Since its inception in 2008, cryptocurrency has been hailed as the future financial system for those who do not prefer a traditional bank account. While many traditional banks are centralized in the sense that they are managed by one entity (government, central bank, or government), cryptocurrency promotes itself as an independent, decentralized financial system where people had keys to their wallets and trade without going through an intermediary. Nevertheless, in light of recent developments within the cryptocurrency industry, the U.S. government has taken proactive measures to prevent cryptocurrency exchange mishaps akin to those witnessed with FTX and Celsius. This includes pursuing legal actions against other cryptocurrency exchanges, such as Binance and Coinbase, to ensure the integrity of the market. These lawsuits will set forth a precedent on how cryptocurrency will proceed in the U.S. and globally as the U.S. Securities and Exchange Commission (SEC) claims that Coinbase’s tokens operate as securities, dismantling the very ethos on which cryptocurrency was founded. The outcome of these legal actions will undoubtedly shape the evolution of the cryptocurrency landscape, impacting its journey toward becoming a trusted alternative to traditional banking systems for those seeking greater financial independence and autonomy.

The beginning of the cryptocurrency lawsuits

In general, a “security” is understood to be a “tradable financial asset that holds monetary value and must be registered with the SEC.” However, the difficulty behind this definition is that not every digital asset is a security. Former SEC chair Jay Clayton said in 2018 that cryptocurrency that replace “sovereign currencies”—for example, Bitcoin and Ether—are not considered to be “securities,” but “digital assets and tokens used initial coin offerings (ICOs)” are securities. The debate around whether cryptocurrency qualifies as securities serves as the basis for the SEC’s decision to file the lawsuit against Coinbase. The SEC began to pay close attention to Coinbase following the exchange’s decision to add 100+ additional tokens to its platform such as Dogecoin, the joke cryptocurrency based on the viral meme. Such coins are typically successful in its initial listing on crypto exchanges, but are known for their extreme volatility and lack of retaining value “over time.”

One other instance that drew the SEC to Coinbase was their case against former Coinbase product manager Ishan Wahi, Wahi’s brother, and his friend for insider trading. During his tenure at Coinbase, Ishan Wahi assisted in coordinating Coinbase’s public announcements on which “crypto assets or tokens would be made available for listing” despite Coinbase’s explicit instructions that such announcements are “confidential” and are not to be used to tip or trade. Disregarding those instructions, Ishan proceeded to tip his brother, Nikhil Wahi, and friend, Sameer Ramani on upcoming listings from June 2021 to April 2022. Due to how these announcements would traditionally see an increase in the listings’ prices, the SEC noted that Nikhil Wahi and Ramani had bought “at least 25 crypto assets, at least nine of which were securities, and then typically sold them shortly after the announcements for a profit [of more than $1.1 million].”

This case also confirmed the SEC’s suspicions of “the economic realities of an offering,” said Gurbir S. Grewal, the Director of the SEC’s Division of Enforcement. Considering the cryptocurrency exchange’s insider trading case, Grewal said: “In this case, those realities affirm that a number of the crypto assets at issue were securities, and as alleged, the defendants engaged in typical insider trading ahead of their listing on Coinbase. Rest assured, we’ll continue to ensure a level playing field for investors, regardless of the label placed on the securities involved.”

According to their complaint filed to the Manhattan federal court on June 6, the SEC alleged that since 2019, Coinbase made billions of dollars by functioning as an intermediary on crypto transactions “while evading disclosure requirements meant to protect investors.” Such operations characterized Coinbase as an “unregistered national securities exchange and broker.” In addition, the SEC noted that a minimum of 13 crypto assets Coinbase released to the public “qualify as ‘crypto asset securities.’” Coinbase’s staking program, dubbed by the SEC as a method “to earn financial returns through Coinbase’s managerial efforts” for investors, is considered to be “an investment contract and unregistered security” by the SEC. Staking entails “users validat[ing] crypto transactions by pledging their own tokens to the process and receiving a financial return depending on how much they staked.” Examples of crypto assets that are securities and did not get registered in Coinbase included tokens like “Solana, Cardano, and Polygon.”

