Are the Remaining Crypto Giants Staring Down the Barrel of the US Government’s Gun?

The latest action from the U.S. Securities and Exchange Commission (SEC) against Kraken is probably only the first stirring of a U.S. government campaign to come for the major remaining crypto exchanges, according to industry lawyers, consultants and former regulators.

The San Francisco-based exchange inked a ground-shaking settlement with the SEC on Thursday, agreeing to shutter its U.S. staking services and pay a $30 million fine amid agency accusations that the services amounted to a sale of securities. That enforcement action likely marks a beginning of similar cases putting big exchanges in the spotlight.

The chairman of the SEC has made plain his intent to come for the cryptocurrency titans, doing everything short of announcing a schedule of enforcement actions, and his counterpart at the Commodity Futures Trading Commission (CFTC) is promising a big year. On the criminal side, the Department of Justice (DOJ) is unlikely to let other companies skate away from behaviors that warranted criminal charges in previous cases.

“We're in the early days of some major upheaval,” said Mick Mulvaney, a former acting White House chief of staff under former President Donald Trump, who is now advising a company in the digital-assets sector. “The industry is giving people that hate it a lot of ammunition."

As Jaret Seiberg – an analyst with Cowen – put it: “We expect the SEC to rely on enforcement over the upcoming year to shape the crypto sector. We see the greatest threat to trading platforms, which we suspect the agency will contend are illegal exchanges.”

With Kraken, Coinbase and Binance headlines swirling, the industry is bracing itself.

When the Justice Department recently began preparing the ground for a major criminal announcement last month, crypto lobbyists and lawyers in Washington thought prosecutors were going to announce a marquee name. When it turned out to be little-known, Hong Kong-based Bitzlato, industry professionals breathed a sigh of relief.

But the money-laundering case did mention that leading crypto platform Binance was one of the company’s major counterparties. Another of Bitzlato’s top counterparties, LocalBitcoins, announced it would shut down this week. One observer noted that prosecutors are usually hesitant to name other companies in legal actions, but they did this time.

Ongoing investigations

Binance and its executives have reportedly been in the DOJ’s sights for potential criminal money-laundering charges. But it may draw SEC attention, too, because when the U.S. regulator went after its rival, FTX, the SEC named that exchange’s native token FTT a security, potentially meaning Binance’s BNB is similarly vulnerable.

And most recently, Binance admitted that it accidentally kept some of its own funds in the same wallet as user assets – the kind of commingling that often draws severe sanctions for regulated companies, even if the company discloses the breach itself.

The industry’s high-profile lapses over use of customer money – conjuring the specter of the collapse of MF Global for Washington’s regulatory community – has spurred a push to segregate crypto customers’ money as one of the main drives for lawmakers seeking to set up regulatory fences around crypto.

A lack of walls around investors’ crypto assets also sparked one of several run-ins another prominent exchange, Coinbase, has been having with the SEC.

A Coinbase statement created an uproar last year over how customer assets are maintained at the exchanges when the company disclosed investor money could be tied up in a hypothetical bankruptcy, and it accused SEC guidance for forcing it to make the statement. The company has also reportedly been dealing with an SEC investigation into a number of its business practices, including staking. As with Kraken, staking has been a significant service offered to Coinbase customers, though the company argued Thursday that Kraken was essentially offering a yield product while Coinbase isn’t.

“Coinbase’s staking services are fundamentally different and are not securities,” said Paul Grewal, chief legal officer, trying to head off the perception that the SEC is signaling that these common crypto services could be targeted at other companies.

Read More: Kraken to Shut US Crypto-Staking Service, Pay $30M Fine in SEC Settlement

But Coinbase’s most important dispute with the U.S. securities regulator may be the impasse over registering as an exchange. SEC Chair Gary Gensler never tires of telling the crypto industry that its exchanges must come in and register, because the “vast majority” of crypto tokens are securities, and exchanges like Coinbase that list them are breaking securities laws. Of course, those tokens are also unregistered, adding another layer of friction with the agency.

Coinbase has maintained that it would never allow securities on its platform, but the matter has been coming to a head. Last year, the SEC pursued an insider-trading case against a former Coinbase manager, and in its accusations identified nine tokens as securities, most of which traded at Coinbase. While the agency hasn’t yet gone after Coinbase with a direct enforcement action, it’s now on the record flagging the trading of unregistered securities at the company and is on the hook for proving it in federal court.

Spokespeople for the DOJ and SEC declined to comment for this story. Representatives of Binance and Coinbase didn’t respond to requests for comment, and Kraken declined to comment, though it said of its settlement Thursday that it “neither admitted nor denied the SEC’s allegations.”

