The world’s second largest digital asset exchange has had a tumultuous last few months, weighed down by court cases, regulatory disagreements, plunging profits, and underwhelming expansions. But a closer look at the past, present and possible future of Coinbase (NASDAQ: COIN) reveals how tumult is its natural state.
At a time when it should be celebrating its international expansion, digital asset exchange Coinbase is plagued by civil suits, accusations of insider trading, and just reported its fifth consecutive quarter of negative profits—begging the question: is the exchange expanding or running away from its problems?
A few short days after Coinbase announced the first listings on its newly launched Coinbase International Exchange in Bermuda, figures released on May 4 showed the company generated revenue of $736 million in the three months ending March 31, a decline of almost 37% from the same period last year. However, admittedly that figure is $129 million better than Q4 2022.
This improvement in Q4 could be spun as growth. However, the figures benefitted from a rise in the fiat value of most high-profile tokens since the year began, and the fact remains that it’s another sign the exchange is in decline compared to last year. It also comes at the worst possible moment for Coinbase, as it expects a notification any day of charges by the Securities and Exchange Commission (SEC), one of the top U.S. financial market regulators.
Coinbase was founded by CEO Brian Armstrong in 2012 and is headquartered in San Francisco, California. Since then, it has become the second largest digital asset exchange by trading volume, second only to the non-domiciled Binance.
Coinbase Global Inc., the parent company of Coinbase, went public on April 14, 2021. It debuted on the Nasdaq stock exchange under the ticker symbol COIN, becoming the first major digital asset exchange to be publicly traded in the United States.
The exchange has fostered an image of legitimacy, claiming it wants to be “the most trusted company in crypto.” To this end, it has registered where possible and made a point of publicly working within the laws and regulations of the U.S., where it is listed and has official offices.
Examples can be seen in the various licenses Coinbase holds to operate. In the U.S., it’s registered as a Money Services Business with FinCEN, as well as being licensed as a digital currency business in several states, including New York (BitLicense) and California.
The exchange has implemented compliance measures, including Know Your Customer (KYC) and Anti-Money Laundering (AML) procedures, which involve verifying customers’ identities, monitoring transactions for suspicious activity, and reporting suspicious transactions to relevant authorities.
This is all nice PR and keeps the exchange looking like a good child, particularly when FTX and Binance are in the negative spotlight. However, recent court cases have brought into question the ethics of what is going on behind the company curtains, and, perhaps more concerning for Coinbase, it is also in the crosshairs of the SEC.
SEC woes and lost causes
The SEC believes it has identified securities violations relating to “aspects of the Company’s spot market, staking service Coinbase Earn, Coinbase Prime and Coinbase Wallet” products.
Coinbase responded on April 19 with a lengthy submission to the SEC explaining why the Wells Notice was unjustified and that any action taken by the regulator “will fail as a matter of fact and law.”
A few days later, the exchange filed suit with the U.S. Court of Appeals for the Third Circuit, requesting the court force the financial markets regulator to respond to a petition filed by the company last July, which asked the SEC for regulatory clarity and new rules specific to the unique nature of digital assets.
The SEC did not respond to the July 2022 petition or the April 19 submission, so Coinbase filed its suit on April 24 to attempt to force the agency’s hand. In its documents, the exchange claimed the regulator had “defaulted on its duty to act on Coinbase’s petition even while attempting to enforce its unlawful position.”
The SEC argued in response:
“That Coinbase would like its policy preferences addressed immediately does not entitle it to extraordinary relief ordering the Commission to act on a rulemaking petition that has been pending for well under a year.”
A court has yet to rule on Coinbase’s petition.
If it ever does address the arguments of the exchange, the two key questions Coinbase will want to be answered revolve around what can be classified as a security and who has the authority to make that classification. This is not a straightforward issue, but the SEC has already given some indication of what its answer might be.
Back in 2020, the SEC notified Ripple Labs that it would be bringing enforcement actions against the Ripple exchange for offering XRP, which the regulator claimed amounted to an unlawful unregistered securities offering.
“Rather than engage in rulemaking, the current SEC administration has sought to expand the SEC’s jurisdiction over the cryptocurrency industry through ad hoc enforcement actions.”
Some fans of this argument later seized on a Supreme Court decision from last June related to the U.S. Environmental Protection Agency’s authority to regulate greenhouse gas emissions, which seemed to be making a slightly different point.
