Attacking its own exchange? Analyzing the SEC’s lawsuit against Kraken in the United States

Intriguing Accusations A Deep Dive into the SEC's Legal Action Against Kraken on US Soil

Author: Wu Shuo Editorial Department

The U.S. Securities and Exchange Commission (SEC) has charged LianGuaiyward Inc. and LianGuaiyward Ventures Inc. (collectively known as Kraken) with operating Kraken’s cryptocurrency trading platform as an unregistered securities exchange, broker, dealer, and clearing agency.

According to the SEC complaint, since September 2018, Kraken has illegally facilitated the buying and selling of securities backed by cryptocurrencies, earning hundreds of millions of dollars. The SEC alleges that Kraken intermingled the functions of traditional exchanges, brokers, dealers, and clearing agencies without registering these functionalities with the commission as required by law. Kraken’s failure to register these functions deprived investors of important protections, including oversight by the SEC, recordkeeping requirements, and safeguards against conflicts of interest.

It is alleged that through its platform services, Kraken provides the following functionalities:

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• Providing a marketplace that brings together multiple buyers and sellers of securities orders through established non-discretionary methods, therefore operating as an exchange;
• Engaging in the business of executing securities transactions for Kraken client accounts, therefore operating as a broker;
• Engaging in the business of buying and selling securities for its own accounts without meeting applicable exemptions, therefore operating as a dealer;
• Acting as an intermediary in processing cryptocurrency-backed security transactions of Kraken clients and operating as a securities storage facility, therefore operating as a clearing agency.

The SEC complaint also alleges that Kraken’s business practices, inadequate internal controls, and poor recordkeeping practices have exposed its clients to a range of risks. According to the complaint, Kraken commingled client funds with its own funds, including using accounts holding client cash to pay for operating expenses. Kraken is also alleged to have commingled client cryptocurrencies with its own, which its own auditors deemed to be “a significant risk of loss to the client.”

“We charge Kraken with choosing to unlawfully profit in the hundreds of millions of dollars from investors instead of complying with securities laws. This decision resulted in a business model riddled with conflicts of interest and put investor funds at risk,” said Gurbir S. Grewal, Director of the SEC’s Enforcement Division. “Kraken’s choice to prioritize unlawful profits over investor protection is something we see frequently in this space, and today, we not only hold Kraken accountable for its misconduct but also send a message to others calling on them to comply.”

The SEC’s complaint, filed in federal court in San Francisco, alleges that Kraken violated the registration provisions of the Securities Exchange Act of 1934 and seeks injunctive relief, conduct-based injunctions, disgorgement of illegal profits and interest, as well as civil penalties.

In February of this year, Kraken agreed to cease offering or selling securities through its cryptocurrency lending program or staking program and pay a $30 million civil penalty.

The investigation by the U.S. Securities and Exchange Commission (SEC) was carried out by Elizabeth Goodie and Jenny B. Krasna of the Enforcement Division’s Cryptocurrency and Cyber Unit, with assistance from Peter Moors of the Boston Regional Office, under the guidance of Sachin Verma and Pasha Salimi. The investigation work was supervised by Paul Kim, George Tengler, and David Hersh of the Cryptocurrency and Cyber Unit. The SEC’s litigation will be led by Alex Johnson, Daniel Braun, and Moors, under the supervision of Douglas Miller, Olivia Choi, and Tengler.

Kraken’s Response

Response link:

Kraken continues to fight for its mission and crypto innovation in the United States

The U.S. Securities and Exchange Commission (SEC) has filed a lawsuit accusing Kraken of operating as an unregistered securities exchange, broker, and clearing agency. We strongly disagree with this and intend to vigorously defend our position in court. Today’s news will not affect the products we offer, and we will continue to serve our customers without interruption. Our commitment to our U.S. and global customers and partners remains unwavering.

The complaint against Kraken does not allege fraud, market manipulation, losses to customers due to hacking or security vulnerabilities, or any breach of fiduciary duty. Though large amounts are mentioned, it is not alleged that a single penny of these funds has been lost or misused – no Ponzi schemes, no failure to maintain adequate reserves, and no failure to keep customer funds separate. In fact, none of these scenarios are true.

Instead, the complaint presents a technical argument: that Kraken’s business requires a specific securities license to operate because the cryptocurrencies we support are, in fact, “investment contracts.” This is legally incorrect, factually inaccurate, and policy-wise disastrous.

We Disagree with the SEC, and the Law is on Our Side

The SEC has attempted this theory before and it was directly rejected by the courts. In that prior case, the SEC argued that the cryptocurrencies traded on the platform were, in fact, securities. However, the U.S. District Court for the Southern District of New York disagreed, ruling that the SEC failed to satisfy the relevant legal tests. The court found that the SEC’s unprecedented legal theory was contrary to the “economic reality” of these transactions. For the same reasons, the SEC’s case against Kraken will fail.

The SEC accuses Kraken of “commingling” its funds with customer funds. This is a similar accusation made against other cryptocurrency exchanges. The SEC has not and cannot allege any loss or harm to customer funds, nor does it allege that any loss will occur. The complaint itself acknowledges that the so-called “commingling” is just Kraken’s use of earned fees.

The SEC has a famous view that crypto asset trading platforms like Kraken only need to “register.” As most securities law experts know, there is currently no legal support for this stance. The SEC has not developed any rules to describe how crypto asset orders should be matched, provide guidance on how trades should be cleared, or propose standards for crypto asset transactions. This accusation is hollow; there are no exchanges, brokers, or clearinghouses for investment contracts. The SEC is demanding compliance with a non-existent system.

Congress is pushing bipartisan legislation

Meanwhile, bipartisan groups of lawmakers are questioning the SEC’s approach of “regulation through enforcement”. They are asking why the agency seems less concerned with “compliance and customer protection” actions against crypto companies and more focused on “orchestrating maximum publicity and political impact.” Others have observed that the SEC’s strategy “has not protected the public.” In fact, this lawsuit does nothing to protect the public. Like previous complaints, its allegations are factually incorrect, legally baseless, and a misguided way to make policy in the United States.

Congress is advancing bipartisan bills in both the House and Senate aimed at establishing clear registration and regulatory frameworks for centralized trading platforms. Congressional action, passed by elected lawmakers, not by enforcement agencies, is the correct path to create new laws for centralized cryptocurrency exchanges in the United States. As we continue to expand our global business and offer a diverse range of products, Kraken’s commitment to the U.S. market remains firm. We will continue to defend our spot market business, customers, and the cryptocurrency innovation community in the United States.

While some critics may assume that crypto asset trading platforms do not want to be regulated at all, that is not our position. In fact, Kraken has been in operation for over a decade and is registered, licensed, authorized, and approved in multiple countries and regions around the world, including the United States, the United Kingdom, the European Union, and Canada. We have always advocated for practical and effective rules for crypto assets. Our testimony to Congress in May highlighted Kraken’s commitment to strong, coordinated consumer protection and anti-money laundering practices in the United States.

Since our founding in 2011, we have tirelessly worked to ensure that U.S. consumers can safely access crypto asset technology aimed at creating a fairer and more inclusive financial system. Comprehensive congressional action is the right way forward, avoiding the United States falling behind through litigation as cryptography and Web3 advance globally.

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