A Crypto Exchange Crackdown

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Kate Linebaugh, our colleague Caitlin Osteroff covers cryptocurrency. What happened this week, sort of in the top line?

It's Tuesday. The Securities and Exchange Commission filed Binance on Monday morning, which is the crypto exchange giant. It's difficult to quantify how much bigger Binance is than anything else. Then, as if this weren't enough to wake us up Tuesday morning, they also sued Coinbase which is the largest US Exchange. There's been a lot of regulatory activity this week.

Crypto has been saying for years that cryptocurrencies are not under the purview of regulators, and that they are not the same as bonds or stocks. The SEC came out and said "Yes, it's true."

Kate Linebaugh, Binance and Coinbase have both said that they will defend themselves against legal action. Coinbase has accused the SEC solely of enforcement. What would you say about the current crypto market?

Caitlin Osteroff: I feel like the tension is really increasing. We've kind of been in this slow-burning move towards regulators crackingdown on crypto. Then, all of a suddenly, you get this sudden burst of activity. It feels like crypto has a bit of a fight on its hands.

Kate Linebaugh welcomes you to The Journal. This is our show on money, business, and power. Kate Linebaugh. Today is Tuesday, 6th of June.

The crypto crackdown will be discussed on the show.

The Securities and Exchange Commission, as its name implies, regulates securities like stocks and bonds. It's this mandate that has led them to crack down on cryptocurrency exchanges. Tell us about Binance and Coinbase that the SEC has sued this week.

They're two very different companies. Binance, which was founded in 2017, is a global crypto exchange. Crypto was based on the idea that we don't need to follow the rules of traditional financial institutions." Binance was a big global company that offered trading in almost every cryptocurrency. They offered derivatives, and all these instruments were available.

Coinbase, on the other hand, took a different approach and was therefore founded in the US. Coinbase is a listed company like Binance. It's on the NASDAQ. So they went through the listing process. They have always claimed that they follow the rules. They have been slower than their competitors to list tokens in the past.

Kate Linebaugh: How does the SEC accuse these two exchanges?

Caitlin Osterroff: Binance and Coinbase are saying, "You weren't registered as a securities trade." If a company sells securities, it has to take a very rigorous registration course. It also requires them to hire lawyers and go through various tests and audits. By being an unregistered securities exchange, you are operating a black market. You are not allowed to trade all the things you used to and you are basically operating in an unregulated manner.

Kate Linebaugh asks: Why would Binance and Coinbase not have registered?

Caitlin Osteroff: They would say that they didn't think they had to. The idea in crypto at that time, and even now, was that these were not securities. They are not securities exchanges because they do not offer securities. When they list an asset they check and see if it will be considered a security by regulators. They often complain, however, that regulators have not provided any explicit guidance on which crypto coins are securities and which ones aren't. They claim that they did not need to register as they were not securities. Now, the SEC is going back and looking at what they listed, and saying "Actually we do believe this was a securities and therefore, you guys are operating a illegal securities exchange." You should have been registered."

Kate Linebaugh, it seems that the SEC case hinges a bit on the question: What is a security exactly? That's right, isn't it?

Caitlin Osteroff: Yeah, that's what I meant. And that's like the logic series that the SEC must prove. The SEC's burden of proof is to prove at least that one of the assets they trade is a security.

Kate Linebaugh Kate Linebaugh, there are additional allegations made against Binance, and its founder Changpeng Zhao (also known as CZ). Before we go into these allegations, could you tell us a little bit about CZ?

Caitlin Osteroff: Yeah, CZ is a very casual, laid-back, mild and meek nerd. That's his public persona. He has a sort of cult-like following on Twitter, where people just adore him for the exchange he's created. CZ is finance. He's the main person in the organization.

Kate Linebaugh Kate Linebaugh, the SEC has made additional allegations against Binance CZ centered on their US business. It claims that Binance allowed US customers to continue trading on its global exchange, even after setting up a US subsidiary four years ago. The report also claims that Binance was not transparent in the way that its exchange was run. Binance claimed that its US exchange is independent. The SEC claims it isn't.

Caitlin Osteroff: In truth, CZ was not only the primary shareholder, but also the 100 percent shareholder in the beginning. He was also the one who made the decisions on the majority of the setup. He ordered, set up the companies and was basically in control of a lot without users knowing.

Kate Linebaugh, in the words of Gary Gensler SEC Chairman: CZ and Binance are engaged, quote, in an extensive web deception, conflicts, lack of disclosure and calculated evasion.

Binance is also accused by the SEC of misusing customer funds. The regulator claims that some customer money may have been spent on a yacht worth $11 million. The regulator claims that US funds were transferred into another bank account controlled by CZ. The money from this account was used to purchase the yacht.

Caitlin Osteroff: The SEC flags that and says, "You shouldn’t buy a yacht using a bank account where US customer funds have been touched." This is one of the main concerns.