The intricacies of the case are unrelated to Coinbase and the SEC’s back-and-forth. However, its ruling is relevant. In its ruling, the Supreme Court formally adopted a doctrine restricting executive-branch agencies from expanding their authority beyond explicit statutory limits.
The “major questions doctrine,” as the Supreme Court named the principle, states that in “extraordinary” cases involving matters of great “economic and political significance,” federal agencies cannot regulate without specific Congressional authorization.
Ripple Labs supporters, including the non-profit Investor Choice Advocates Network and the crypto investment firm Paradigm Operations LP, argued that in its jurisdictional overreach, the SEC had run afoul of the major questions doctrine. This same argument appeared again in the SEC’s insider trading case in Seattle federal court against former Coinbase employee Ishan Wahi and was argued by Coinbase in an Amicus Curiae brief.
Coinbase seemed to have shifted tact from its earlier argument that “the SEC should make crypto-specific rules” to one of “the SEC doesn’t have the authority to make rules on the fly and therefore shouldn’t regulate the industry at all.”
In its April 19 submission response to the SEC’s Well’s Notice, the exchange cited the major question doctrine again, stating that it “forecloses” regulation of the digital asset industry:
“Ultimately, Congress is the appropriate body to develop a comprehensive regulatory regime for the digital asset industry. Until it does so, the Commission may not assert authority over the entire industry via enforcement.”
The SEC has not responded directly to these various “major question doctrine” arguments, but a court document filed by the agency last year in the Ripple case gives an insight into its opinion. In the court document footnotes, the SEC states the major question doctrine:
“It was Congress—not the SEC—that enacted a broad definition of ‘security,’ sufficient to encompass virtually any instrument that might be sold as an investment… Whether Ripple illegally offered and sold securities turns on what Congress legislated by statute and what the Supreme Court has decided, not a rule promulgated by an agency, and the SEC is explicitly authorized to enforce the statute.”
The SEC also addressed the much-used critique of its methods, saying, “enforcement of well-established laws that Congress enacted is not ‘regulation by enforcement,’ it is simply enforcing the law.”
Coinbase and fellow advocates for a change in the SEC’s tact might complain about the regulator not issuing digital asset-specific rules, but if they are right about the implications of the major questions doctrine, then the SEC cannot issue those rules without a Congressional mandate. So crypto advocates that use this argument are effectively asking for one of two things: a continuation of the status quo of enforcement until Congress issues industry and asset-specific rules; or a complete lack of regulation and enforcement until Congress issues these rules.
The upshot is that Coinbase’s attempts to fend off the SEC from clarifying certain assets in which it trades as unregistered securities are likely to amount to nothing, at least until the slow-moving wheels of Congress make industry-specific rules. In the meantime, Coinbase is currently, and has been since its inception, a trading platform for unregistered securities in violation of U.S. securities laws.
The exchange has known this since the civil and criminal charges were filed last July against former Coinbase staffer Ishan Wahi and two associates who were caught trading on advance knowledge of which new tokens would be listed on the exchange.
The SEC said at the time that “at least nine” of the tokens involved in the insider trading scandal were unregistered securities, and Wahi was recently found guilty and sentenced to two years in prison for these offenses. The SEC’s charges and the guilty verdict only make sense if Coinbase is, in fact, listing securities.
So, despite threats, suits, and contradictory arguments, the exchange can expect the SEC to follow through on its Wells Notice imminently, adding to its growing collection of ongoing lawsuits.
A pair of civil suits
With all these regulatory debates and headaches ongoing, May 1 brought two more pieces of unwelcome news for Coinbase; two civil cases being filed against the company on the same day.
A class action suit filed in the Northern District Of California Court accused Coinbase of keeping customers’ biometric data used to set up accounts without notifying them in writing that it would be doing so. This, the suit claims, is illegal based on the Illinois Biometric Information Privacy Act (BIPA).
As part of its KYC checks, Coinbase requires users to upload scans of a valid identity card and a selfie, which it uses to create a biometric template of a user’s face to confirm a facial match.
The case, brought by Michael Massel and “on behalf of all others similarly situated,” hinges on the BIPA Act, which demands that companies with operations in the State of Illinois not obtain or possess an individual’s biometrics without informing the person in writing that the data will be stored, how long it will be stored for, and receiving written consent from the individual to do so. None of which, allegedly, Coinbase did.
