SEC's frequent and heavy-handed regulatory actions will continue to affect the volatility of digital assets

Main points

• In the absence of digital asset legislation, the SEC continues to regulate through enforcement;

• Economic data continue to point to more persistent inflationary pressures than the Fed would like. Two more rate hikes in the first half of 2022 are now largely foreseeable;

• Silvergate has attracted interest from a number of prominent buyers, despite being the most shorted stock in the U.S. stock market.

SEC continues to regulate through enforcement in absence of digital asset legislation

Last week, the U.S. Securities and Exchange Commission (SEC) took two significant actions related to digital assets. These actions followed charges last month against Genesis and Gemini for unregistered offers and sales of crypto asset securities through the Gemini Earn lending program.

The first action took place on February 9, when the SEC continued its regulatory enforcement in the absence of digital asset legislation. The SEC charged Payward Ventures, Inc. and Payward Trading Ltd. (both commonly referred to as Kraken) with “failure to register their crypto asset staking-as-a-service offers and sales” program. The Kraken entities settled with the SEC by paying $30 million and immediately ceasing to offer or sell securities through crypto asset staking services or staking programs in the United States. Additionally, without admitting or denying the allegations in the SEC’s complaint, Kraken agreed to permanently cease conducting staking operations in the United States.

The announcement prompted multiple responses from industry leaders and the SEC. The first came from SEC Commissioner Hester Peirce, who objected to her organization’s decision. Peirce claimed that registration is impossible and that “it is difficult for cryptocurrency-related products to navigate the SEC’s registration pipeline.” Furthermore, she suggested that there is not enough guidance available to allow companies like Kraken to make informed decisions related to registration.

Industry leaders responded. Coinbase CEO Brian Armstrong and its chief legal officer Paul Grewal, as well as Kraken chairman Jesse Powell, tweeted their agreement with Peirce’s objection. They responded that there is currently no way to sign up for such a program.

The next day, February 10, Coinbase backed up its executives’ claims. Coinbase released an official statement written by Paul Grewal, saying that staking is not a security under the Securities Act of 1933 and the Howey Test. The exchange added that securities laws would prevent U.S. consumers from accessing basic crypto services and force them to use offshore platforms. On Twitter, Brian Armstrong added that the company would be happy to defend Coinbase staking in court.

On the same day, SEC Chairman Gary Gensler gave interviews to Bloomberg and CNBC to clarify the regulator's decision. In the case of Kraken, Gensler explained that Kraken did not disclose information that would allow general public investors to understand the company's treatment of token deposits. More broadly, exchanges and platforms are generally non-compliant and need to distinguish business functions and register separately. He added that there is sufficient guidance, forms, and staff support to help companies register and draft disclosure information.

When asked by Bloomberg’s David Westin if there was further action, Gensler responded: “Whether you call it earn, lend, staking as a service, annual yield, the label doesn’t matter, it’s the economics that matter, the investing public is putting their hard-earned money into a platform and getting these yields, the law requires them to disclose, the company needs to be registered.”

The second action took place on February 12, when the Wall Street Journal published an article stating that the SEC’s enforcement staff sent a notice to Wells Trust Co. stating that the regulator plans to sue the company for violating investor protection laws. The letter stated that the stablecoin Binance USD (BUSD), which Paxos owns and is responsible for issuing, is an unregistered security. It is worth noting that the Wells notice is not the final indication that the SEC will take enforcement action.

Immediately after the SEC threatened legal action, Paxos announced the termination of its relationship with Binance and would cease issuing new BUSD tokens in accordance with the instructions of the New York Department of Financial Services (NYDFS), effective February 21. In addition, the company assured BUSD holders that they can redeem their funds with USD or the regulated USD-backed stablecoin Pax Dollar (USDP) until at least February 2024.

The next day, on February 13, Binance CEO Changpeng Zhao responded that the exchange would continue to support BUSD for the foreseeable future and would begin adjusting its products accordingly, removing the use of BUSD. Later that day, Paxos emailed The Block a statement confirming receipt of the SEC’s notice and stating that it “categorically disagrees” with the SEC’s assertions, that it will “vigorously litigate where necessary,” and that it “clarifies that there are no other allegations against Paxos.”

Some revelations

These two SEC actions leave much for speculation. However, some first-order effects can be reasonably inferred from statements by all the parties involved.

First, any centralized or decentralized exchange and other digital asset business that engages in interest-bearing accounts, products, or services for crypto assets should anticipate future actions by the SEC. While the SEC’s guidance is broad, vague, and potentially incomplete, its actions are consistent.

