The Securities & Exchange Commission (SEC) isn’t one of our favorite federal agencies. It’s placed numerous roadblocks in the way of Americans looking to invest overseas. And the agency’s attempt to limit supposedly risky investments to “accredited investors” – generally, people with a net worth over $1 million – in our view unnecessarily limits the ability of less well-off investors to diversify their portfolios.
More recently, the SEC has turned its steely gaze on the cryptocurrency phenomenon. And this powerful bureaucracy obviously doesn’t like what it sees.
The agency’s enforcement efforts have entered a new phase with a flurry of rulings and lawsuits against some of the nascent industry’s biggest and most powerful players. Understandably, those players are pushing back. In the middle are companies and investors seeking some sort of regulatory certainty that doesn’t appear to be forthcoming anytime soon.
At the center of the controversy is disagreement over whether cryptos are property, commodities, or securities. For tax purposes, the IRS ruled in 2014 that what it called “virtual currencies” were property. You have a capital gain or loss every time you make a transaction; even something as small as buying a cup of coffee using bitcoin or another crypto. Meanwhile, the Commodity Futures Trading Commission (CFTC) says that cryptos are commodities, just like gold, cotton, or oil.
But while the SEC once waffled on the question, it has concluded that cryptos “may be securities, depending on the facts and circumstances.” In July 2017, an agency report concluded that “offers and sales of digital assets by ‘virtual’ organizations are subject to the requirements of the federal securities laws.”
It then began systematically targeting the crypto industry. Beginning with smaller promoters, the agency moved up the crypto food chain. By 2020, it had forced the messaging platforms Telegram and Kik to disgorge profits generated from their respective ICOs.
An even bigger target was Ripple Labs, which the agency tried to force into a settlement in 2019. Ripple was introduced in 2012 and combines a cryptocurrency called XRP and a digital payment network. But the payment network turned out to be more popular than XRP. Ripple’s founders thus tried to find ways to increase its value – and were very successful in doing so.
The SEC says those efforts proved that XRP was a security. In a lawsuit the agency filed against Ripple in December 2020, it claims that XRP is an unregistered security, names top Ripple executives as defendants, and demands billions of dollars in fines. According to the lawsuit, Ripple Labs has foisted XRP into the market through sweetheart deals with large buyers in which the crypto was sold at a discount, giving those buyers a guaranteed profit. Smaller investors lost out.
We think the SEC makes a convincing case that Ripple’s promoters didn’t give those smaller investors adequate disclosure of their inside deals. But that’s hardly the whole story.
In its defense, Ripple points to the fact that the SEC has made no effort to crack down on bitcoin and ether. Both are much larger market cap cryptos and aren’t registered as securities. The company has also hired top-notch legal talent to defend itself, including the former head of the SEC. It promises to fight the lawsuit all the way to the Supreme Court.
Ripple has also marshalled a network of XRP enthusiasts that calls itself the “XRP Army” with more than one million followers on YouTube and Twitter. This “Army” has uncovered substantial evidence of SEC misconduct and even perjury. In response, the SEC has made damaging admissions, including that despite many requests by Ripple for official guidance from the agency, the SEC never pronounced XRP a security until it filed its lawsuit.
The lawsuit also ignores the real utility of XRP as the key component of a digital payments network. Instead, the SEC is alleging that its only purpose is as an investment. Indeed, the agency claims that Ripple’s executives should have known XRP was a security from the moment it was launched, even though the agency wasn’t willing to call it that until it filed its lawsuit.
It’s anyone’s guess how the case against Ripple will be resolved, although the SEC wins the vast majority of the time when it takes companies to court.
The Biden administration has also indicated a renewed enthusiasm for regulating cryptos, and appointed Gary Gensler to head up the SEC. Gensler, a professor at MIT’s Sloan School of Management, has taught courses on blockchain technologies and digital currencies. Some of his pronouncements have ruffled feathers. However, we’d find it hard to disagree with statements he’s made such as one in an August speech where he claimed the crypto market is “rife with fraud, scams and abuse.”
In the same speech, Gensler compared the market to the “wildcat banking” era; the pre-Civil War period during which banks issued their own currencies, which on numerous occasions became worthless. He also said (and we again agree) that there’s no way thousands of cryptos will have “long-term viability.”
But we do have a problem with calling virtually every offering of a cryptocurrency a “securities offering” and requiring it to be registered with the SEC. Not every crypto fits neatly into this box, as the agency’s case against Ripple demonstrates.