The suit seeks $5,000 per intentional and reckless violation of BIPA, or statutory damages of $1,000 per violation—if the court finds that Coinbase’s violations of BIPA were not willful—as well as attorneys’ fees and court costs of the class action.
Depending on the number of intentional or reckless violations found, this could prove costly for the exchange at a time when its profits are already suffering. However, if the suit proceeds, the plaintiff’s promise to seek via discovery “all of the ways in which Coinbase disclosed, redisclosed, or otherwise disseminated” the data could prove more damaging in PR terms than any monetary pay-out—depending on what the company has been doing with its customers’ data.
The very same day, the biometric data suit landed in California, over in Delaware, Coinbase CEO Brian Armstrong and several executives were being accused of insider trading by shareholders.
The Derivative Complaint, which is a legal claim filed on behalf of a business entity by one or more of its shareholders, was filed with the Court of Chancery of Delaware by investor Adam Grabski and on behalf of Coinbase Global.
The suit, brought by investor Adam Grabski on behalf of Coinbase Global, alleges that Coinbase executives, including CEO Brian Armstrong, failed to disclose a disparity between the company’s internal valuation and perceived market value before it went public in April 2021, saving themselves a reported $1.09 billion as a result.
The suit names eight senior officers and directors of the company, including CEO Brian Armstrong. They are accused of choosing to put the exchange through a direct listing of existing shares instead of the more common initial public offering (IPO) in order to stop the issuing of new shares and avoid the standard lockup period (preventing insiders from immediately selling their shares) that comes with an IPO.
The direct listing allowed the executives to sell their pre-existing shares as soon as the company went public, and the suit claims that the defendants “were able to sell $2.9 billion worth of Coinbase shares made available to the public through a direct listing of the company’s stock.”
Coinbase was dismissive of the suit, calling it “frivolous” and “meritless.” While they might be playing it cool, it is nonetheless an embarrassing spotlight that the company doesn’t need right now, with SEC charges almost certainly en route and a potentially awkward data management suit to deal with as well.
A history of questionable practices
Despite their seemingly blasé response to the accusation of insider trading, perhaps such suits should come as no surprise, considering that Coinbase has been dogged by allegations of questionable trading practices from the start.
Before Coinbase went public in 2021, they settled a case with the Commodity Futures Trading Commission (CFTC) for “reporting false, misleading, or inaccurate transaction information,” which undermined the integrity of digital asset pricing on the platform.
The settlement required Coinbase to pay a civil monetary penalty of $6.5 million and to cease and desist from any further violations of the Commodity Exchange Act or CFTC regulations.
The CFTC order also accused the platform of wash trading—making fake trades to manipulate prices—by a former employee on Coinbase’s GDAX platform from August through September 2016:
“A former Coinbase employee used a manipulative or deceptive device by intentionally placing buy and sell orders in the Litecoin/Bitcoin trading pair on GDAX that matched each other as wash trades. This created the misleading appearance of liquidity and trading interest in Litecoin. Coinbase is therefore found to be vicariously liable as a principal for this employee’s conduct,” said the CFTC.
The employee in question, referred to as “Employee A” in the settlement, was not named, but there is a strong suggestion that it is Charlie Lee, who was also, coincidentally, the creator of Litecoin.
Charlie Lee was an employee of Coinbase when the exchange added Litecoin, a digital currency he created in October 2011. From January 2012 to April 2017, Litecoin’s price stagnated without much major interest; the only small bump in the activity being seen around the time it was added to GDAX (now Coinbase PRO) in late August 2016, but as the CFTC pointed out, this was the same time its activity was being manipulated with wash trading.
After this brief suspicious spike in trading, Litecoin returned to its relatively poor performance until just before it was about to be added to Coinbase. In the days before Coinbase made the announcement, on March 30, its activity and value shot up—in other words, a classic ‘pump’ by those who knew it was about to be added. Soon after it was added, Lee quit working for Coinbase to “shift focus to Litecoin.” Once Litecoin hit highs of around $370 in December 2017, then came the ‘dump’; Lee liquidated all of his Litecoins, citing concerns about “conflict of interest,” and saying, “Please don’t ask me how many coins I sold or at what price.”
This is the inauspicious start to the Coinbase story, but in 2023 has the company turned a corner and, court cases aside, put its questionable practices behind them?
