Understanding the SEC's Role in Crypto: A Beginner's Guide

Over the past few years, the Securities and Exchange Commission has filed several lawsuits against major companies in the industry, including Coinbase, Binance, Ripple and others. However, many crypto investors aren’t aware of what role the SEC plays in the crypto markets.

Read this guide to learn more about the SEC and the impact of the agency's actions on the crypto industry. However, keep in mind that this guide is not financial or legal advice, but a way for you to gain a better understanding of how and why the SEC is involved in the crypto and Web3 space.

What is the SEC and why does it matter?

The US Securities and Exchange Commission (SEC) is an independent arm of the US federal government tasked with regulating the securities market. The financial regulator is responsible for investor protection, formation of capital, and maintenance of fair, orderly, and efficient markets.

The SEC was formed after the Wall Street Crash of 1929, which led to the Great Depression. Congress enacted the Securities Act of 1933 as the first law to regulate security offerings. The Securities Exchange Act of 1934 then led to the creation of the SEC, replacing the Federal Trade Commission as the enforcer of the '33 Act. Among other laws, these two remain the most significant in defining the SEC's role.

The Federal Securities Act regulates the primary market. Under this law, companies issuing securities must register with the SEC beforehand. This move makes some of their financial information public so investors can make informed decisions. The Exchange Act, on the other hand, governs the secondary trading of securities and lays the groundwork for the US financial market regulations.

So, how does the SEC's role extend to cryptocurrencies?

The Securities and Exchange Commission remained silent on cryptocurrencies for quite some time. However, the ICO boom of 2017 that led to the rapid growth of the crypto industry caught the regulator's attention. In the same year, the SEC published the DAO report stating that some tokens issued during ICOs were securities subject to federal securities laws.

However, industry players maintain that cryptocurrencies are not securities and shouldn't be treated as such. Still, there is a need for regulation of the budding crypto industry in the US to provide clarity to crypto companies.

Despite the controversies over asset classification, it's a consensus that industry regulation is a necessary step. The SEC needs to step in and protect the investors, as is part of the agency's mission. If the young industry is to keep flourishing, there's a need to lock out the bad players. This became even more apparent in the last year when the industry made huge losses in events such as the FTX and LUNA collapses.

SEC crypto announcements: A legal perspective

The debate on whether crypto assets are securities or not has been ongoing for several years. Industry leaders have stated the SEC hasn't been clear on whether it classifies them as securities and has previously issued conflicting statements on the same.

The confusion over how to classify crypto assets came up following the launch of Ethereum in 2015. The previous year, the team behind the Ethereum project sold 60 million ether (ETH) tokens to raise funds for the network's launch. The Initial Coin Offering (ICO) had similarities to the traditional Initial Public Offerings (IPOs), raising the question of whether Ether was a security.

In 2018, SEC's Hinman declared that a crypto asset would not be deemed a security if the blockchain project was 'sufficiently decentralized' at some point. He then added that ETH had achieved this threshold sometime between its launch in 2015 and his 2018 speech, although he did not specify when. Later, in 2019, the regulator issued a detailed SEC Staff guidance that listed around 50 factors that would be used to determine a network's level of decentralization.

A significant concern in classifying crypto assets is that they all conflict with the Howey Test. The Howey test came into effect in 1946 and has since then been used to determine if an asset is an investment contract and thus subject to securities laws. For an asset to qualify as an investment contract, it needs to meet the following conditions:

• Investment of money

• Common enterprise

• Expectation of profits

• Profits are derived from the efforts of others.

Most cryptocurrencies easily meet the first two conditions. Obtaining any cryptocurrency requires an investment, which, oftentimes, is in fiat. Also, many projects, especially those launched through an ICO, can be traced back to a common enterprise.

That leaves the remaining two conditions as the determinants of whether a crypto asset is a security. While many investors get into crypto projects to make profits, most crypto assets don't meet the fourth condition.

Case study: The SEC and Ripple's XRP

The SEC vs. Ripple is the longest-standing crypto trial and has been going on for the last two years.

On 22nd December 2020, the SEC filed charges against Ripple for issuing unregistered securities. According to the motion, Ripple had issued unregistered XRP to investors since 2013, raising $1.3 billion for the company's development. Further, the SEC claimed Ripple had used the unregistered XRP to settle the company's non-cash transactions.