In the meantime, the Gensler-led SEC announced last month that it would sue America’s largest crypto exchange, Coinbase, if it launched a program called Lend. The Lend initiative would let crypto investors loan out a “stablecoin” crypto called USDC whose value is tied one-to-one to the US dollar. Borrowers would pay 4% interest on the loan – an attractive return to crypto investors given the zero-interest rate policy of financial repression the Federal Reserve has forced on investors for more than a decade.
The SEC claims that Lend constitutes a security subject to its jurisdiction, despite the fact that dozens of other crypto companies offer lending features that the agency hasn’t targeted. But it won’t tell Coinbase how it came to that conclusion, other than justifying it “through the prism of decades-old Supreme Court cases.” Like Ripple Labs, Coinbase requested advance guidance on this issue, but the SEC refused to provide it until it issued its warning letter. Indeed, Coinbase CEO Brian Armstrong says that the SEC refuses to meet with him at all.
And the SEC isn’t the only federal agency viewing crypto with a jaundiced eye. In 2013, the Treasury’s Financial Crimes Enforcement Network (FinCEN) concluded that money services businesses that deal with virtual assets are money transmitters and must comply with applicable anti-money laundering regulations. FinCEN also announced that what it calls “virtual currency” held on a non-US exchange is a reportable account on Form 114, the “foreign bank account report” (or FBAR).
Meanwhile, a proposed rule that’s part of the Biden infrastructure bill expands the definition of “broker” with respect to crypto transactions. If enacted, crypto exchanges, crypto miners, and possibly even crypto software developers would need to report crypto transactions to the IRS. This is similar to the rules requiring financial institutions that pay interest or dividends to investors report these payments on Form 1099 to the agency.
We’ve also been warning for some time of growing IRS resources devoted to unearthing untaxed crypto holdings. In April, a federal judge in Boston signed off on an IRS summons to Circle, a mobile payments platform. In May, a San Francisco federal court upheld another summons for a crypto exchange called Kraken.
Meanwhile, the upward tear cryptos enjoyed almost across-the-board in 2020 and the early months of 2021 has paused. On May 19, crypto prices dove off a cliff after the Chinese government announced it would prohibit financial institutions and payment platforms from providing crypto-related services. When this news reached investors, bitcoin’s price plummeted to 53% below its April 15 peak.
Then on September 24, China banned all financial transactions involving crypto, tagging them illegal and outlawed crypto mining operations. In response bitcoin’s price dropped 7%, although it soon recovered.
We’ll repeat our initial question: when the dust settles and Congress, along with an alphabet soup of regulatory agencies have had their way with crypto, will this asset class have staying power?
Our take is that cryptos are here to stay. The revolutionary promises of instantaneous payments made peer-to-peer, rather than through a central authority, and of smart contracts, which are self-executing without an intermediary, are too valuable to simply go away. But the long-term viability of individual cryptos as a store of value is hardly guaranteed.
After all, the barriers to entry for a new crypto are almost non-existent. If you want to launch your own crypto, you can do it for virtually nothing. A service called WalletBuilders offers a free tool to create your own crypto “without any knowledge of programming.” Naturally, there’s no telling if it will be as successful as bitcoin, ether, or XRP – but who knows? You might just become the next crypto billionaire.
But the real obstacle to the survival of privately issued cryptos are governments. And it’s not just the SEC and assorted federal agencies. The 900-pound gorilla in the room are central banks. Dozens of them are exploring the idea of issuing their own central bank digital currencies (CBDCs). As we’ve pointed out before, the advantage of CBDCs from the standpoint of central banks and governments is that they can be inflated at will and also micro-managed.
Once introduced, CBDCs will gain market share since central banks will make them convenient to use. It will become much more difficult for private cryptos to survive, especially if they’re regulated as securities and forced to adhere to strict anti-money-laundering rules. Or if as in China, unapproved cryptos are banned altogether.
The fact is that it’s only been 12 years since bitcoin – the first crypto – was launched. It’s far too early to know how bitcoin or any other crypto is going to perform in the long term.
At the same time though, crypto is no longer a pie-in-the-sky concept, but a rapidly developing industry with long-term implications that are only now beginning to take shape.
We continue to believe that the Permanent Portfolio concept should be the underpinning of your investment strategy to protect funds you simply can’t afford to lose. Crypto investments should be viewed as more speculative holdings whose values can erode instantaneously.