Why SEC Chairman Gary Gensler is Cracking Down on the Crypto Market: Latest Speech

Reasons behind SEC Chairman Gensler's Crypto Market Crackdown: Key Points from Recent Speech.

SEC Chairman Gary Gensler spoke at the Piper Sandler Global Exchange and FinTech Conference on June 8th, once again emphasizing the importance of regulation, from signing securities laws to Howey tests, and citing a series of SEC enforcement actions against the crypto market, emphasizing that the crypto securities market should not be allowed to undermine public trust in the capital market. The cryptocurrency market should not be allowed to harm investors. He also pointed out that the regulation is now clear, and issuers, broker-dealers, and exchanges should know exactly how to comply. This is not a problem of insufficient guidance, but exchanges just don’t want to follow what they are told by regulators.

Below is the full text of the speech, translated by BlockingNews:

A Well-Regulated Market

I want to focus on an area that I think sits at the intersection of the two things emphasized in the title of this conference – exchanges and fintech – and that is crypto.

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The reason the U.S. capital markets have flourished is because since the Securities Act of 1933 was signed, we’ve spent 90 years developing a road of rules that help ensure investor protection, transparency, and competition. A year after the law was signed, President Roosevelt and Congress passed the 1934 Securities Exchange Act to regulate securities intermediaries like exchanges and broker-dealers. The law also created the U.S. Securities and Exchange Commission, which celebrated its 89th birthday last Tuesday.

Crypto Securities

There’s no sign that investors and issuers in the crypto securities market should not be protected by our securities laws.

Congress could have said in 1933 or 1934 that the securities laws only apply to stocks and bonds.

“The purpose of Congress in enacting the securities laws was to regulate investments, whatever form they might take, and whatever name they might be given.” This is more than just a talking point. As Justice Thurgood Marshall wrote in the Supreme Court’s famous Reves decision, this is the law of this land.

Congress listed over 30 items in the definition of a security, including the term “investment contract.”

As the Supreme Court explained in another famous decision, SEC v. W.J. Howey Co., an investment contract exists when funds are invested in a common enterprise with a reasonable expectation of profits to come from the efforts of others. This test has been reiterated by the Supreme Court numerous times – most recently in 2019 citing the Howey test.

In the Howey case, the court stated that the definition of an investment contract “embodies a flexible rather than a static principle, one that is capable of adaptation to meet the countless and variable schemes devised by those who seek the use of the money of others on the promise of profits.” As I have said many times, the vast majority of crypto tokens meet the test for investment contracts. Disliking this fact and not receiving it are two different things.

These tokens are promoted by teams through websites and Twitter accounts. Investors may even meet the founders. These tokens do not come out of nowhere. They do not grow out of the ground like corn or wheat. While they are digital, they cannot be distinguished from the large capital markets where securities and currencies have already been digitized.

Satoshi Nakamoto’s innovation has driven the development of crypto assets and underlying blockchain ledger technologies. However, regardless of the ledger used, whether it is a spreadsheet, database, or blockchain technology, the economic reality of the investment is most important when investors put their funds at risk.

Therefore, crypto securities issuers need to register their investment contract offers and sales with the US Securities and Exchange Commission or meet exemption requirements. For decades we have had rules about how issuers must do this. We have flexible rules for disclosures required in registration statements – Regulations S-K and S-X – and registration exemptions, including Regulations A or D.

We have also provided market participants with years of guidance on what constitutes or does not constitute a crypto asset security, including the DAO report in 2017 and the staff’s “Framework for ‘Investment Contract’ Analysis of Digital Assets” in 2019. More than 100 Commission orders, settlement agreements, and court decisions have also made it clear when the offer and sale of tokens is a securities transaction, including our actions against Telegram, LBRY, and Kik.

In fact, just this week, we alleged that Binance’s chief financial officer and chief compliance officer knew of the relevance of the Kik case to their own business. As we allege in our lawsuit against Binance, internal Binance communications demonstrate that its personnel were well aware that they needed to “begin preparing everything” in response to subpoenas and Wells notices related to Binance’s exchange token, BNB, including a “war chest” to prepare for the “battle.”

