Proof of State is the Wednesday edition of Fortune Crypto where Leo Schwartz delivers insider insights on policy and regulation.
In a year shaped by court cases, 2023 had one last surprise up its sleeve. On Dec. 28, with dreams of a Bitcoin ETF lulling the crypto industry to 2024, Judge Rakoff of the Southern District of New York issued a summary judgment against Do Kwon and his failed Terraform Labs.
Pleased not to be spending New Year's Eve in a Montenegrin or Brooklyn holding cell, the rest of the crypto sector applauded the resolution to the Terra debacle, though questions of fraud and the involvement of Jump Trading will be left to a jury trial in January. Still, unlike July's surprising Ripple decision, Rakoff's reasoning could spell trouble for the future of the industry.
As always, the ruling hinged on the question of whether the crypto tokens that Terraform offered investors qualified as unregistered securities. The edge case was UST, Terra's signature stablecoin, which was ostensibly pegged to $1—until it disastrously was not.
The Howey test, after all, determines that an investment contract is defined as an investment of money in a common enterprise with the expectation of profits derived from the efforts of others. If stablecoins are set at $1, how could they represent an investment contract?
Even putting aside the separate Reves Test, which complicates the designation of a security, Rakoff said that one factor clearly puts UST in the investment contract category. Terraform offered the stablecoin in conjunction with a lending and borrowing protocol called Anchor that promised yields of up to 20%. As Rakoff wrote, UST on its own was not a security, but instead constituted an investment contract when offered in combination with Anchor.
Stablecoins remain a corner of crypto where regulators will give the most leeway, with their novel status presenting a jump ball situation between the SEC, CFTC, OCC, Federal Reserve, and Treasury Department (which isn't even to mention state regulators). After legislation targeting an update to anti-money laundering provisions, stablecoin supervision represents the lowest-hanging fruit for Congress.
And yet, while it may have been evident before, there is now a clear judicial decision that explains when the SEC could target stablecoins. Two of the biggest issuers—Paxos and Tether—have opted not to offer yields to investors for their products, which could either enter them into bank or securities territory, despite the historic returns on cash-like instruments. USDC, still the second-largest stablecoin by market cap despite its ruinous 2023, is a separate matter.
USDC is already a unique situation. Nominally, its issuer until recently was the Centre Consortium, which was really just a partnership between Circle and Coinbase. In August, the two firms finally sunset Centre, formalizing the stablecoin's 50/50 split, though Circle would continue to handle matters of governance. Coinbase, however, is the main purveyor of USDC. If you go on its dedicated page now, you'll be met with an offer: Buy USDC and earn a 5.1% reward by "simply holding USDC on Coinbase."
At this point, you may ask yourself why the USDC rewards program is so different than UST and Anchor Protocol. I did, so I asked Todd Phillips, a financial regulation expert and assistant professor at Georgia State University. "Coinbase is playing a dangerous game," he told me. "I do not know how they can justify that as not being an investment contract."
There are several complicating factors. For one, Coinbase says that the rewards come from its own funds, which it writes off as marketing expenses, as opposed to doling out yields based on its own investments. At worst, one could describe this as a subterfuge to hide that the yield is still just a promise of Coinbase's future success. According to Phillips, any "rational court" would see through the tactic.
For another, Phillips filed an amicus brief on behalf of the SEC in its ongoing lawsuit against Coinbase, so he already has a clear point of view. So does Coinbase, however. As the company has made clear in its legal battle against Gary Gensler, it wants an update to U.S. financial regulatory policy—which could include a refresh of the Howey Test. And as CEO Brian Armstrong marches forward with his crusade, USDC could become collateral damage.
Leo Schwartz
leo.schwartz@fortune.com
@leomschwartz
