Sophia’s Thoughts on the Need for Regulation

CryptocurrencyBitcoinETFRegulationSEC
Written By Gustavo Schwenkler

The SEC lawsuits against Binance and Coinbase shook the crypto world. They triggered a new debate about the need for crypto regulation. Where will this all lead to?

These are Sophia's Thoughts:

  • Crypto exchanges have reacted aggressively in response to the SEC lawsuits. Coinbase is vowing to fight. Binance, Crypto.com, and Robinhood have shut down parts of their crypto offering.

  • The market has reacted in a mixed way to the lawsuits. There were large sell offs of tokens deemed as securities by the SEC, such as Cardana (ADA) and Solana (SOL). The question of what coins are securities and which ones are commodities continues to occupy American investors. But it will likely have a smaller impact in the long run.

  • Regulation is required in crypto markets to protect consumers and prevent contagion from crypto markets to the broader economy. A new regulatory framework in Europe leads the way in this regard.

  • Sophia has remained neutral throughout the week. But there were notable exceptions highlighted by Sophia, including Bittorrent (BTT) and Conflux (CFX).

🚀 Last week’s market performance

The crypto market took a hit after the SEC lawsuits, losing around 7% over the last 7 days. The losses were primarily driven by crashes in coins that the SEC labeled as securities in its lawsuit against Coinbase. These coins include Cardano (ADA, down 22%), Solana (SOL, down 27%), and Polygon (MATIC, down 22%). Bitcoin (BTC) was spared by the SEC and “only” lost 5% over the course of the last 7 days.

Exchange tokens continue to be affected by the lawsuits, although in different ways. Binance Coin (BNB), that native token of Binance, is down 13% in the last 7 days. In contrast, Coinbase (COIN) actually gained almost 1% over the same time period. Binance is facing the more serious charges from the SEC and has vowed to end USD trading. Coinbase, on the other hand, is committed to fighting the charges in pursuit of regulatory clarity in the US.

🧐 What is your crypto mood today?

In each Sophia's Thoughts newsletter, we ask about your crypto mood. Your response to this question helps Sophia get a better sense of the pulse of crypto markets. And this ultimately translates into better insights for you when combined with Sophia's AI models. Your data empowers Sophia to provide you with even better intelligence going forward!

🌊 Repercussions of the SEC lawsuits

A week ago, the SEC filed lawsuits against Binance and Coinbase. Both exchanges are accused of operating unregistered securities exchanges. But Binance is also accused of more serious charges, including mismanagement of customer funds. We reported about all of this in our newsletter from last week.

While the market has reacted in mixed ways to the news, exchanges have been proactive. Coinbase has vowed to fight the SEC. Coinbase’s CEO Brian Armstrong sat down with the Wall Street Journal to discuss their approach. One of the points repeatedly made by Coinbase is that there is no clarity on what regulation applies in the US. So Coinbase is running a legal fight against the SEC to push regulators and lawmakers to provide clearer regulatory frameworks. In less positive news, Moody’s downgraded its outlook on Coinbase from stable to negative.

Binance took a more aggressive approach. It decided to terminate all trading in US Dollars in its US entity, Binance.US. In the same vein, Crypto.com halted its institutional offering in the US. And Robinhood announced that it will stop trading three securities deemed as securities by the SEC (Cardano, Solana, and Polygon).

Many fear that the regulatory uncertainty in the US can have a longer term impact on crypto markets. The venture capital firm Andreesen Horowitz reports that the fraction of global crypto developers based in the U.S. declined by 26% from 2018 to 2022. In the meantime, other countries are leading the way in enabling innovation-friendly crypto regulation. For example, the UK’s Financial Conduct Authority’s Regulatory Sandbox program lets new startups test innovative blockchain products live while enjoying regulatory leniency. This approach has been praised by industry participants by balancing both regulation & innovation.

🤨 What’s the deal about securities & commodities?