When market participants in the cryptocurrency space say on Twitter or television that they were not “reasonably notified” of their actions potentially being illegal, don’t believe them. They may have made an economic decision that weighed the enforcement risk as a cost of doing business.

Registration and compliance, as with other parts of the securities markets, need to play a role – something bond and stock issuers at this conference know well. But that is appropriate, because it is this work that ensures investors receive the comprehensive, fair and truthful disclosures they deserve.

Some issuers of cryptocurrency securities argue that their tokens have functionality beyond being investment instruments. However, as courts have made clear in cases like Telegram and others, some extra functionality does not remove a digital asset from the definition of a security under the investment contract test. Retail investors typically purchase these assets, at least in part, because of the issuers’ efforts to build profits.

Indeed, in the famous Howey test, the Supreme Court wrote that if the investment contract test is met, “the fact that an enterprise is speculative or non-speculative, or that a scheme involves a security or some other form of investment, is immaterial.” However, for tokens that are used specifically in the issuer’s blockchain ecosystem, staff is willing to provide a no-action letter.

Cryptocurrency Intermediaries

Given that most crypto tokens are subject to securities laws, most crypto intermediaries must also comply with securities laws.

Again, these laws have been on the books for decades. Sections 5, 15(a) and 17A(b) of the Exchange Act require intermediaries that act as exchanges, brokers and dealers, and clearing agencies for securities to comply with securities laws and to register or meet exemptions from registration.

Again, these crypto entities know the rules. As Binance’s chief compliance officer candidly told a colleague in 2018, “We are a U.S. securities exchange without a license.”

Registration is not just a process issue. Failing to register is not just a foot fault in a tennis match. It goes to the core of providing basic protections for retail investors and our markets.

This year, we have charged Beaxy, Bittrex, Binance and Coinbase separately with mixing and facilitating illegal securities offerings, among other things, without registering with the SEC. The Commission has taken settled actions against EtherDelta and Poloniex in 2018 and 2021, respectively.

These so-called failures deprive key investor protections, including rulebooks to prevent fraud and manipulation, appropriate disclosures, segregation of customer assets, safeguards for conflicts of interest, oversight by self-regulatory organizations, and routine inspections by the U.S. Securities and Exchange Commission. When intermediaries fail to register, it is investors who are harmed, and the U.S. financial markets may be affected.

In other parts of our securities markets, exchanges, broker-dealers, and clearing functions are separated. This separation of core functions helps mitigate conflicts that can arise from mixing such services.

I do not agree with the notion that “cryptocurrency intermediaries can’t comply,” and recent history has borne that out. I do recognize, and I believe it is necessary, to work toward this. This is not just a matter of “promising to comply with applicable laws” and not just seeking to hold a series of meetings with the U.S. Securities and Exchange Commission (SEC) during which time you are unwilling to make necessary changes to comply with securities laws.

Cryptocurrency intermediaries may need to separate lines of business, develop rulebooks to prevent fraud and manipulation, properly segregate customer funds, mitigate conflicts, or change their clearing and custody methods. These are investor protections. In fact, they did not consider these things in building their platforms, and this should not be a free pass for investors to take on risk.

Every securities exchange that is registered at this meeting has done difficult work in registering and developing appropriate rulebooks and supervision, and each is bound by all of our rules. We should not undermine 90 years of securities law.

As SEC Enforcement Director Gurbir Grewal said, “You can’t ignore these rules because you don’t like them, or because you prefer different rules: the consequences for the investing public are too great.”

In addition, just last month, a company that limits its business to cryptocurrency securities was approved as a special purpose broker-dealer by FINRA. This can be done.

We have also addressed the issues in the cryptocurrency security industry through rulemaking. Although many industry insiders who called for rulemaking were unhappy with this rulemaking.

We have issued a re-release that restates the applicability of existing rules to platforms trading in crypto asset securities, including so-called “DeFi” systems. This version also provides additional information on systems that would be included in the proposed new exchange definition.