In response to the allegations by the SEC’s press release, Paul Grewal, Coinbase’s chief legal officer, stated that the company will remain operational and has “demonstrated commitment to compliance.” Ed Moya, a senior market analyst from Oanda, stated that the SEC’s measures of regulating cryptocurrency exchanges “looks like it’s playing Whac-A-Mole” and due to their nature of offering a variety of tokens on blockchain, “it seems like this is just the beginning.” On Binance’s end, the SEC has accused them of “inflating trading volumes, diverting customer funds, improperly commingling assets, failing to restrict U.S. customers from its platform, and misleading customers about its controls.” Binance vowed to defend themselves against the SEC’s accusations, stating that their mission to defend themselves “reflected the SEC’s ‘misguided and conscious refusal’ to provide clarity to the crypto industry.”

However, there is a paradox introduced to the equation as Bitcoin has seemed to benefit from the SEC’s decision to regulate Coinbase and Binance. According to Moya, the SEC is “making life nearly impossible for several altcoins and that is actually driving some crypto traders back into bitcoin.” Considering that many alternative tokens and cryptocurrency has promoted their decentralization as a crucial factor as to why one should invest, the SEC’s attempts to centralize these exchanges indicate that there may be more regulations and consequences of such regulations, signaling a sense of legitimacy to this market.

Even though the definition of a “security” has been drafted into government legislation through the Securities Act of 1933, many use 2 U.S. Supreme Court cases to see “if an investment product constitutes a security.” Gary Gensler, the Chair of the SEC, has been an advocate of the notion that “tokens constitute securities” and has now placed his focus on regulating cryptocurrency exchanges and other relevant activities. Although several crypto companies have the license of being an alternative trading system, no cryptocurrency platform operates as a full stock exchange. Gensler further rationalizes his decision to come after crypto exchanges in an exchange with CNBC: “The whole business model is built on a noncompliance with the U.S. securities laws and we’re asking them to come into compliance.”

To Gensler’s statement of compliance, crypto companies stated that tokens do not fall under the definition of a security while demanding additional clarification on the SEC’s rules. Regardless of what they have said regarding the SEC’s decisions on cracking down on the cryptocurrency market, many companies have begun to boost their compliance, “shelved products and expanded outside the country in response to the crackdown. Beyond stating repeatedly that their tokens are not securities, Coinbase was among those who petitioned the SEC for additional clarification on what entails a security and claimed that the U.S. lacks “a clear and workable regulatory regime.” 

The Ripple effect

In 2020, the SEC began a three-year-long battle with Ripple, the fintech company behind the XRP token, by filing a lawsuit that Ripple sold its unregistered XRP tokens as securities to investors “worth $1.3 billion.” At the time of the lawsuit, Ripple CEO Brad Garlinghouse said that the SEC’s lawsuit was “fundamentally wrong as a matter of law and fact.” According to Garlinghouse, “XRP is a currency” and therefore, “does not have to be registered as an investment contract.” Garlinghouse further elaborated on his stance of XRP not qualifying as security through the Justice Department and the Treasury’s FINCEN’s decision to deem XRP as “a virtual currency in 2015 and other G20 regulators have done the same.” Considering that the SEC permitted XRP to operate as a currency for “over eight years,” the sudden shift of XRP’s perception as a currency to security ultimately raised questions for both its CEO and the crypto industry as a whole. Ripple argued that XRP “should be classified as a currency”—very much like Bitcoin—instead of a security. By characterizing XRP as a “security,” Ripple will be forced into abiding by strict regulations and disclose to investors of potential risks.

On July 13, 2023, U.S. District Judge Analisa Torres ruled partially in favor of Ripple and stated that it “did not violate federal securities law by selling its XRP token on public exchanges.” Judge Torres applied the principle of a Supreme Court case that defined an investment contract as “an investment of money in a common enterprise with profits to come solely from the effort of others.” The landmark win gave rise to the value of XRP to soar drastically, going as high as 75%. Considering the SEC’s track record of winning against other crypto companies like Block.one and Kik, the ruling was deemed to be a landmark win for a cryptocurrency company against the SEC. Despite the specificity of the case, Reuters deems that this win will aid in other crypto companies’ battle against the SEC on “whether their products fall under the regulator’s jurisdiction.” The SEC’s lawsuit against Ripple took the crypto industry by storm due to how the SEC alleged that many of these crypto companies are selling securities and fall under their regulatory jurisdiction, bringing “more than 100 enforcement crypto actions” but many have settled. Nevertheless, the SEC also scored a victory in this lawsuit as Judge Torres determined that Ripple did violate federal securities law by “selling XRP directly to sophisticated investors.” Sophisticated investors, in this case, referred to “institutions such as hedge funds and the like.”    