A failed endeavor
Unfortunately for those heavily invested in the exchange, there are suggestions that it might be up to new worrying schemes. Namely, the platform was planning to, and potentially already has, borrowed money to lend to its customers, using crypto as collateral.
Coinbase Borrow, as it was called, was a short-lived endeavor launched by the company last year.
If you were an eligible Coinbase customer, you could borrow up to 30% of your BTC balance on Coinbase, up to US$100,000 with a minimum of $2,000. If the USD value of your BTC increases, you could apply for more than one loan.
The program was supposed to work with customers using their digital currency holdings as collateral to borrow money. However, in the company’s 2023 annual report, in a section entitled ‘risk factors,’ which references the Coinbase Borrow scheme, the report states that:
“In the future we may enter into credit arrangements with financial institutions to obtain more capital. Any termination or interruption in the financial institutions’ ability to lend to us could interrupt our ability to provide capital to qualified customers.”
So Coinbase seemed to be planning to borrow money in order to lend more money. What would then happen if Coinbase’s borrower customers defaulted? Surely the exchange had thought about this possibility and covered itself so that it could repay its debts? Apparently not:
“The efficacy of our security interest in customer collateral is not guaranteed under applicable state law or the Uniform Commercial Code (UCC) and therefore we may be exposed to loss in the event of a customer default, even if we appear to be secured against such default.”
The UCC establishes U.S. rules for creating and enforcing security interests, ensuring that lenders have legal rights and protections when borrowers default on their loan obligations. If Coinbase was not covered by this or any other law, then the Coinbase Borrow scheme was more of a danger to the company than the customers. But if enough borrowers started defaulting en masse on their loans, the platform would have a serious problem repaying its own debts, which would likely have knock-on effects for the rest of the exchange’s customers if it spiraled into bankruptcy.
The exact number of eligible users who utilized the Borrow program isn’t clear, but it appears Coinbase has seen the danger highlighted in its annual report and an email sent to Coinbase Borrow customers on May 3, shared by one customer on Twitter, the exchange announced—without providing a reason—that from May 10, customers wouldn’t be able to take out new loans using Coinbase Borrow.
The risky folly was cut short before it ended in tears. Disaster potentially averted this time, but the future increasingly looks uncertain for the controversial exchange, particularly in the U.S.
Moving away from the US and its regulation
The various issues the company has faced, and continues to face in the U.S. have not gone unnoticed by those calling the shots at Coinbase, or by the market.
On May 1, U.S. multinational investment bank and financial services corporation Citi downgraded its assessment of Coinbase shares from “Buy” to “Neutral,” citing an uncertain regulatory backdrop.
In a note explaining the move, an analyst for the global bank reportedly wrote that, “until the regulatory’ rules of the road’ are better established in the U.S., the stock will remain weighed down by this high level of uncertainty.”
The timing of this was unfortunate for the company, to say the least, as a few days later, it revealed its loss of earnings for a fifth straight quarter.
It was also supposed to be a time of some fanfare for Coinbase, as it had just announced the opening of its international exchange in Bermuda. However, the Citi analyst’s note also mentioned “Coinbase’s notions of redomiciling outside of the U.S.” as part of the reason for the downgrade of its stock.
Coinbase International Exchange, as it is known, will initially let traders bet on the price of BTC and ETH via perpetual futures contracts, with hopes to expand its offerings further down the line. But some saw the move as the beginning of an exodus from the U.S. to more ‘crypto-friendly’ shores.
In a possible attempt to quell some of the concern over this move abroad, expressed by Citi Bank and the market in a blog post on May 2, the exchange stated:
“Rest assured that Coinbase is committed to the U.S., but countries around the world are increasingly moving forward with responsible crypto-forward regulatory frameworks to strategically position themselves as crypto hubs. We would like to see the U.S. take a similar approach instead of regulation by enforcement which has led to a disappointing trend for crypto development in the U.S.”
Coinbase also took the opportunity to take another [possibly parting?] shot at the SEC, suggesting the regulator’s regulation-by-enforcement approach is “suppressing crypto development in the U.S.”
Whether this move will prove a success or failure for the company remains to be seen. But in the backdrop of court cases, regulatory battles, and falling profits, when even expansion inspires such concerned responses, it suggests Coinbase has some way to go to win back the trust of the self-styled “safest, most trusted name in crypto.”
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