like shares issued in a company raising capital. The SEC currently mainly applies the Howey Test, which was decided by the Supreme Court in 1946. Under this framework, when an investor commits money with the intention of profiting from the efforts of the organization's leaders, the assets may be within the SEC's jurisdiction.

What are the implications of being defined as a security?

Calling tokens securities makes it more expensive and complicated to operate a cryptocurrency trading platform. According to US rules, this label has strict investor protection requirements for platforms and issuers. This means exchanges will face constant scrutiny from regulators, which could lead to penalties and, in the worst case, criminal offenses if criminal authorities are involved.

If a large number of cryptocurrencies were to be classified as securities, it would fundamentally change the way the cryptocurrency industry operates. First, compliance with securities laws has become critical, requiring these altcoins and their issuers to comply with strict regulatory requirements. This includes registering with the SEC, making required disclosures and complying with reporting obligations.

In addition, classification can lead to potential transaction restrictions. If most altcoins are considered securities, they can only be traded on registered stock exchanges subject to specific rules and regulations. This could limit the liquidity and accessibility of these assets for retail investors and introduce additional barriers to market participation.

For POS public chains like Polygon or BInance Smart Chain, wearing a securities hat will cause many problems, such as financial bookkeeping used by users to pay transaction fees, KYC of verifiers, taxation, and whether any DeFi applications on the chain are banned. legally authorized. These tags are arguably more damaging to the long-term health of the industry than the closure or withdrawal of several exchanges from the US market.

SEC Litigation Future Scenarios

The lawsuits against Binance and Coinbase reflect growing tensions between the government and the cryptocurrency industry. SEC Chairman Gary Gensler made it clear that no more digital currencies are needed, emphasizing that the United States already has a digital currency called the U.S. dollar. US Treasury Secretary Janet Yellen also expressed support for the SEC's actions, favoring the use of regulatory tools to protect consumers and investors. This reflects regulators taking a clearer stance against cryptocurrencies or becoming a bedrock principle of the traditional financial system.

In the future, we may see the following four trends:

• Supervision and law enforcement has expanded, and direct prosecutions have been initiated against more blockchain projects, especially public chains with large market capitalization. Recently, the SEC has mainly launched lawsuits against exchanges. Except for BUSD and NEXO, the SEC has not directly issued warnings or lawsuits for the 19 tokens mentioned in the relevant documents, which may indicate that there may be more enforcement actions in the future.
• Charges from civil to criminal. Charges may not yet come, as the SEC and CFTC have no authority to initiate criminal charges. Criminal charges against cryptocurrency exchanges or projects often involve fraud, money laundering, or other illegal activities. Such cases are typically handled by law enforcement agencies such as the FBI or the US Department of Justice. Last year, for example, the DoJ announced criminal charges against six defendants in four cryptocurrency issuance cases for alleged involvement in cryptocurrency-related fraud. Another example is Sam Bankman-Fried (SBF) involving 12 criminal charges in the case involving FTX and Alameda, including SBF conspiracy to commit bank fraud and conspiracy to operate an unlicensed money transmission business, as well as wire fraud against FTX customers, investment in FTX securities fraud and conspiracy to make illegal political contributions and defraud the Federal Election Commission. *SEC or Gensler's authority may be revoked. Many American politicians do not approve of the SEC's tough regulation.

For example:

U.S. Senator Bill Hagerty tweeted, “The SEC is using their role to wipe out an industry. Allowing a company (Coinbase) to go public and then preventing them from registering as a compliant exchange.”

U.S. Senator Cynthia Lummis also tweeted, “The SEC failed to provide a path to registration for digital asset exchanges, or even worse, failed to provide sufficient legal guidance to distinguish what is a security from what is a commodity .”

On June 16, two Republican representatives, Warren Davidson and Tom Emmer, proposed a bill called the "SEC Stabilization Act", which is intended to reshape the SEC and remove the current chairman Gary Gensler. The bill proposes to increase the number of SEC members, increase directors to oversee the committee, and prevent regulatory policy from being influenced by the SEC chairman's personal ideas or political struggles.

4. Legal see-saw or quick rectification fines. The sued team and individuals are actively responding to the lawsuit, and the legal tug-of-war may last for several years. For example, the lawsuit between Ripple and the SEC has continued since December 2020 and has not yet been resolved. Of course, if the accused team and individual quickly compromise, conduct business rectification and accept fines, the case may also be settled quickly. For example, Kraken and the SEC settled in less than one month earlier this year.

Progress in Encryption Industry Legislation

Congress may pass a legislative framework for cryptocurrency regulation that will provide clearer rules for the operation of cryptocurrencies and related businesses in the United States. This clarity is likely to spur further development and innovation in the industry. A draft legislation in the House Financial Services Committee, co-sponsored by Representatives Patrick McHenry and Glenn Thompson, is considered the most viable piece of legislation. The legislation seeks to clarify the agencies' jurisdiction over certain digital assets and "strike the right balance" between protecting consumers and encouraging responsible innovation.

The 162-page draft, published in early June, argues that digital assets that begin as securities could eventually be regulated as commodities. Whether it is a security or a commodity depends largely on how decentralized the underlying blockchain network is.

It proposes that if a network meets certain requirements, the network will be considered decentralized and commodity-eligible tokens will be regulated by the Commodity Futures Trading Commission (CFTC).

