By Brett Munster
Coinbase is not playing SECond fiddle
In our April 11th issue, we covered the Wells Notice the SEC sent to Coinbase. As a quick refresher, a Wells Notice is a formal notification to a company that it intends to bring enforcement action in the future but is not an official action yet. Rather than waiting for that regulatory action to be issued, Coinbase went on the offensive and filed a lawsuit against the SEC first. While that may sound counter-intuitive (usually it’s not a good idea to sue the agency that is responsible for regulating you), in this specific case it could prove to be a savvy move by Coinbase. Regardless of the outcome of the lawsuit, Coinbase is likely to get what they want. Let me explain.
Back in July 2022, Coinbase filed a “rulemaking petition” asking the SEC to officially lay out which tokens the SEC considers securities and the criteria used to make that determination. Coinbase also requested rules be set for how a company should go about listing cryptoassets and remain compliant given the unique characteristics cryptoassets have that make some of the current rules impossible to abide by in practice.
The SEC is required by law to respond to Rulemaking Petitions within a reasonable amount of time. It’s now been ten months since Coinbase filed their petition and the SEC has yet to respond. Given the plethora of public statements, interviews Gensler has done, and comments made to Congress in recent months on the same topic Coinbase requested, it’s hard to argue that the SEC hasn’t had a reasonable amount of time to come up with their answer. All the lawsuit is claiming is that because the SEC hasn’t responded, the agency has not performed its legal duty and Coinbase is merely requesting that the court compel the SEC to provide an answer to the petition filed last year.
The legal system seemed to agree with Coinbase. Last Thursday, the court ordered the SEC to respond to the rulemaking petition within 10 days. With the enormous caveat that I’m not a lawyer nor have I ever played one on TV, based on my understanding, there are three possible scenarios for how this could play out.
First, the SEC could give Coinbase exactly what they are asking for in their petition and provide comprehensive, clear rules on the criteria for what is and isn’t a security and how exchanges can register with the SEC. In this case, the industry would finally have the clarity it has been asking for years and we can begin to move on. However, the chances of this happening are about as close to zero as it gets.
Second, the SEC could provide a response that includes vague language and gives the SEC broad authority over the crypto industry which would still be more than they have ever done in the past. It’s likely the crypto industry would not like the SEC’s response in this case but at least the SEC would be on record with their official criteria which could then be challenged in court (something that is not possible today because again, the SEC has never issued any formal rules on crypto). Having the SEC set some sort, any sort, of official rulemaking would at least give Coinbase (and the rest of the industry for that matter), precedent to take the SEC to court over the legality and constitutional nature of those rules. Not ideal, but it’s a step forward.
Given Gary Gensler’s reluctance to provide any guidance in the past, even when pressed in congressional hearings, it’s unlikely he takes door number two. Gensler is a bad faith regulator, but he is not dumb. He is very smart and calculating and he knows that any response to Coinbase’s petition will become a basis for all future court cases the SEC gets embroiled in. This would also be an admission that further rules are needed which would fly in the face of Gensler’s repeated position over the last several months that the crypto industry does not need any more rules.
The most likely outcome of the lawsuit is option number 3. Just because the SEC is required by law to respond to Coinbase’s petition, that doesn’t mean they have to provide any sort of answer. The SEC could simply say “no” as their response thereby refusing to provide any rules or guidance. Technically, that is a response to the petition and would satisfy the legal requirement. But here is the problem with that approach. Gensler is on record saying the current rules are clear. He is also on record saying crypto companies should just come in and talk to the SEC (which Coinbase and many companies have done countless times and gotten no response other than legal action against them). By saying nothing, it dramatically undermines Gary’s message and credibility for future court cases.
When it comes to crypto, Gensler has purposely positioned the SEC in this legal gray area because it allows the SEC to exercise influence and authority over parts of the market that Congress has yet to clearly define. That ambiguity gives him the most reach and power. The lack of concrete guidance from the SEC on cryptoassets also allows the agency to avoid any litigation from the crypto industry on any new rules they were to put in place thus allowing Gensler to issue enforcement actions whenever and to whomever he likes. Coinbase is now taking the first steps to force the SEC out of that ambiguity. Coinbase doesn’t have to win this lawsuit to get what it needs. If the SEC says no to Coinbase’s petition, that builds a court record that Coinbase can later use to show that they have tried to pursue a legal pathway, but the SEC has refused to provide one and thus there is no way for crypto companies to comply with the current laws. No matter what the SEC does following this lawsuit, it gives Coinbase legal footing against the SEC that has never previously existed. I believe that the purpose of this lawsuit isn’t to win, it’s to set precedent in Coinbase’s favor (and the crypto industry’s favor at large) to win future, more important court cases against the SEC.
