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The United States Securities and Exchange Commission (SEC) has recently taken a number of actions against high-profile crypto companies. This includes Kraken, one of the largest crypto exchanges operating in the country, as well as Paxos. Paxos is the issuer of the BUSD – Binance USD stablecoin. In 2023, the SEC has included regulating the crypto markets as its priority. The current crackdown can have a large effect on the crypto industry as a whole. Here is a breakdown of these important events as well as their potential impacts:
SEC and Kraken settle on $30 million suit over staking
Towards the beginning of February 2023, the SEC served Kraken a suit over its staking program. Staking allows users of the Kraken platform to pool their crypto together, in order to receive new tokens. The tokens were received from the blockchain validators. According to the SEC, the firm provided its clients with access to unlicensed securities. In the United States, whether a financial product falls within the definition of a security is determined using the Howey test. If it satisfies the test, the issuer of the instrument needs to follow the regulation of the This test classifies a financial instrument as a security if it fulfils four conditions.
First off, the instrument needs to be an investment of money. While the term money is loosely defined, it does encompass cryptocurrencies, as defined by the SEC. Secondly, it needs to be in a common enterprise, between various different investors. Next, there has to be a reasonable expectation of profits. Kraken met this criteria with a fixed rate for staking. Finally, the profit needed to be derived from the efforts of others – in this case, the blockchain validators. This is how the SEC built its case that Kraken was issuing unlicensed securities via its staking program.
The company settled with the regulatory body for the sum of $30 million. It has also agreed to end its staking services in the States. The implications of this settlement are quite far reaching. Nowadays, staking is very popular, and this settlement means it is possible for the industry to be facing a serious threat. Notably, the Ethereum proof-of-stake chain, which replaced the proof-of-work chain in 2022 is likely to be classified as a security as well. On the day of Kraken’s settlement, the price of the ETH token fell by 9%.
This means a set of new risk disclosures will most likely have to be adopted for digital assets. In fact, the lack of proper risk disclosures is exactly why the SEC sued Kraken in the first place! The penalties for violations will be quite severe, as this lawsuit has demonstrated. In the coming years, it is possible for crypto companies to change their approach to advertising to their clients in the United States, following this decision.
Paxos, Binance under fire by US regulators
Aside from targeting staking, the SEC seems to have aimed at the stablecoin markets as well. A stablecoin is essentially a token which has its value pegged to a FIAT asset. Most stablecoins are pegged to the USD and exchange at a rate of around 1:1 with it. According to the regulator, they also fall within the notion of a security. And again, that was done via the Howey test we mentioned above. However, in the case of stablecoins it is not as clear whether they meet the four criteria, and the legal qualification of them as securities is not as clear-cut.
For instance, if stablecoins are pegged to the dollar, is there a “reasonable expectation for profit”? And can holding stablecoins be said to be a “common enterprise”, if they are held by individuals? At any rate, that still remains to be seen. It is possible for this debate to be settled in court, as the SEC is threatening Paxos with a lawsuit. The company claimed the SEC served it with a Wells Notice – a document stating coming legal action from the regulator.
Once again, Paxos is the issuer of the BUSD token, associated with Binance. The connection between the two firms is tenuous, and it is unclear to what degree Binance has control over Paxos. The regulator claims that the firm is not disclosing the risks associated with the assets properly – the same complaint as it had about staking.
But the possible action from the SEC does not end the troubles the company is facing. Less than a day after the indication of the possible lawsuit, the New York Department of Financial Services has ordered Paxos to stop issuing BUSD tokens. The regulator issued an investor warning against the company, stating there had been issues regarding the relationship between it and Binance. In the wake of the FTX collapse, the connections between the various players on the crypto market are taken a lot more seriously.
Binance itself is also a rather controversial firm. There have been persistent criticisms of the company. It does not really state where its headquarters is, for instance. That would significant difficulty in litigating against the firm. More recently, it was revealed that Binance CEO Changpeng Zhao (CZ) had moved large sums of money between Binance’s US branch and a firm called Merit Peak, which is listed with him as the CEO. Reuters reports that in the first three months of 2021, over $400 million were moved that way.