Crucial turn

If the government wages a legal war against the platforms for the way they do business – and not a reactive enforcement buzzsaw like the one that took down FTX – it could mark a crucial turn.

“The SEC has a number of options, and they're not going to be afraid to use them,” said Mark Hays, a senior policy analyst for Americans for Financial Reform who supports the SEC putting tough limits on the industry. “It seems quite possible that a major platform could be subject to some of those things in the near future.”

The sector is already suffering a crypto winter and is reeling from a series of self-inflicted wounds that left it with a tattered reputation and a shortage of trusted institutions. While crypto purists take pride in the decentralization ethos they nurtured, the vast majority of people investing in digital assets prefer to hand over their assets to be handled by others. A new cage match with regulators could entangle the dwindling number of options.

“For an industry that's already seeing a lot of capital flying away from it, that's bound to have a major impact,” Hays said.

SEC chief Gensler has said the “runway is getting shorter” for the industry to satisfy compliance requirements, and he warned in a CNBC interview on Friday – after his agency moved against Kraken staking – that “other platforms should take note of this and seek to come into compliance.” At the SEC’s sister agency, CFTC Chair Rostin Behnam said last week that this will be a “strong year of precedent-setting cases.”

Wait for Congress

There’s a race being run between the executive branch of the U.S. government – the Treasury Department, financial regulators and the Department of Justice – and federal lawmakers in the legislative. While Congress has the greater power to outline lasting rules for the industry, the likelihood that it’ll come up with crypto legislation before regulators make their moves is dwindling.

"The risk is that Congress goes so slowly that the administration is able to do things that impact the basic fabric of the industry,” said Mulvaney, who served in the House of Representatives and also ran a regulatory agency before now advising Swiss startup Astra Protocol. “That is a valid concern, which is why those of us who are industry advocates hope that Congress moves quickly."

Meanwhile, the inferno of FTX and some of the other crypto misdeeds are "confirming some of people's darkest concerns about crypto and blockchain," he said, which further hinders the legislative process. However, he said it’s “not a capital offense” for the industry, and the current drama shouldn’t be terminal, because FTX was about people taking and misusing money, not failings in the technology.

Blaming the individuals instead of the innovations is a mantra catching on with Republican lawmakers, including Rep. Patrick McHenry (R-N.C.), who is now chairman of the House Financial Services Committee that will have an instrumental role in crypto legislation this year. He’s also building a case against Gensler as an instigator of the industry’s missteps.

“Gary Gensler’s regulation through enforcement isn’t protecting consumers,” McHenry said as his committee got to work last week. “Americans have lost billions of dollars in digital assets to bad actors on his watch.”

Gensler has never backed down from his simple claim that most of the industry is running afoul of securities laws, and most tokens meet the legal definitions of securities outlined in the so-called Howey Test. And the industry, in turn, has steadily maintained that he’s asking them to sign up for a program that doesn’t exist.

No path

“The SEC has never said what a compliant crypto exchange would look like under a securities regulatory regime,” said TuongVy Le, who handles regulatory strategy at Bain Capital Crypto. “There’s just a lack of clarity there.”

Patrick Daugherty, a lawyer who once worked at the SEC but now represents crypto companies and exchanges, put it in more stark terms:

“There is no path available under current law for a crypto exchange to register with the SEC,” he said, citing a registered exchange’s requirements to maintain an audit trail, have only brokerages as members and trade only securities and nothing else. “There is no crypto exchange in existence that can comply.”

Daugherty, who works at Foley & Lardner in Chicago, said he doesn’t necessarily recommend his clients voluntarily go in and talk with the regulator, as Gensler often suggests. He said the agency never says yes to anything, and it sometimes uses what it learns in enforcement actions.

“I don’t think it’s the staff; I think it’s the chairman,” Daugherty said. “This is how Gensler chooses to do things"

But some crypto companies are negotiating settlements with the SEC, as Kraken did with this week’s action. That can be troubling, too, said Le, because the agency isn’t writing crypto rules; it’s steering the industry with its punishments.

Such deals are worked out in private negotiations with the companies, even though the outcomes may be expected to set industry precedent.

“The reason the rulemaking process exists is so that these conversations are not all happening in back rooms somewhere,” Le said.

Though she said she can’t picture what a settlement looks like that breaks through the impasse of crypto platforms registering as exchanges, she hopes something is being worked out. Unlike many in the industry, she has an optimistic take on Gensler.

“I don’t think he wants to kill the whole industry,” she said.