Engaging with regulators for any reason is never easy. During examinations, it feels akin to having a police officer poke through your underwear drawer with his or her baton.

For companies seeking to launch a new product or service, engaging with regulators can be a completely different kind of torture. It starts with the firm asking questions of regulators, like, “Do you think this idea runs afoul of current regulations? What if we changed it instead—so it does this or doesn’t do that?” Each question leads to more questions as every nuance is sorted out between your firm and the regulator with a seemingly endless stream of emails and paperwork. And lawyers. Lots of lawyers.

Now, try entering the process when the regulator either doesn’t understand the technology on which your idea is based or has entrenched itself in the position the technology is somehow irrevocably flawed, prone to fraud, or worse.

This last scenario describes what recently happened to Coinbase, a publicly traded company that created a platform for its users to buy and sell cryptocurrency. Already operating in an industry that has almost no regulation, Coinbase wanted to vet a new product called Lend with the Securities and Exchange Commission (SEC). The process did not go well.

Coinbase laid out its side of the story in a Sept. 7 blog post entitled, “The SEC has told us it wants to sue us over Lend. We don’t know why.”

The SEC, through a Wells Notice, explained its staff determined Lend is a security. Coinbase vehemently disagreed—resulting in the standoff.

Coinbase blinked Friday, announcing it will not launch Lend next month as planned, despite having “hundreds of thousands” of customers preregister for the program. Coinbase said in its note it will “continue our work to seek regulatory clarity for the crypto industry as a whole.”

So, what was Lend?

Lend would have allowed Coinbase cryptocurrency holders to earn interest on select assets, specifically USD Coin (USDC). USDC is cryptocurrency pegged to the value of the U.S. dollar, known in the market as a stablecoin. (Most cryptocurrencies are not pegged to any government-issued currency. Instead, their value is set by the market; that is, whatever others are willing to pay).

Coinbase remains adamant such an arrangement is not a security like an investment contract or note. Customers would not have been investing in the platform, the company said, “but rather lending the USDC they hold on Coinbase’s platform in connection with their existing relationship.”

Lend would have operated much like how a traditional bank lends money, using the deposits of its customers to make loans to others. But here was the big difference, at least for regulators: Coinbase would have been the only entity truly guaranteeing the return on a Lend participant’s money (USDC). Where would Lend investors have gone if they felt Coinbase somehow ripped them off? They’d have no recourse.

“The SEC is trying to send a message that they don’t like this, and they want to regulate it or shut it down,” said Benjamin Sauter, an attorney with the law firm Kobre & Kim.

All eyes on the SEC

Some speculation arose SEC Chair Gary Gensler, who taught a course on cryptocurrency at the Massachusetts Institute of Technology and clearly understands it, could take a more nuanced stance on the industry. But while he has declared himself to be “technology-neutral,” he’s labeled cryptocurrency as the “Wild West”—a position he reinforced in Sept. 14 testimony before Congress.

“Right now, large parts of the field of crypto are sitting astride of—not operating within—regulatory frameworks that protect investors and consumers, guard against illicit activity, and ensure for financial stability,” Gensler said. “This asset class is rife with fraud, scams, and abuse in certain applications. We can do better.”

“The entire (cryptocurrency) industry is looking for guidance from the SEC on what it deems a security. They’d prefer to do that through the regulatory process, rather than through the enforcement process. But it’s tough for the regulatory scheme to keep up with this technology, which is moving so fast.”

Devin Donohue, Member, Cozen O’Connor

Gensler pledged to increase scrutiny of the cryptocurrency market, both to enhance investor protections and increase collaboration between other federal agencies that regulate commodities trading and banks.

While Gensler and the SEC have encouraged firms to come and talk to them—which is exactly what Coinbase did—these companies should not expect the agency to bend to their will.

“Make no mistake: To the extent that there are securities on these trading platforms, under our laws they have to register with the Commission unless they qualify for an exemption,” Gensler said.

Christopher LaVigne, partner with the law firm Withers, said any hopes among the cryptocurrency market that a Gensler-led SEC might take a measured approach have been dashed.

“He’s indicated he will aggressively enforce what he sees as applicable law,” LaVigne said.

In the past, a bank seeking the SEC’s thoughts on a new product might request a no-action letter and could use the feedback to tweak their product, LaVigne said. But in those instances, disagreement between the bank and the regulator were around the margins. With cryptocurrency offerings, there is a fundamental disagreement between firms and the SEC over whether securities law even applies to the product.

“The entire industry is looking for guidance from the SEC on what it deems a security,” said Devin Donohue, member of the law firm Cozen O’Connor. “They’d prefer to do that through the regulatory process, rather than through the enforcement process. But it’s tough for the regulatory scheme to keep up with this technology, which is moving so fast.”

Among Coinbase’s complaints about its treatment at the hands of the SEC is that its competitors in the same industry have offered similar products for years without the agency taking any action. But Coinbase is what Sauter called “an easy target” as far as enforcement goes: a public company based in the United States. It may be more difficult for the SEC to establish jurisdiction over some of Coinbase’s competitors, many of which are based outside of the United States but potentially serving U.S.-based customers.

A case being watched by the industry is the SEC’s lawsuit against Ripple Labs and its cryptocurrency, XRP, which is still playing out in U.S. District Court for the Southern District of New York. The court is likely to offer an opinion in that case about whether XRP, which was the third-largest cryptocurrency by market cap when the SEC filed its complaint in December 2020, is a security that falls under the SEC’s regulatory purview.

Further insight might come when the President’s Working Group on Financial Markets issues recommendations on stablecoins, potentially later this year.