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U.S. holders of cryptocurrency have been eager to participate in
the crypto lending market, but recent actions by the SEC are
causing unexpected, and likely unintended, changes in how these
loans are made. In fact, the SEC’s actions may well reduce the
amount of lending done through products registered with the SEC and
increase the amount of lending on platforms that are not operated
by licensed U.S. companies.
Cryptocurrency lending has been increasing at a blistering pace
over the last several years. By some measures, the volume of
cryptocurrency lending has surpassed the volume of lending on
traditional peer-to-peer lending platforms, which are limited to
fiat currency loans. U.S. holders of cryptocurrency have been eager
to participate in this lending market, but recent actions by the
U.S. Securities and Exchange Commission are causing unexpected, and
likely unintended, changes in how these loans are made. In fact,
the SEC’s actions may well reduce the amount of lending done
through products registered with the SEC and increase the amount of
lending on platforms that are not operated by licensed U.S.
companies.
Lending Lessons From `Prosper’
While cryptocurrency lending may have surpassed traditional
peer-to-peer lending in volume, there was a time when the value of
peer-to-peer fiat loans was increasing so quickly that some viewed
them as a threat to traditional banking. It appeared possible that
peer-to-peer lending platforms could “disintermediate”
banks, who were profiting from the difference between the rate of
interest paid by banks to depositors and the rate of interest paid
to banks by borrowers whose loans were funded with deposits.
While changes in the interest rate environment contributed to
the slowing growth of peer-to-peer lending, another significant
factor was the SEC’s decision to treat peer-to-peer loans as
securities. The SEC staked out this position in 2008, when it
issued a cease-and-desist order against Prosper Marketplace based
on the assertion that the promissory notes issued on the
peer-to-peer Prosper marketplace were securities that Prosper had
failed to register with the SEC. After the SEC’s action against
Prosper, some peer-to-peer lenders tried to register their products
with the SEC and comply with the regulations that apply to
securities issuers. Others simply went out of business rather than
incur this expense.
The SEC Slams the Door on Coinbase’s Lend Program
The SEC’s position on cryptocurrency lending began to emerge
publicly late last year. In September 2021, Coinbase revealed that
the SEC had sent it a “Wells Notice,” which is a
preliminary determination by the SEC’s staff that it will
recommend a civil enforcement action, if Coinbase allowed
customers to participate in its proposed “Coinbase Lend”
program. That product would have allowed eligible Coinbase
customers to earn interest on select assets on Coinbase, starting
with 4% APY on USD Coin (USDC).
Rather than quietly withdraw its proposed Lend program, Coinbase
publicly expressed its disagreement with the SEC. Coinbase’s
chief legal officer articulated Coinbase’s grievances in an
article posted on The Coinbase Blog. The blog post noted that the
SEC had told Coinbase that it viewed the Lend product as a security
under SEC v. W.J. Howey Co., 328 U.S. 293
(1946) (Howey), and Reyes v. Ernst
& Young, 494 U.S. 56
(1990) (Reyes), but that the SEC had not
explained to Coinbase how it came to this conclusion.
BlockFi Is Fined $100 Million
While the SEC never publicly explained how it
applied Howey and Reyes to
Coinbase Lend, in February 2022, it articulated how it would apply
these cases to cryptocurrency lending products when it issued a
cease-and-desist order against BlockFi Lending. The SEC alleged
that BlockFi unlawfully failed to register the offer and sale of
its retail cryptocurrency lending products, the BlockFi Interest
Accounts (BIAs), as securities. The SEC further charged that
BlockFi violated the registration provisions of the Investment
Company Act of 1940, and made a false and misleading statement on
its website concerning the level of risk in its loan portfolio and
lending activity. To settle the SEC’s charges, BlockFi agreed
to pay $50 million to the SEC and agreed to pay another $50 million
to 32 states to settle similar charges.
As described by the SEC, BlockFi offered and sold BIAS to
holders of crypto assets, who lent these assets to BlockFi in
return for BlockFi’s promise to pay a variable monthly interest
in cryptocurrency. BlockFi then pooled the loaned assets, over
which it had legal ownership and control, and
exercised discretion over how to invest them, including by
lending them to institutional borrowers. BlockFi set the variable
interest rate paid to the lenders based, in part, on the yield that
it could generate. BlockFi offered and sold BIAS to retail and
other lenders in various ways, including through advertising and
general solicitation on its website and social media.