A big part of the conversation since the SEC lawsuits is whether some coins are securities or commodities. In its lawsuits against Binance & Coinbase, the SEC explicitly labeled the following coins as securities:

  • Algorand (ALGO)

  • Axie Infinity (AXS)

  • Binance Coin (BNB)

  • Binance USD (BUSD)

  • Cardano (ADA)

  • Chiliz (CHZ)

  • Cosmos (ATOM)

  • COTI (COTI)

  • Dash (DASH)

  • Decentraland (MANA)

  • Filecoin (FIL)

  • Flow (FLOW)

  • Internet Computer (ICP)

  • Near (NEAR)

  • Nexo (NEXO)

  • Polygon (MATIC)

  • Solana (SOL)

  • The Sandbox (SAND)

  • Voyager Token (VGX)

Notably, the SEC did not include Bitcoin (BTC) or Ethereum (ETH) in this list. This suggests that they are deemed as commodities by the SEC.

Whether a coin is classified as a security or a commodity matters a lot for how it is regulated in the US. In broad terms, a security can be defined as any investment that promises a potential profit through the efforts of someone else. More formally, a security is defined by the Howey Test put forth by the US Supreme Court. Securities are regulated in a very strict way by the SEC in the US.

In contrast, a commodity is an investment that may promise a future profit without the need of efforts by someone else. Commodities are regulated in a loser way by the CFTC in the US. Exchanges and crypto issuers naturally would prefer many crypto assets to be considered commodities rather than securities to avoid strict regulation from the SEC. Ripple is currently fighting the SEC after it declared Ripple to be a security token.

The issue of whether a coin is a security or a commodity is not as relevant in other countries. In some countries, like Singapore, there is a single regulatory agency with a unified framework for all crypto. Other countries, like Australia, focus on regulating how cryptos are used and traded versus how crypto are created. More novel regulatory approaches, like MiCA in Europe, have defined brand new investment categories for crypto that offer more suitable regulatory approaches.

Whether coins are deemed securities or commodities is a uniquely American question. The answer will probably impact how crypto will be treated in the US in the short run. But, in the long run, the answer may be less relevant as more crypto-specific regulation is adopted on a global scale. This is what many practitioners and experts are hoping for.

🎯 The goal of regulation

The Central Bank of Ireland states that the goal of financial market regulation is to ensure “the safety and soundness of the financial system and protecting consumers.” Nowhere is this more necessary than in crypto markets these days. Cryptos are heavily traded by consumers. And consumers are often affected by the wild swings of crypto markets. Regulators care about protecting consumers because they worry that, if financial losses are excessive for consumers, this may affect how they spend money elsewhere. If consumer consumption declines, it can have broad repercussions on the economy and lead to recessions.

So the main goal of crypto regulation is to protect consumers and prevent contagion from crypto to the broader economy. In traditional financial markets, one way this is accomplished is by regulating the places where financial assets are traded. In crypto, this would mean regulating exchanges. Many countries require that crypto exchanges register with the regulatory agency and report critical performance metrics. Newer regulatory approaches, like in Europe, require that registered exchanges follow strict policies against money laundering & market abuse. And, ever since the FTX collapse, there have been calls for strict segregation of user & operating funds for exchanges. This is to ensure that consumer investments are protected from the whims of exchange operators.

The decentralized nature of crypto allows for investors to easily build leverage. That is, to trade more assets than they physically have. For example, the stablecoin Terra failed last year after its algorithms were unable to back the assets it had pledged to its investors. Leverage can easily lead to large consumer losses. As a result, many of the newer regulatory approaches target stablecoin issuers. One key regulatory proposal out of Europe requires all European stablecoin issuers to operate without leverage. That is, stablecoins need to be backed by assets rather than by algorithms. Other countries are expected to follow suit.

🧠 Sophia’s crypto intelligence for the week

Sophia remained mostly neutral on crypto last week. She did, however, flag some notable exceptions:

Going forward, Sophia is taking a more muted approach. Sophia is mostly neutral on coins today. Sophia perceives most valuations to be justified currently given fundamentals and social chatter.

It remains to be seen how regulatory actions will continue to impact crypto markets going forward.

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Gustavo Schwenkler
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