According to Reuters, this reveals the possibility that Binance US is also controlled by the CEO of the international Binance, even though the two are supposedly not connected. The US branch of the firm is licensed domestically and complies with domestic regulation, while the other does not. The US company has denied the allegations. Its representatives have stated to Reuters that the only thing in common between the two firms is their names – and that no funds are transferred back and forth between them.
There has been a probe into the relationship between the two by the US authorities as well, aiming to determine if any financial regulation has been breached by the firms. On February 15, CZ told The Wall Street Journal that Binance expects that it will settle in a possible suit over breaches of compliance.
The consequences of the actions against Paxos
In response to the warning from the New York regulator, Paxos has stated that it will stop issuing new BUSD tokens on February 21, 2023. The firm also stated it will end its relationship with Binance, as to quell any suspicion that there is collusion between the two like there was between Alamada and FTX. Time will tell if that is enough to avoid the collapse of another crypto giant. However, the effects of these enforcement actions are already present for the BUSD market, and crypto as a whole. Following them, the market cap of the crypto market has dropped below $1 trillion for the first time in three weeks.
And the market cap of the BUSD token has also shrunk. In a tweet, (CZ) has stated that it has dropped by $2.45 within a well. The outflow is caused by clients of the firm redeeming their tokens and exchanging them for other stablecoins. This has led to an increase in the market cap of Tether – the largest stablecoin.
Are stablecoins and staking under the jurisdiction of the SEC in the first place?
At the time of writing, it is unclear whether stablecoins and staking can be determined to be securities in the first place. That is why the recent actions of the SEC have drawn some ire – seen by some as a “power grab”, and the regulator seeking to expand its jurisdiction. The criticism comes from inside the SEC as well. Its Commissioner Hester Pierce dissented to the action. She stated that staking as a service was too diverse to be effectively regulated by the Howey test itself.
She further claimed that the market would be harmed by the actions of the regulator, as it would be difficult for the firms to gain the appropriate licenses to issue securities in the current crypto market. Others support the crackdown, on the other hand. In 2022, there were several large profile collapses. The US White House published a memo in January 2023, highlighting the need to introduce regulation into the market, and to increase the powers of bodies like the SEC to prevent losses for investors.
Regardless, whether the SEC has jurisdiction over the two instruments is very likely to be determined in 2023. That is because the decision of a previous lawsuit is expected in the first half of the year. The suit in question is against Ripple Labs. It is focused on the XRP token, and whether that can be considered a security. The verdict will be very impactful for the markets and the actions that the regulator will take in the future. If the court sides with it, that means most companies that offer the assets will have to register as securities issuers if they wish to operate in the United States.
Other US regulatory actions from 2023
Two months in, 2023 has already proven to be quite intense for crypto firms. It seems the US government has changed its sentiment towards the market, and seeks to introduce much stricter rules. In January, banks were encouraged to stay away from it by a joint warning by the Federal Reserve, the Office of the Comptroller of the Currency, the Federal Deposit Insurance Corp.. The three bodies warned of the risks associated with the volatile assets.
According to them, banks holding a large amount of digital assets could lead to uncontrollable risks that should not spread to the banking system. They fear a contagion from large bankruptcies like the FXT one. Following that, the Federal Reserve denied a crypto bank, called Custoida, its application for a membership. The bank is a settlement agent for many large crypto exchanges. It is the bridge they have to conventional payment systems, and liquidity in the USD. This is why The Federal Reserve also determined the anti money-laundering and terrorism prevention measures of the bank to be insufficient to be allowed membership. Custodia came out with a press release, in which it expressed disappointment with the denial and its intentions to sue over it.
In January, the Reserve also tightened its rules on banks and prohibited them to hold the majority of their assets in crypto. It also states that issuing stablecoins is possible only if the issuer is registered with the Office of the Comptroller of Currency, which regulates the banks in the country, which was not previously the case/