Gensler has backed himself into a corner by saying the rules are clear and handing out one-off enforcement actions without any rule making. Let’s just take the simple case of whether cryptoassets are securities or not. Gensler has said multiple times that all cryptoassets, except bitcoin, are securities. If that’s the case, what makes bitcoin different from every other cryptoasset? I have some ideas (as I’m sure most people do), but the SEC has never once articulated why bitcoin is a commodity while all others are securities. That is definitely not clarity.
And what about ETH? It’s the second largest crypto so surely it should be easy for the SEC to explain why it is a security. Right? Turns out the answer is no. When asked by Congress no less than 7 times just the other week if Ethereum is a security, Gensler could not answer yes or no. Not to mention the CFTC has come out and specifically stated that Ethereum, along with many other cryptoassets, are in fact commodities which directly contradicts Gensler’s view. How is any of that providing clarity for the market?
Even Gensler’s own position on cryptoassets isn’t consistent. In 2018, an MIT professor teaching a course on “Blockchain and Money” stated three quarters of all cryptoassets are NOT securities. That professor was…wait for it…Gary Gensler. But that was five years ago, and one could argue a lot has changed since then. Fair point. But as recent as 2021, as Chair of the SEC, Gary Gensler said “Right now, the exchanges trading in these cryptoassets do not have a regulatory framework, either at the SEC or our sister agency the Commodity Futures Trading Commission.” Apparently, even Gary Gensler of 2021 doesn’t agree with Gary Gensler’s current rhetoric that there is market clarity.
It’s no wonder that a recent survey of investors showed that the vast majority of them agree that the US does not have clear rules when it comes to digital assets and 78% want better clarity from regulators about how digital assets are classified or treated. Furthermore, nearly 90% said that regulatory clarity would increase their confidence in making future investments in cryptoassets.
Assuming Gensler responds to this lawsuit by saying no to issuing new rules and guidelines, this would be yet further evidence of the SEC acting in bad faith towards the crypto industry. The truth is the SEC has never once gone through a notice and comment rulemaking process or issued formal guidance with regards to defining cryptoassets, laying out a pathway for exchanges to register, or defining what disclosures need to be included. To claim that the rules are clear is disingenuous at best. Coinbase’s lawsuit is an attempt to force the SEC to either issue rules (which would contradict the SEC’s stance that current frameworks are adequate and any allow companies to challenge those rules in court) or engage in a subsequent legal battle the SEC is poorly positioned to defend itself against.
Coinbase is playing 3D chess here and this lawsuit is only the opening move. Coinbase has the resources and desire (this is existential to their business after all) to fight the SEC all the way to the Supreme Court if need be. Coinbase also has a top tier legal team including their Chief Legal Officer Paul Grewal (a former federal judge) and former Secretary of Labor Eugene Scalia (yes, Justice Scalia’s son) who has a track record of beating the SEC in court. Coinbase is building a strong case that the SEC has failed to provide a well-defined regulatory framework and it’s going to be very interesting to watch this unfold over the next few years.
Watershed crypto legislation in the EU
While the current regulatory agencies have taken a hostile approach to crypto in the US and Congress has yet to enact any new legislation, the EU is taking a very different approach. On April 20th EU lawmakers voted 517-29 in favor of the Markets in Crypto Assets Act (aka MiCA). MiCA is arguably the world’s most comprehensive crypto regulatory framework to date, will cover the whole EU with one unified set of crypto regulations and is expected to become law in the next 12-18 months.
Unlike in the US where a stablecoin bill, a crypto exchange bill and a SAFE harbor bill are all being negotiated separately, the EU decided to put these concepts under the same landmark legislation. MiCA covers stablecoin issuance, crypto asset services like exchange and custody, token offerings and more.
Though the bill is far from perfect, it does the one thing that the crypto industry has been clamoring for years – provide clarity. Rather than treat all cryptoassets the same, MiCA creates a well-defined cryptoasset taxonomy that includes various subcategories of cryptoassets based on their characteristics. Utility tokens, asset-referenced tokens, e-money tokens (known in the states as stablecoins), NFTs, and security tokens each have their own unique set of requirements and disclosures. Though there are exemptions for utility tokens and small-scale tokens, issuers of cryptoassets have to draft a detailed white paper with all the relevant information about the project, the issuer, the risks involved, the technology used, the economic design of the token, and the environmental impact of the consensus mechanism. MiCA requires crypto companies in the EU to obtain a license for offering crypto brokerage services unless they are already licensed under the EU Markets in Financial Instruments Directive. Under the license, crypto companies must comply with minimum requirements around safekeeping of assets, wind-down plans, information disclosure and prudential requirements.
The one area the MiCA smartly leaves untouched is DeFi. MiCA exempts decentralized protocols from its regulatory umbrella if “crypto-asset services are provided in a fully decentralized manner without any intermediary.” However, MiCA does not define what constitutes “sufficient decentralization” at this time so it’s unclear which projects would be considered exempt.