While our current investment adviser custody rules already apply to crypto funds and securities, we recently proposed updating it to cover all crypto assets and strengthen protections provided by qualified custodians.

These are just two of the rules we have proposed related to the crypto market.

In addition, recognizing the risks and uncertainties associated with crypto assets, staff have provided views on accounting by public companies related to crypto assets and disclosures concerning material developments in the crypto asset market.

Lending and Staking as a Service

Another common feature of the crypto market is that intermediaries and sponsors offer lending or staking-as-a-service programs, promising returns in exchange for investors’ crypto tokens. Their products and promises of returns have many names, often used to attract users to their platforms.

However, in decades of cases, the Supreme Court has been clear that the economic reality of a product – not labels – determines whether it meets the securities law’s definition. What assets investors put into a lending or staking-as-a-service platform is immaterial – cash, gold, Bitcoin, or anything else. What matters is what the intermediary says it will do with the assets, which determines what legal protections, if any, are offered. Customers invest their assets through the platform, which then either lends or pools and stakes them, in each case promising returns. These are classic securities, whether or not they involve crypto currencies.

Likewise, the SEC has been clear on this for years. From 2021’s BitConnect, to 2022’s BlockFi, to a series of actions this year, the SEC has consistently maintained that these lending and staking-as-a-service products need to be registered and offer investors appropriate public disclosures.

Just this week, we have charged Coinbase, along with 10 states, with offering and selling its staking program without properly registering.

Behavior: Fraud, Manipulation, and Bankruptcy

Frankly, given the wide range of misconduct, it is not surprising that we see so many problems in these markets. We have seen this story before. It’s reminiscent of the days before the federal securities laws were enacted in the 1920s. Hucksters. Frauds. Con artists. Ponzi schemes. The public lining up to leave in front of bankruptcy courts.

Earlier this week, we alleged that certain Binance entities misled investors with respect to risk controls on the platform and its inflated trade volumes, actively concealed who operates the platform, its affiliated market makers’ manipulation of trading, and even concealed where investor funds and cryptocurrencies were being held and who was detained.

We also allege that affiliated company Sigma Chain controlled by Binance founder Changpeng Zhao acted as the primary market maker for Binance.US, engaged in manipulative trading and wash trading to fraudulently inflate trading volumes on the platform, including during the period surrounding the launch of Binance.US, its subsequent round of fundraising, and the recent launch of certain new crypto securities tokens.

Additionally, it is alleged that billions of dollars of customer funds from the two Binance platforms were mixed into accounts controlled by Zhao’s entity Merit Peak Limited.

These allegations also describe how Zhao and Binance attempted to evade U.S. securities laws by announcing false control behind-the-scenes so that they could keep high-value U.S. clients on their platform. Our complaint cites the words of Binance’s chief compliance officer, who said, “On the surface, we’re like, no, we don’t have U.S. clients, but in reality, we should be creative in how we get them,” the CCO further stating, “CZ would definitely agree haha… senior management will show me how to always find a way to support the business.”

We also witnessed deception to investors by FTX. With the collapse of Terra and LUNA, we saw deception. We allege that Do Kwon and Terraform repeatedly made false and misleading statements to build trust with investors before causing them catastrophic losses.

In the case against Justin Sun and his three companies, we allege a scheme to pay celebrities to shill tokens without disclosing compensation.

I could go on, but in a market rife with fraud, abuse, and misconduct, there are too many to list.

We also see many companies self-destructing before and after FTX, harming countless investors. Due to the bankruptcies of BlockFi, Celsius, FTX, Genesis, and other crypto companies, investors are often queuing up in court.

Let me be clear: these types of misconduct and bankruptcies are more likely to occur in markets where issuers and intermediaries fail to comply with basic laws. Even if we may not uncover fraud or such egregious misconduct, investors need proper disclosure, segregation of their hard-earned assets, and the assurance that they are not trading against the company.

Conclusion

Ultimately, the market hinges on trust. For 90 years, this trust has relied on compliance with securities laws.

The cryptocurrency securities market should not be allowed to undermine public trust in the capital markets.

The cryptocurrency market should not be allowed to harm investors.

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