The SEC concluded that the BIAs were securities because they
fell within two categories of instruments—”investment
contracts” and “notes”—listed in the
definitions of securities in §2(a)(1) of the Securities Act of
1933 and §3(a)(10) of the Securities Exchange Act of 1934.
The SEC based its conclusion that the BIAs were investment
contracts on Howey.
The Howey test for whether an instrument is an
“investment contract” asks whether the instrument
evidences “[1] an investment of money [2] in a common
enterprise [3] with [a reasonable expectation of] profits [4] to
come solely from the efforts of
others.” Howey, 328 U.S. at 301. The SEC
concluded that loaning digital assets to BlockFi was an
“investment of money,” that BlockFi’s deployment of
pooled digital assets created a “common enterprise,” that
the purchasers of BIAs had a “reasonable expectation of
profits” in the form of variable monthly interest paid, and
that these profits came “from the efforts of others”
because BlockFi’s success in determining how to invest the
pooled digital assets would determine whether the common enterprise
was profitable.
The SEC based its conclusion that the BIAs were securities notes
on Reyes. Under Reyes, a
note is presumed to be a security unless it falls into certain
categories of financial instruments that are not securities (which
clearly did not apply to BIAs), or if the note in question bears a
“family resemblance” to notes in those categories based
on a four-factor test. 494 U.S. at 64-66. Those factors are the
motivations of a reasonable seller and buyer, the note’s
“plan of distribution,” the reasonable expectations of
the investing public, and whether other risk-reducing factors
exist, making unnecessary the application of the securities laws to
protect the public. The SEC concluded that each of these factors
supported the finding that BIAs were notes because (1)
BlockFi’s motivation was to sell BIAs and obtain crypto assets
for the general use of its business and BIA
purchasers’ motivation was to receive interest, (2) BIAs
were offered and sold to a broad segment of the general public, (3)
BlockFi promoted BIAs as an investment, specifically as a way to
earn a consistent return on crypto assets and for investors to
build their wealth, and (4) no alternative regulatory scheme or
other risk reducing factors exist with respect to BIAs.
Is the SEC Pushing Crypto Lenders to DeFi?
While the SEC described its enforcement action against BlockFi
as part of an effort to ensure that cryptocurrency lenders have
more “information and transparency,” it seems at least as
likely to have the opposite effect. First, as SEC Commissioner
Hester M. Peirce noted in her dissent from the SEC’s action
against BlockFi, it is likely to discourage other companies from
offering lending products that are registered with the SEC. The
size of the penalties, which Commissioner Peirce described as
“disproportionate,” will lead many companies based
outside the United States to decline to offer cryptocurrency
lending products to United States customers, rather than encourage
them to offer these products with more accurate disclosures. In
addition, the SEC’s decision to force BlockFi to register as an
investment company imposes a difficult and time-consuming burden
that is more severe than registering the BIAs as securities,
without providing additional protection to cryptocurrency lenders.
As Commissioner Peirce observed, “Inviting people to come in
and talk to us only to drag them through a difficult, lengthy,
unproductive, and labyrinthine regulatory process casts the
Commission in a bad light and thus makes us a less effective
regulator.”
Second, retail cryptocurrency lenders now have options other
than licensed entities such as BlockFi. Holders of crypto assets
increasingly lend cryptocurrency using DeFi platforms. Some of
these platforms are controlled by stakeholders located in
jurisdictions outside the United States; others are controlled only
by automated “smart contracts” that are not subject to
anyone’s control. Many holders of crypto assets view these DeFi
lending platforms as investor-friendly innovations. It seems
unlikely, however, that the SEC is purposely driving retail
cryptocurrency lenders to these DeFi platforms and away from
companies like BlockFi. After all, BlockFi makes detailed
disclosures to customers, blocks transactions with sanctioned
jurisdictions and entities, operates an anti-money laundering
program, and has successfully applied for dozens of state lending
and money transmission licenses. While a few DeFi products have
some of these features—permissioned liquidity pools are one
example—most do not.
The SEC’s current enforcement-driven approach to regulating
cryptocurrency lending appears to be likely to reduce the
availability of innovative lending products registered with the SEC
and to increase the use of unlicensed cryptocurrency lending
platforms by retail investors. It is difficult to know how this
interaction between innovation and regulation will play out, but if
the SEC does not alter its current approach, it may be disappointed
with the results.
Published by The New York Law Journal
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