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Sept. 11, 2021, 10:01 a.m. EDT

Here’s why Coinbase is in hot water over crypto lending — and how the SEC is sending a shot across the bow for DeFi

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By Mark DeCambre

Coinbase Global finds itself in a dust-up with its top regulator over lending practices that the Securities and Exchange Commission says run afoul of existing securities rules.

Brian Armstrong, the outspoken chief executive of Coinbase /zigman2/quotes/225893452/composite COIN -6.69% , late Tuesday disclosed that the crypto platform is being investigated over a lending program that allows customers holding Circle’s USD stablecoin — an asset intended to serve as a digital dollar — to earn interest of around 4% APY, by lending it to Coinbase, which in turn lends it to traders.

Crypto experts and financial specialists explained to MarketWatch that the legal dispute could be one that establishes clearer rules for the burgeoning segment of the digital-asset market known as decentralized finance, or DeFi, where investors lend out digital coins to earn additional fee income.

Also read: What is decentralized finance? An expert on bitcoins and blockchains explains the risks and rewards of DeFi

Crypto professionals say that DeFi has been growing, and Coinbase — which currently offers a variety of services, including trading of bitcoin /zigman2/quotes/31322028/realtime BTCUSD -1.19% , meme asset dogecoin /zigman2/quotes/226077044/realtime DOGEUSD -1.87% and Ether /zigman2/quotes/108573964/realtime ETHUSD -1.93% — wants to expand its fee-generating offerings as a publicly traded company.

Similar to the stock market, the coins that are lent out by customers can facilitate speculation via crypto derivatives and other products.

In the eyes of the SEC, however, the lending program securitizes the crypto, with the interest passed on to the customer, similar to how a bond pays interest to a holder or how a stock pays dividends.

Armstrong, in a series of tweets, made the case that the SEC, run by Gary Gensler, who took the reins of the regulatory body in the middle of April, hasn’t made clear its position on what is and isn’t a security.

However, at least one former regulator said that the SEC has been crystal clear on its stance on the matter.

“When does a crypto asset become a security? When you start lending it out,” Amy Lynch, a former SEC regulator and president of FrontLine Compliance, told MarketWatch in a phone interview Wednesday afternoon.

Coinbase had planned to eventually expand its crypto lending program to other assets outside of USD Coin.

Lynch said she advises that companies that offer crypto lending services register with the SEC or go through a broker/dealer to comply with regulatory rules.

For example, Gemini partners with crypto lender Genesis, a subsidiary of Digital Currency Group. In that case, Gemini, owned by twins Cameron and Tyler Winklevoss, collects part of the spread between interest paid on the crypto and interest Genesis charges on its loans to institutions. 

Lynch said Coinbase may not be eager to establish such an arrangement because it would mean sharing fees.

“If the SEC decided that this is an area of concern, they are going to start looking more closely at the firms that do this,” she said.  

Indeed, The Wall Street Journal recently reported that the SEC sent letters to companies seeking information about crypto lending platforms. MarketWatch’s sister publication reported that the regulator sought information, including on whether digital assets being offered are securities that should be registered.

R.A. Farrokhnia, a professor at Columbia Business School, said Coinbase represents financial innovation and that regulation should not stifle the “new new thing.”

“What you are witnessing is the evolution of crypto, and specifically the next phase is decentralized finance,” Farrokhnia said.

“Regrettably, despite crypto being in our financial ecosystem for the past several years, there hasn’t been a clear-cut regulatory framework…indicating what’s allowed and what isn’t allowed,” he said.

“So, this lack of regulatory clarity on what exactly is considered a security under the existing framework…[without the] creation of brand-new regulation, custom-made for our new reality, is causing all sorts of confusion,” Farrokhnia said, explaining that he believes the SEC should express greater willingness to collaborate with the nascent crypto industry.

Gensler, who has trained the SEC’s focus on investor protections — perhaps more than any other regulator to date — has openly said that he also aims to upgrade crypto rules.

“To the extent that something is a security, the SEC has a lot of authority. And a lot of crypto tokens — I won’t call them cryptocurrencies for this moment — are indeed securities,” Gensler told CNBC during an interview back in May.

“We need to update and freshen our rules to ensure that, while retail investors and any individual has First Amendment rights to speak and so forth, that they’re not misleading the public, they’re not manipulating the public, manipulating the markets,” he said.

Lynch said the SEC’s stance on Coinbase’s lending may be influenced by a recent lawsuit against BitConnect, which offered its own digital security in 2016 in exchange for bitcoin and created an automated program that made money by trading the contributed bitcoin. Investors thought profits were being shared but the SEC alleges that the program was an elaborate Ponzi scheme .

Coinbase shares on Wednesday finished down 3.2% and are down 7.3% for the week, compared with a weekly decline for the Dow Jones Industrial Average /zigman2/quotes/210598065/realtime DJIA -0.17% and the S&P 500 index /zigman2/quotes/210599714/realtime SPX -0.84% of 0.5% and 1%, respectively.

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