The SEC's crypto crackdown is escalating as it goes after the Winklevoss twins' firm over 'unregistered securities.' Here's what they are.

Gary Gensler became chair of the SEC in April.

Alex Wong/Getty Images

• The SEC has stepped up its campaign to reign in what its Chair has called the "Wild West" of crypto.
• Gary Gensler has gone after the Winklevoss twins and Kraken, the world's third-biggest crypto exchange.
• But its targeting of unregistered assets has left some in the crypto sector with one response: it's war.

After lots of calls to clean up the wild west of crypto, it looks like the SEC is finally getting stuck in.

It's gone after big names like Gemini and Kraken - and it's using rules on unregistered securities as its key hammer.

We explain what those are and what the industry makes of the regulatory crackdown.

What has been targeted?

The SEC has been swift in recent weeks in its push to reprimand crypto offerings it regards as breaking the rules, leaning on the argument that they are unregistered securities.

The highest-profile suit came against the crypto giant Genesis and the Winklevoss twins' Gemini in January, after the SEC accused its disastrous "Gemini Earn" program of being an offering of unregistered securities.

Then Kraken, the world's third biggest crypto exchange, last week paid a $30 million settlement to the SEC and agreed to stop its "staking" program, where investors lock in their holdings of digital assets for a interest-based reward.

And this week, crypto firm Paxos was forced by the New York Department of Financial Services (NYDFS) to stop minting its Binance-branded stablecoin after a planned lawsuit from the SEC over the sale of unregistered securities. This differs from previous staking suits. 

A spokesperson told Insider it categorically disagreed with SEC staff, arguing its BUSD coin was not a security.

Why now?

The collapse of FTX in November, locking out billions of dollars in customer deposits, has undoubtedly increased the urgency to rein in potentially risky offerings, as did that event's contagion effects on Genesis and Gemini.

But regulators' discomfort with crypto stretches back years - as far as the asset has been popular. In October 2021, SEC Chair Gary Gensler referred to the crypto sector as "a bit of the Wild West."

Emerging evidence suggests programs like staking have become a means for crypto firms to inflate the value of their assets using consumer funds. 

An investigation into now-bankrupt crypto giant Celsius found the company had used customer funds to prop up the value its native coin in a bid to return high yields to investors.

What is an unregistered security?

A security, most simply, is a financial instrument traded for profit. They form the basis of investment contracts for thinks like equities, debt, and derivatives.

The SEC points to the Howey Test to determine if an asset can be classed as a security. This test has four prongs, all of which need to be passed to be determined a security: [1] An investment of money [2] in a common enterprise [3] with expectations of a profit [4] to be derived from the efforts of others.

In the US, if an asset is deemed to be a security it needs to be registered with the SEC. For example, an initial public offering (IPO) of a stock newly listed on the stock exchange represents the first offering of its freshly registered securities. 

Securities need to be registered as it gives the issuing company the relevant shareholder information to pay dividends and provide relevant stock-related information. It also helps reduce fraud by keeping on record the legitimate owner of the security.

According to the SEC, an unregistered security is simply one that hasn't been rubber-stamped by the regulator. 

Unregistered securities have been the subject of several scams, with the SEC saying their hallmarks include the promise of high yields with no risk, aggressive sales tactics, and are backed by unqualified investment professionals. As such, their use is limited.

Only accredited investors, defined as those with a net worth higher than $1 million or an annual income exceeding $200,000, can trade unregistered securities, essentially locking out most retail investors. The threshold is seen as a gauge of financial sophistication and suggests a buffer for eligible investors against potential losses.

The debate in the crypto world, though, doesn't fall on whether the assets should or shouldn't be registered, but more fundamentally on whether they should be classed as securities at all.

So, what is the confusion?

There's long been a debate whether a digital asset - essentially, software - is a commodity like gold, or a security like an ETF. To this end, crypto is typically regulated by the Commodities and Futures Trade Commission (CFTC), indicating its status as a commodity. 

Gensler though, has argued most cryptocurrencies meet the legal definition of a security, and should be registered with the SEC.

But the evolution of the crypto sector, namely through programs like staking and initial coin offerings (ICOs), are blurring the lines and giving the SEC ammunition to pursue a clampdown. 

The crackdown focuses on firms that promised returns to clients, whether for staking their crypto for a blockchain or for lending their crypto with a guaranteed percentage return, as with Kraken and Gemini's Earn program respectively. These could be seen as investment contracts.

Crypto enthusiasts tend to argue that the asset doesn't pass all four prongs of the Howey test to determine a security or investment contract, as it doesn't generate value through the effort of others.

Meanwhile, last week Coinbase's chief legal officer Paul Grewal also rebuffed the idea of staking being a security. In a note, he argued that staking failed all four prongs of the Howey Test, not just the fourth one of value creation.

"Trying to superimpose securities law onto a process like staking doesn't help consumers at all," Grewal wrote. "Instead, unnecessarily aggressive mandates will prevent US consumers from accessing basic crypto services in the US and push users to offshore, unregulated platforms."

More fundamentally, the crypto industry's bigwigs, from Brian Armstrong to Anthony Scaramucci, have piled in on the SEC's ruling on Kraken's "staking" program, describing it as an attack on economic freedoms.

What's next?

Crypto firms and the SEC will have to wait on the outcome of various lawsuits to set a precedent. The outcome could mean crypto firms having to register offerings and assets as securities, but some argue this has left them in no man's land.

"Regulation by enforcement is puzzling for crypto enthusiasts," Globalblock Crypto, a digital asset brokerage, said in a note.

"The SEC claim that "all crypto projects have to do is come in and register," yet when they do, they are just told "no". People are desperately trying to figure out how to offer a product legally whilst getting zero guidance."

Scott Melker, "The Wolf of All Streets" crypto trader, had more choice language.

""It is clear that the US is going to war with the crypto industry," he tweeted.

"If it's war they want, it's war they'll get."

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