The reality of the SEC vs. Ripple Labs

Despite the ruling, the debate regarding whether tokens qualify as securities is far from over. Preston Byrne, partner at Brown Rudnick and a fellow crypto entrepreneur, noted that the “Ripple summary judgment is obviously not the last word on the issue” if XRP accepts their victory since they will be held responsible for the “multi-billions of dollars in institutional sales that they’re on the hook for.” Furthermore, skeptics have pointed out that the ruling may not provide the robust basis that crypto firms were hoping for in their quest to influence the SEC’s approach towards them. This is because the SEC is expected to draw upon the judge’s determination that Ripple did indeed breach federal securities laws by selling to “sophisticated investors” in a specific context. The SEC announced their intention to file an “interlocutory appeal” of the ruling where they could address particular “legal issues” on which there was “substantial ground for differences of opinion.”

On Coinbase’s end, they have become progressively optimistic over the ruling. Grewal, Coinbase’s general counsel, claimed that Coinbase “will win” due to the Ripple decision “further strengthen[ing] the case.” Coinbase’s argument follows that should XPR not be designated as a security, other cryptocurrencies such as Coinbase will also not be subject to the SEC’s regulations. Consequently, Coinbase has legally sought to dismiss the SEC lawsuit and cited Ripple’s ruling as the basis behind their motion to dismiss. It should be also noted that Judge Torres’ ruling “pertained solely to the primary market transactions through which Ripple sold XRP, while COIN [Coinbase] is in the business of facilitating secondary-market transactions on its exchange.” And so, Coinbase is not fully in the clear with the SEC’s lawsuit as it still faces immense regulatory pressure “that could derail its stock rally.” A clear indication is Coinbase’s announcement that it will no longer provide staking services in 4 states—California, New Jersey, South Carolina, Wisconsin—in the midst of securities allegations. Even though Coinbase’s insistence that its staking products are “not being sold as securities,” Berenberg analysts noted the program’s vulnerability to be characterized as such. The analysts further affirmed their belief of Coinbase Earn as a “securitized product” from “outside legal assessments.”

However, the Ripple lawsuit has propelled the crypto community back to square one with the Terra case. Terraform Labs and its founder Do Kwon were charged with “orchestrating a multi-billion dollar crypto asset securities fraud” in February 2022 and had sought to dismiss the case by using the Ripple lawsuit. What stood out with regards to Terraform Labs was that they distinguished themselves by having a “stablecoin” that was equivalent to the U.S. dollar, but that was not the case whatsoever. The coin crashed and lost a total of $42 billion from investors, prompting Kwon to go on the run to Singapore. By citing the SEC’s lawsuit against Ripple, Terra aimed to make the case that its token, Luna, did not count as a security due to the lack of identification of the seller. Jed Rakoff, the Manhattan judge presiding over the case, was skeptical and ruled that the seller’s identity was irrelevant to “whether a reasonable individual would objectively view the defendants’ actions and statements as evincing a promise of profits based on their efforts.” Terra further argued that the SEC “did not have the authority to regulate stablecoins without congressional authorization,” but such argument did not convince Rakoff as he characterized the crypto industry as not representing “a portion of the American economy” bearing “vast economic and political significance.”

As it turned out, the Ripple case’s July ruling was “never precedential in the first place”—indicating that other judges do not have to defer to it when confronting similar or identical cases. Such legal precedent would not be a reality until the U.S. Court of Appeals for the Second Circuit’s intervention, and even then “it’ll be only be binding on the district courts within the circuit.” Regardless of the SEC’s appeal and the ensuing process, experts recognize that it will take a long time from months to years before the central argument of the Ripple case will have a resolution. The ruling did call for additional clarification on “clear rules for tokens” and called for Congress to identify “the status of digital assets.” However, the Ripple action did not catapult any immediate action from the U.S. Congress on any crypto-related legislation. Needless to say, any clarification on cryptocurrency, with regards to the U.S., will take a longer time than one should anticipate.