However, according to Ripple, the company had complied with the country's laws. In 2015, FinCEN declared XRP a currency, and Ripple had been operating as such ever since. The fact that the project relies on community consensus as an open-source project disqualifies the common enterprise factor of the Howey Test and is thus not an investment contract.

The long-going battle has been a series of court filings, motions, and rulings. The most recent move seems to be a small win for Ripple after the judge denied SEC's motion to seal the Hinman documents. The documents contain the 2018 speech, where the then director, William Hinman, stated that ETH was not a security. The court added that the documents would be instrumental in the court's decision.

The SEC vs. Ripple case is monumental for the industry, which will change regardless of the court's decision. A ruling in favor of the SEC would be the court's stamp that XRP is a security. It could cripple the industry as it would mean several other companies and exchanges have violated securities laws.

Conversely, a ruling for Ripple may clarify the regulatory status of XRP and, potentially, most other cryptocurrencies. Investors in the crypto industry would move with more certainty, potentially spurring growth.

Case study: The SEC and Coinbase

The SEC's lawsuit against Coinbase is the latest move by the SEC in what seems like an industry-wide crackdown on crypto.

On June 6, 2023, the Securities and Exchange Commission sued Coinbase over allegations of illegal operations. SEC further stated that Coinbase had been trading about 13 cryptocurrencies that are considered securities.

Coinbase remains adamant that cryptocurrencies are not securities and that the exchange has been fighting for regulatory clarity from the SEC. The company issued a statement to this effect following the Wells notice issued by the SEC earlier in the year. CEO Brian Armstrong maintains the SEC didn’t define the regulatory conditions, which the company would have been obliged to.

The relationship between the US crypto exchange and the regulator hasn't been all ugly. The exchange was set on working with regulators rather than disputing them. However, the relationship went sour following the SEC's continued vagueness over the classification of crypto assets.

The recent complaint claims Coinbase made billions but did not give investors the correct projections. Further, the exchange was aware that some of the products on the platform were securities and continued its operations as an unregistered exchange. However, Coinbase maintains that the regulator approved the company before it went public in 2021, giving it the green light to sell its shares.

Case study: The SEC and Binance

Just a day before the SEC went after Coinbase, it brought 13 lawsuit charges against Binance, the world's largest cryptocurrency exchange. The SEC also sued the exchange's founder, Changpeng Zhao, who they allege inflated the exchange's trading volume, among other claims.

The SEC also accuses Binance of secretly controlling Binance US and that the exchange illegally offered commodity derivatives to US customers despite not being registered with the regulator. The complaint further claims that Binance leadership was well aware of the violations of the US regulations.

In response to the allegations, Binance said they were disappointed the regulator was after a unilateral approach to regulating the crypto market. Binance maintains that they were willing to work with US regulators and policymakers, acknowledging that the US was a hub for financial innovation and regulation by enforcement was not the right approach.

Case study: The SEC and Kraken

In February this year, the SEC filed a complaint against Kraken, claiming it offered its crypto staking-as-a-service to US investors without registering the platform.

Since 2019, Kraken had been offering staking services on its platform for returns of up to 21%. The SEC argued that the staking process stripped investors of complete control over their assets, exposing them to the platform's risks. As such, Kraken needed to disclose certain information per the securities laws, which it failed to do.

Kraken didn’t deny or admit the charges. Instead, the exchange settled with the SEC and paid $30 million in fines. Following the settlement, the platform also had to end its staking services in the US.

Conclusion

The Securities and Exchange Commission is undoubtedly an influential entity in the crypto space. However, its lawsuits against big crypto companies have created a lot of debate about how clear and fair the SEC is being with cryptocurrencies. Most people in the crypto industry seem to agree that rules are needed, but they also want clearer guidelines from the SEC.

Moving forward, the results of ongoing legal battles, like those involving Ripple and Coinbase, will have a big impact on how crypto is regulated in the future – and it's really important that the SEC and the crypto industry work together to make sure the rules are fair, clear, and effective. This will help protect investors and allow the exciting world of crypto and Web3 to continue to grow and innovate.

Download Trust Wallet tooday to securely store and manage all your crypto assets.

Join the Trust Wallet community on Telegram Follow us on X (formerly Twitter) Instagram Facebook Reddit

Note: Any cited numbers, figures, or illustrations are reported at the time of writing, and are subject to change.