What Does BlockFi’s Massive $100m Settlement with SEC Mean for Crypto?

Why BlockFi Had to Settle with the SEC

The offending BlockFi product enabled users to deposit their own cryptocurrency with the US firm and earn up to 9.25% interest per year. For the SEC, this product — known as the BlockFi Interest Account — was essentially a debt security, in that users lent money to BlockFi and were promised a regular stream of interest payments in return.

So as far as the regulator was concerned, BlockFi’s ‘products’ weren’t materially different from a company raising money by selling its own corporate bonds. It seemed that BlockFi’s lawyers were largely in agreement with this view, which would account for why the company agreed to pay $50 million and cease offering its product, while also paying $50 million to 32 states to settle similar charges.

It’s also worth pointing out that the SEC charged BlockFi with violating the Investment Act of 1940, which stipulates that firms that hold at least 40% of their assets in securities must register with the SEC. According to the SEC, BlockFi failed to do this, having operated for around 18 month as an investment company, as defined by the above act.

Finally it should be noted that current BlockFi customers in the USA will be unaffected by the settlement and continue earning interest on their crypto holdings on BlockFi. Unfortunately new users will not be able to earn interest until BlockFi launches its official, registered BlockFi Yield product in the future.

Why the Settlement Comes as a Blow to Crypto in the US

Speaking of the settlement, SEC chairman Gary Gensler made a point of highlighting how it sets a strong precedent for the US-based cryptocurrency industry.

“This is the first case of its kind with respect to crypto lending platforms. Today’s settlement makes clear that crypto markets must comply with time-tested securities laws, such as the Securities Act of 1933 and the Investment Company Act of 1940,” he said.

Anyone looking for a positive spin on the settlement could agree with Gensler in saying that it “further demonstrates the Commission’s willingness to work with crypto platforms to determine how they can come into compliance with those laws.” And indeed, it does suggest that regulators are willing to accept cryptocurrencies and crypto-based products so long as they conform to the existing regulatory regime.

But therein lies the rub. It’s no accident that the cryptocurrency sector has expanded so quickly while remaining largely unregulated, in the United States and elsewhere. Indeed, crypto wouldn’t be where it is today if it had complied with all potentially applicable laws and regulations from the very beginning.

And when it comes to the specific case of crypto-based lending, it’s likely that many firms would find the costs of registering with the SEC too onerous to pursue. Indeed, this appears to be the main takeaway from Hester M. Peirce’s statement on the BlockFi settlement, with the SEC commissioner formally dissenting from the Commission’s official decision.

“Applying the securities regulatory framework has consequences, some of which may be unfortunate. Rather than forcing transparency around retail crypto lending products, today’s settlement may stop them from being offered to retail customers in the United States,” she wrote.

Registering with SEC Will Be Costly

Of particular concern for the industry should be Peirce’s acknowledgement that registering debt securities via an S-1 form is an expensive process, in terms of both money and time. As she wrote, “Getting an S-1 to the point where staff will declare it effective is often a months-long, iterative process. When crypto is at issue, the timeframe is likely to be longer than it would be for more traditional filings.”

In fact, it gets even worse if the SEC is inclined to define you as an investment company, as it does with BlockFi. According to Peirce, BlockFi cannot register in the normal way as an investment company, because it issues debt securities, meaning it needs an exemption or exclusion. However, obtaining such an exclusion could be difficult, particularly when the SEC already sets a high bar for crypto-related firms.

“The Commission’s lack of experience with the market intermediary exclusion combined with the nature of BlockFi’s business suggests that the sixty-day timeframe (even if extended an additional 30 days) allocated for BlockFi to ‘provid[e] the Commission staff with sufficient credible evidence that it is no longer required to be registered under the Investment Company Act’ is extremely ambitious,” Peirce adds.

It’s also very likely that other leading crypto-lending platforms, such as Celsius and Gemini, are classifiable as investment companies under the Investment Act. Again, this will make securing legitimacy in the eyes of the SEC particularly difficult.

Also note that BlockFi can afford to register because it’s an example of a larger crypto-lending firm, with its latest funding round valuing it at $3 billion. It’s therefore highly plausible that smaller firms and platforms, with smaller resources, won’t be able to jump through the numerous hoops the SEC is now installing. Particularly when even Coinbase nixed plans to offer its own lending product back in September, spooked by the possibility of an SEC lawsuit.

And make no mistake, the SEC is intent on being consistent with its hardened stance. It’s currently investigating Celsius, Gemini and Voyager Digital along similar lines as it did with BlockFi, all as part of a broader inquiry into firms that pay interest on cryptocurrency deposits.

Fear, Uncertainty and Doubt

The payment of interest for deposits is becoming increasingly common in the cryptocurrency sector, with the crypto lending industry accounting for just over $40 billion in locked value (as of December 2020). Yet the BlockFi-SEC settlement doesn’t impinge only on centralized platforms offering lending products, but also decentralized alternatives.

The thing is, just how exactly it affects decentralized lending protocols (which are peer-to-peer) is unclear at the moment, a factor which could throw another bucket of ice over the US-based cryptocurrency lending market.

For Defi, regulatory clarity still remains unclear. BlockFi is a centralized player offering yields through custody of users’ funds. This is a fundamentally different approach to how DeFi functions,” said Alkemi Network co-founder Brian Mahoney, speaking with the Street.

Also speaking to the Street was Ran Hammer, the vice president at blockchain infrastructure provider BizDev Orbs, who argues that the settlement creates uncertainty for decentralized platforms.

“BlockFi actively managed deposited funds and its ability to pay interest was based on this entity’s business decisions, and the SEC’s position on this type of platform is clear. We are still waiting for clarity on how the SEC (and the courts) would treat a decentralized platform that doesn’t have a specific person that makes decisions,” he said.

Needless to say, such uncertainty is bad for the future growth of the American cryptocurrency sector, and may dissuade platforms from offering services to US-based users. Still, the United States represents only one area within the global cryptocurrency sector, meaning the SEC’s current stance may not deter crypto-based lending from growing elsewhere.

And looking at the bigger picture, it’s highly possible that once the market matures and grows in size, more companies will follow BlockFi’s example and seek registration. It may be relatively costly, but assuming that interested firms do expand enough to be able to afford the costs, it will provide crypto with a surefire means of offering innovative new products without being hassled by the regulator.