The specific judgments include that no one has unilaterally had the right to "control or substantially change" the function or operation of the network in the past 12 months, and no token issuer or affiliate has more than 20% of the currency holding ratio.

However, the draft bill is expected to face substantial opposition from congressional Democrats. SEC Chairman Gary Gensler and some Democrats argue that most digital assets should be classified as securities and that existing regulations are sufficient.

It’s unclear when the bill might enter Congress’ voting agenda, but the bill is an important step in the ongoing discussion on digital asset regulation.

Encryption case precedent

Ripple (XRP): In 2020, the SEC filed a lawsuit against Ripple Labs Inc. and two of its executives, alleging they conducted an unregistered securities offering worth $1.3 billion through a digital asset known as XRP. The SEC's claim is that while Ripple positions XRP as a cryptocurrency, its issuance process is closer to a traditional securities offering and therefore should be regulated by securities laws. This is the largest cryptocurrency-related lawsuit brought by the SEC to date. As of my knowledge base update (September 2021), this case is still ongoing and no final decision has been made.

Block.one (EOS): In 2019, the SEC announced a settlement with Block.one, which agreed to pay a $24 million fine to resolve SEC allegations that Block.one conducted EOS between 2017 and 2018 The initial coin offering (ICO) violated securities laws. This is an important case because it shows how the SEC can impose substantial fines on ICOs that violate securities laws.

Telegram (Grams): In 2020, the SEC successfully blocked Telegram’s Grams token offering. The SEC’s contention in the case is that Grams tokens are unregistered securities, and therefore their offering violates securities laws. Ultimately, Telegram agreed to pay the fine and refund investors.

Kik (Kin): In 2020, the SEC successfully brought a lawsuit against Kik Interactive Inc. for an unregistered offering of securities through a digital asset known as Kin. Kik eventually agreed to pay a $5 million fine to settle the SEC's charges.

BlockFi: The SEC believes that investors lending crypto assets to BlockFi in exchange for the promise of variable monthly interest payments provided by the company is a security under applicable law; cash) with more than 40% investment securities and not registering as an investment company is a violation of the registration requirements of the Investment Company Act of 1940. Ultimately, BlockFi will pay a $50 million fine directly to the SEC and pay another $50 million in fines to 32 US states to settle similar charges. The settlement represented the largest recorded fine imposed on a crypto company at the time.

NEXO: The SEC charged Nexo Capital with issuing and selling an unregistered retail cryptoasset lending product, the Earn Interest Product (EIP). On January 20, 2023, the encrypted lending platform Nexo reached a settlement with the SEC and state regulators, will pay a total of $45 million in fines and stop providing lending products. The SEC agreed to the settlement with Nexo after considering the company's expeditious remedial actions and the company's cooperation with the Commission staff.

Kraken: The SEC filed securities violation charges against the cryptocurrency exchange Kraken in February 2023, because of its opaque concerns about the interest-earning business of pledged tokens it provided. That month, the SEC reached a $30 million settlement with Kraken, and Kraken will cancel the "encryption pledge" plan that provides investment returns.

Encrypted interest-bearing business

U.S. regulation is not only aimed at areas related to the issuance and trading of security tokens, but also involves financial management services, such as BlockFi and NEXO mentioned above.

If a company provides a platform for users to store funds and pay certain interest, then this business model is closer to the deposit business of a bank or financial institution. In this case, the company needs to be registered and licensed as a bank or financial institution according to the local laws and regulations.

In the United States, such firms may need to obtain a license from the Federal Reserve System, the Federal Deposit Insurance Corporation (FDIC), the Office of the Comptroller of the Currency (OCC), or state banking regulators. These agencies oversee banks and financial institutions, ensuring that they operate in compliance with laws and regulations.

In other countries, companies may need to obtain a license from the appropriate banking and financial services regulators. In Europe, for example, this could include the European Central Bank and national banking supervisors in each country.

It should be noted that such a license usually needs to meet a series of requirements, including capital requirements, risk management requirements, corporate governance requirements, etc. Additionally, companies need to comply with regulations such as anti-money laundering (AML) and customer identity verification (KYC).

Is regulation obsolete?

Proponents of more regulation argue that the designation of securities will bring more information and transparency to investors due to applicable SEC disclosure requirements. But cryptocurrency lovers say their projects are somewhat decentralized, making the old rules inappropriate, with crypto trading platforms arguing that the assets they list should be treated as commodities, not securities. In the United States, the rules governing trading in commodities and their derivatives are more focused on ensuring that companies, producers and farmers can effectively hedge against commodity price volatility.

Despite heightened scrutiny from regulators, the crypto industry is still looking to Congress to finally pass new laws to legalize the industry. Last year, Democrats and Republicans introduced several bills that would bring cryptocurrencies under the jurisdiction of the Commodity Futures Trading Commission and make other products, including stablecoins, more legal by regulating the assets those products can hold.

Due to the unique properties of encrypted assets, which can contain multiple sources of value beyond traditional securities, it may be outdated to only use the securities regulatory framework ninety years ago for regulation.

Table 2: Classification of value sources of encrypted digital assets. Source: TrendResearch

Table 3: Cryptoassets previously defined as securities by the SEC in various lawsuits in June litigation documents. Source: SEC, Trend Research

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