Kate Linebaugh: How have Binance and CZ responded?

Caitlin Osteroff: They have said that there was never any co-mingling of funds, that user funds were not at risk and that they deny this vehemently. They have also stated that they are disappointed, as they expected to settle this with the SEC and not see it become a lawsuit. So, it's clear that the settlement did not happen. Binance has stated that they will fight the case and that many of the allegations made are false.

Kate Linebaugh Kate Linebaugh, As for Coinbase the company stated that it has demonstrated a commitment to compliance, and that the lack of clear rules in crypto has hurt them. Binance and Coinbase both said they would continue to operate. Both companies have been around for many years. Why is the SEC pursuing them now?

Caitlin Osteroff: This is a million-dollar question. Many people believe it's a reaction to the collapse of FTX.

Kate Linebaugh: FTX is the crypto exchange which collapsed last year.

Caitlin Osteroff: They believe regulators are trying to compensate for the time they lost by allowing FTX to grow large enough to damage retail investors and institutions.

Kate Linebaugh: Other have pointed out the SEC investigation into Binance preceded FTX's crash. The SEC began investigating Binance in 2020.

Caitlin Osteroff: But many people are sitting and wondering, "Why now?" Why are there so many enforcements and why do they come back to back?

Kate Linebaugh: What could these two back-to-back cases mean for crypto?

What would Binance and Coinbase do if the SEC won these cases?

Caitlin Osterroff: That would be huge. If they ended it with Binance admitting wrongdoing, or agreeing to cease operations in the US, as SE saw it, and the other monitoring it demanded, then that would be a massive blow to Binance. I doubt that it would cause Binance any serious long-term damage. In the US I believe people expect it to mean the end of the US operations, and a kind of retrenchment away from the American market.

Kate Linebaugh, what impact has this case had on Binance and Coinbase so far?

Caitlin Osteroff: We've seen some outflows on both exchanges. There are fewer traders and some traders have removed funds from the exchange. This has led to a bigger price fluctuation in different coins. It's just one of those things that you can see a slight pullback from some people. No one is completely abandoning these exchanges. Many people are expecting them to fight it, but they do not expect any sort of immediate decision on the health or Binance and Coinbase in the near term.

Kate Linebaugh Kate Linebaugh says that part of the calculation is based upon how long it can take for these cases to be resolved, especially if companies do not settle.

Caitlin Osteroff: Both of these cases will likely end up in court and this means years of litigation. The SEC has another large cryptocurrency lawsuit from a few year ago that is still in progress.

Kate Linebaugh, what are you looking for?

Caitlin Osteroff: I hope I get a day where I don't receive a huge handout from SEC. I'm trying to find out who is benefiting from this. All of the money that is being pulled will go somewhere. We're now trying to understand how the crypto industry will reorganize itself after this. Will there be a real departure of companies from the US? What happens if traders simply move to other US exchanges?

Kate Linebaugh, Could we see more SEC cases?

Caitlin Osterroff: Sure, I'd say. Strangely, the SEC has been mainly targeting small, no-name crypto companies up to now. It's interesting because it is one of those rare instances where the SEC has come out against big crypto companies. I believe that many crypto companies will also try to push actual legislation in Congress based on this, saying "The SEC has gone on a rampage." There is no need for legislation, we only require actual legislation. So maybe there will be more efforts on this side in Washington. The US presidential election is also approaching, so it will be interesting to see how crypto invests its money in some of the potential candidates. When the administration changes, it's possible that the whole approach to crypto will also change.

Kate Linebaugh Kate Linebaugh, could these cases challenge the ethos you mentioned where crypto believes that it does not have to conform with rules?

Caitlin Osteroff: I believe that this will happen, especially in the US. It's going create a template for how crypto businesses have to operate. It could also be that crypto companies become successful and say "No, in fact, crypto does not fall under any of these regulations." This will, I believe, in some way shape the way crypto companies operate. It will likely be a much more ad-hoc approach, depending on where the companies are offering their services.

Kate Linebaugh: How could this affect the crypto-ecosystem more broadly?

Caitlin Osteroff: It will be a major setback if these cases succeed. We saw the crypto prices drop Monday because of all this. I think that people have been a little hesitant about crypto. The regulatory uncertainty will continue to make people hesitant, and they'll remain so. In covering this topic for the past couple of years, I was surprised by how resilient Binance and crypto have been. It's a case where bad news doesn't seem to bother many of the diehard fans of these coins. You might see some institutions leaving, but at the end, I believe that there will still be a certain amount of people willing to accept the risks of trading crypto.

Kate Linebaugh, that's it for today. Tuesday, 6th June. The Journal is a joint production of Gimlet, the Wall Street Journal and Patricia Kowsmann. Thanks for listening. Tomorrow, see you.