The other important thing MiCA accomplishes is a unified legislation framework across Europe. Until now, crypto companies in the EU had to register in each individual country separately, which all had different rules and regulations. As a result, none of the largest crypto companies are headquartered in Europe today and not a single EU country is part of the top 20 countries in the 2022 global crypto adoption index. Once MiCA takes effect, crypto companies with a license in one EU country will be able to “passport” that license to all other 27 member countries, providing a streamlined path to compliance in multiple jurisdictions. MiCA has the potential to create the conditions for crypto companies to thrive in the EU for the first time.
It’s also very possible MiCA will lead to more institutional adoption among European investors as they will likely feel more comfortable allocating to crypto now that the asset class has a clear set of rules. Furthermore, creating regulatory clarity could very well attract capital, talent, and companies from jurisdictions with far more anti-crypto or opaque policies such as the United States. Back in July of last year when MiCA was being drafted, CFTC Commissioner Caroline Pham said “as the U.S. struggles to provide regulatory clarity to the domestic crypto industry, global regulatory frameworks like MiCA could fill the gap.” Sure enough, last week we saw both Coinbase and Gemini confirm they will be opening up offshore exchanges. The longer the US regulatory vacuum for cryptoassets persists, the greater impact MiCA is likely to have on global standards.
MiCA isn’t perfect, but the legislation is rightfully being hailed for providing the kind of clear framework the industry needs to continue to innovate and grow.
What’s next for Ethereum?
Last year Ethereum changed its method for validating transactions from Proof-of-Work to Proof-of-Stake (aka “The Merge”) and then last month enabled users to withdraw their staked funds for the first time (aka “Shapella”). These were two of the biggest updates to the Ethereum network in its history but that doesn’t mean Ethereum is done improving. In fact, there are a number of additional upgrades coming as soon as later this year. The last thing we want is for any of our readers to be at a dinner party and someone makes a funny comment about Proto-Danksharding, everyone laughs, and you have no idea what anyone is talking about (though I fully recognize its likely most of you attend much cooler dinner parties than I do…). Regardless, lets cover two of the most important improvements coming to Ethereum over the next year or two.
The first and possibly most important improvement coming to Ethereum is sharding. If you remember our coverage of The Merge, we highlighted the fact that The Merge didn’t directly improve scalability, it merely created the preconditions necessary for future upgrades to increase the transaction throughput and speed. Well, sharding is that future upgrade.
As we know, Ethereum’s base layer can handle a limited number of transactions before blocks become full, wait times increase, and fees rise. Hence, we have Layer 2 networks such as Arbitrum and Optimism. The idea behind Layer 2 networks is that they take on the computational burden of processing transactions which frees up the underlying Ethereum base chain to handle the security and storage functionalities. While this is a huge improvement and we have seen Layer 2 networks take off in usage, Layer 2s still can’t quite reach their full potential due to the design architecture of the underlying Ethereum base chain. The fastest Layer 2 networks still have to submit a significant amount of data to build consensus on the Layer-1 chain. Moreover, it places a heavy burden on validators to download this data given an estimated 95% of the transaction fees on Layer 2s are due to costs associated with posting data to the base layer.
Sharding alleviates this data problem by splitting the Ethereum blockchain network into multiple, parallel blockchains, each one responsible for processing transactions of a given type. This greatly increases the space for more data which should make transactions on Layer 2 as cheap as possible for users and should allow Ethereum to scale to more than 100,000 transactions per second. Simply put, sharding is akin to adding additional lanes to a congested highway. Anytime you hear the word “sharding” in crypto, think of greater scalability and more transactions.
The end goal for Ethereum is what is called “Danksharding” which is a specific method of sharding named after the individual who first proposed sharding on Ethereum, Dankrad Feist. However, the fully realized version of Danksharding is still years away and requires several steps to get there. The first step in that process is EIP-4844, otherwise known as “Proto-Danksharding.” The ‘Proto’ prefix refers to crypto researcher Proto Lambda. Now I know that Proto-Danksharding sounds weird and intimidating, but it’s really quite simple. Proto-Danksharding is just a fancy term that refers to the first step of improving Ethereum’s transaction capabilities by enabling Layer 2s to transfer their data much more cheaply and pass the savings on to end users in the form of cheaper transactions. It’s likely to also decrease the cost of running a node on the Ethereum network which should lead to a more robust and decentralized network.
EIP-4844 is currently scheduled to be implemented in Q3 or Q4 of this year. However, if history is any indication, it’s very possible that the timeline gets pushed back to early 2024.