Second, retail investors should expect long-term volatility in digital assets due to litigation proceedings and settlements between companies and regulators. There is a clear divergence of opinion on whether there are enough rules and forms to cooperate with regulators. In addition, at least verbally, industry-leading companies are determined to deal with regulators in court rather than settle outside of court.

Third, any business engaged in issuing and trading unregistered stablecoins should anticipate future actions by the SEC. Gensler made it clear that the SEC considers stablecoins to be securities, in part because of their similarities to money market accounts and money market mutual funds. However, due to past efforts, such as Circle's attempt to go public last December, some issuers and stablecoins may be further along in compliance than others.

Inflation, retail sales and PPI all exceeded expectations, indicating that inflationary pressures persist

It's been a busy week for key macroeconomic data. Tuesday saw the release of the much-anticipated inflation data. At 6.4% and 5.6%, CPI and Core CPI beat expectations by 0.2% and 0.1%, respectively. Both doves and hawks can point to a number of areas to support their stance. Hawks point to a sharp increase in household food prices (up 11.3% year-over-year) and double-digit increases in electricity prices. The report also includes updated category weights and methodology changes, which make it more difficult to draw conclusions from the data.

Later in the week, the market saw both retail and producer price index (PPI) come in well above expectations. Initial jobless claims were below the downside, suggesting that the labor market remains strong despite tighter fiscal conditions. Equity markets fell sharply on the PPI news, while cryptocurrencies continued to hold gains. By the end of the week, the case for the Fed to raise rates two more times in March and May looked strong. The market was pricing in an 82% chance of a March rate hike and a 67% chance of a May rate hike.

Silvergate Capital shares continue to attract attention from financial institutions

It’s been a month since we last reported on Silvergate Capital’s (SI) Q4 2022 earnings and the significant ownership acquisition by Block.one and Brendan Blumer in November 2022. Following the report, SI stock has risen by more than 50% amid a series of lawsuits from FTX customers, an alleged DOJ fraud investigation, and the departure of Silvergate board member Rebecca Rettig. Despite these headlines and legal headwinds, SI’s customers are likely to stick with the world’s largest digital asset trading network.

Two weeks ago, MicroStrategy Chairman Michael Saylor told CNBC that the company would remain a customer of SI. He said, “We will continue to do business with Silvergate. The badly run institutions collapsed — FTX, Alameda, Voyager, BlockFi. Silvergate was a responsible institution.” He added, “I think they conducted their business in the right way in a responsible manner, and they are a good citizen of the ecosystem.”

During the same period, investors and financial institutions seem to agree with Saylor. In general, funds and investors are net long SI stock, even though it recently became the most shorted stock with 73% short interest. Since the end of January, the market's interest in SI has only increased:

• January 31 – BlackRock increased its stake from 5.9%-7.20%;

• February 2 – State Street increased its stake from 5.3%-9.32%;

• February 9 – Vanguard increased its stake from 8.59%-9.47%;

• February 10 — Block.one increased its stake from 7.46% to 8.09%;

• February 10 – Brendan Blumer increased his stake from 9.27%-9.90%;

• February 13 – Group One Trading holds a 7.27% long position. 93.64% of this position is in call options. The company also holds a short position equivalent to 90.73% of its long position;

• February 14 – Citadel Securities holds a 5.50% long position. 92.63% of this position is in call options. The company also holds a short position, which is 77.56% of the long position;

• February 14 – Susquehanna Intl holds a 7.5% long position. 81.81% of this position is in call options. The company also holds a short position of 92.93% of its long position size;

• February 14 – Jane Street Group holds 5.5%. 91.62% of the position is in call options. The company also holds a short position, which is 37.65% of the long position;

• February 14 – Soros Fund Management takes a short position of 100,000 shares at $17.40 per share.

Earlier this week, hedge funds such as Citadel Securities and Susquehanna Intl made headlines for disclosing ownership of SI shares as 13G filings became due. However, a closer look at the 13Fs of the listed hedge funds mentioned above shows that the market's reaction is largely exaggerated. While these funds are net long, they also hold a large number of short positions relative to their long positions. This suggests that these funds are market making, not as the headlines would have the public believe. All in all, this could mean that investors can expect a higher degree of volatility in the coming months.

Summarize

The SEC continues to regulate digital assets through enforcement actions, such as the recent charges against Kraken and potential charges against Paxos. Industry leaders have responded by disagreeing with the SEC’s stance, with some willing to challenge it in court. These actions could lead to long-term volatility in digital assets as companies and regulators fight in court. Regulation remains the biggest risk facing cryptocurrencies.

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