How Recent SEC Action Against Cryptocurrency Lenders Could Signal Regulation for the Entire Crypto Market

How Recent SEC Action Against Cryptocurrency Lenders Could Signal Regulation for the Entire Crypto Market

Throughout 2021 the Securities and Exchange Commission (SEC) has had its eyes on cryptocurrencies, but as of yet has not taken any serious action that would impact the growing crypto market as a whole. As noted in our previous blog, the SEC has put out statements indicating that the leadership at the Commission believe that cryptocurrencies should be regulated by the Commission, and action has been taken against cryptocurrency operations that were fraudulent. The debate about whether cryptocurrencies can and should be regulated by the SEC comes down to the debate over whether cryptocurrencies can be classified as securities, in which case they could be regulated by the SEC, or if they fall into a different category. Despite statements by SEC Chairman Gary Gensler clearly indicating his belief that the SEC should regulate cryptocurrencies, such as when he said "To the extent that something is a security, the SEC has a lot of authority. And a lot of crypto tokens — I won’t call them cryptocurrencies for this moment — are indeed securities”, or when he compared the crypto market to the “Wild West”, Chairman Gensler has indicated that it would be up to Congress to make the final decision. This stance may be changing due to legal action being pursued against cryptocurrency lenders. 

Cryptocurrency lenders are companies that do exactly what the name implies – lend cryptocurrency, and charge interest rates on those loans. They also allow users to lend their own cryptocurrencies to the platform in exchange for interest payments of their own. Interest rates can be very high for loans, which has been attractive for investors. But there are also risks associated with the territory. Cryptocurrency investments are not insured by the FDIC, many of the purchases of cryptocurrencies are made using other cryptocurrencies and therefore are not as liquid an asset as other investments may be, and as the SEC has pointed out on multiple occasions, the market is not regulated. 

In September of 2021 the SEC threatened to sue one of the largest crypto exchanges, Coinbase, over their plans to launch a crypto lending program, eventually leading to the discontinuation of the program completely. Coinbase claimed that the SEC pointed to the Howey Test in their argument that the platform’s planned lending practices would constitute securities lending, which the SEC claimed would give them authority to regulate the practice. The Howey Test was developed in 1946 to determine whether something is a security by asking three questions:

  1. Is there an investment of money?
  2. Is it a common enterprise (meaning that money pooled together from multiple sources)?
  3. Is there an expectation of profit to be gained from the efforts of others?

Many legal experts have argued that according to this test crypto lending should be classified as a security, although there is still some debate. 

On January 26, 2022 it was reported that the SEC had launched an enforcement review on multiple other large cryptocurrency lenders. The review is still ongoing, and focuses on whether the companies’ offerings should be registered as securities. The case only involves crypto lenders, but because the SEC’s main argument revolves around the question of whether a cryptocurrency can be classified as a security, courts could set a precedent that could have implications beyond just crypto lenders. And the SEC is not alone in their legal concerns; six state attorneys general have also threatened lawsuits against lenders. Given Chairman Gensler’s previously referenced quote on the subject, a ruling in favor of the SEC could have major ramifications not just for the lenders in question but the entire crypto market. If the courts decide that cryptocurrencies are securities, then the SEC would theoretically have the right to regulate the crypto market. 

It could take a long time for the legal dispute against crypto lenders to be resolved, and even then it may not be in favor of the SEC’s argument. But if courts do end up setting the precedent that cryptocurrencies can be classified as securities, that would likely set the stage for the implementation of SEC regulations against not just lenders, but possibly all crypto market participants. What those regulations might look like is still unknown. The SEC has stated three main objectives when it comes to potential regulations: policing for fraud, implementation of disclosure requirements, and the ability to get a regulatory framework set up before the cryptocurrency market becomes so large that it could pose a systemic financial risk. It is still unknown what shape that regulatory framework would look like, but it is looking more likely that a framework will eventually be established.