The second major upgrade on Ethereum’s horizon is Proposer-Builder Separation (aka PBS). This is likely further out on the timeline than Proto-Danksharding but still worth knowing about. When transactions are submitted on the Ethereum blockchain, they initially enter a pool of pending transactions known as the mempool (short for memory pool). Validators (ie: anyone who staked at least 32 ETH) can see every transaction in the mempool and pick which individual transactions to verify and then group them together to form a block. Because validators ultimately decide which transactions are completed and in what sequence, there is an opportunity to front-run certain transactions before the block is built.
The value that a validator can obtain, above the standard block reward and gas fee, from front running transactions due to the ability to change the order of transactions within a block is called Maximum Extractable Value (often referred to as MEV). MEV is essentially an invisible tax in the form of slippage (deviation from the price a user tried to buy ETH at and the price they actually received) on the Ethereum network. MEV can also cause congestion and increased gas fees as there are additional transactions that get put in blocks which in theory could crowd out other transactions from the mempool. Taking advantage of MEV opportunities requires sophisticated technical know-how and custom software making it much more likely that institutional operators benefit from MEV rather than everyday stakers. It potentially could also lead to more centralization because the staking returns for large, centralized operators could be higher thus disincentivizing smaller or individual stakers.
Proposer-Builder Separation looks to solve these problems. As the name implies, PBS splits the validator function into two separate roles. The first role consists of grouping individual transactions and the order into a block (block builders) and the second role is validating a block of transactions and propagating it to the network for inclusion in the blockchain (block proposers). The key to this is that the block proposers can’t see the contents of the block, they simply choose what they believe will be the most profitable based on which block has transactions that are willing to pay the highest fees. Proposers then pay a small fee to the block builder as a thank you for doing their job before sending the block to the network and collecting those fees.
This separation greatly limits the opportunity for a builder to benefit from MEV. Block builders still have the ability to pick transactions from the mempool and in which order. However, if builders try to front run transactions, the rewards from doing so are likely to go to the block proposer, not the builder. Thus, there should be less incentive for sophisticated operations to front run transactions as builders.
For proposers, PBS levels the playing field. Rather than doing their own MEV searching, block proposers can only pick a pre-built block. Block proposers have no way of directly influencing which transactions or which order the transactions make up a block so it should be impossible to front run any transaction as a proposer. Furthermore, a small or solo validator sees the same information as a large validator so sophisticated operations do not gain any advantage over smaller validators when proposing blocks. This should limit any centralizing force MEV would otherwise exert on the Ethereum network.
By altering the economics, the hope is that PBS will solve most of the problems caused by MEV. But that is not the only thing PBS should solve.
PBS also helps increase the censorship resistance of the network. Under the current system in which one validator plays both roles, there is potential for validators to purposely exclude certain transactions for whatever reason they deem fit. By separating this into two functions, it makes it much harder for block proposers to exclude transactions as they do not get to see which transactions are included in each block.
PBS is likely 18 -24 months out so it’s not coming anytime in the immediate future. In the meantime, you can impress all your friends with your knowledge of Proto-Danksharding, MEV and PBS.
In Other News
Coinbase is suing the SEC over the organization’s refusal to answer a rule-making petition that was filed last summer.
Parker Lewis argues that there may be no greater, more important use of energy than that which is deployed to secure the integrity of a monetary network.
How crypto can solve long-standing issues in the bond market.
Franklin Templeton’s tokenized money market fund passes $270m AUM.
Ethereum (ETH) Shanghai upgrade brings record inflow into Ether staking.
Google has reached a partnership with Poylgon in which Google will use its its cloud technology to enhance Polygon’s blockchain network’s speed, security, and overall user experience.
The U.S. House will have a crypto bill in 2 months, says representative Patrick McHenry.
U.S. bank failures are fueling crypto adoption.
The White House published a blog post reiterating its plans to impose a 30% federal tax for all electricity usage for digital asset mining.
Disclaimer: This is not investment advice. The content is for informational purposes only, you should not construe any such information or other material as legal, tax, investment, financial, or other advice. Nothing contained constitutes a solicitation, recommendation, endorsement, or offer to buy or sell any securities or other financial instruments in this or in any other jurisdiction in which such solicitation or offer would be unlawful under the securities laws of such jurisdiction. All Content is information of a general nature and does not address the circumstances of any particular individual or entity. Opinions expressed are solely my own and do not express the views or opinions of Blockforce Capital or Onramp Invest.
Disclaimer: This is not investment advice. The content is for informational purposes only, you should not construe any such information or other material as legal, tax, investment, financial, or other advice. Nothing contained constitutes a solicitation, recommendation, endorsement, or offer to buy or sell any securities or other financial instruments in this or in any other jurisdiction in which such solicitation or offer would be unlawful under the securities laws of such jurisdiction. All Content is information of a general nature and does not address the circumstances of any particular individual or entity. Opinions expressed are solely my own and do not express the views or opinions of Blockforce Capital or Onramp Invest.
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