(Bloomberg) — U.S. regulators face a tough balancing act when it comes to addressing “yield farming” in cryptocurrencies without pushing important financial innovation offshore, according to Duke University finance professor Campbell Harvey.
The practice — which allows investors to lend their crypto in exchange for interest rates that are much higher than those offered by traditional institutions — has come under scrutiny by the Securities and Exchange Commission, which alerted Coinbase Global Inc. that its planned Lend product may run afoul of securities laws.
Harvey, the co-author of a new book called “DeFi and the Future of Finance,” sat down this week for a Q&A about the case and its implications for the rapidly growing world of decentralized-finance, or DeFi, where yield farming is done through algorithms without a centralized exchange like Coinbase. Below are lightly edited highlights of the interview.
Q: What do you think about the SEC’s notice to Coinbase?
A: Number one, it’s mysterious because we don’t really know what the SEC’s case is. The Wells notice is a notice that they will be taking action, and often what happens after that is there’s negotiation. And this is the reason that all of the details of the case are not laid out. Because if you’re about to negotiate with somebody, you don’t put all your cards on the table.
You probably saw the tweet storm, Coinbase CEO Brian Armstrong is very upset. And one of the reasons is that it’s hard to argue when you don’t really know what the case is going to be. I believe that he’s got another agenda. And this goes well beyond Coinbase. Right now, there’s just so much uncertainty in this space. We need some resolution of that uncertainty. And basically, given that his company is the leading firm in the space, given that it is a fully regulated exchange, given they had a successful IPO, he is taking the lead and has a broader agenda to basically try to get some clarity here and to raise public awareness of what’s really at stake.
This notice about the savings accounts that Coinbase is going to offer is only one of the uncertainties, there are many other things, including some of the key assets that Coinbase is actually trading.
Q. So does this look like a product that falls under securities or banking laws?
A. So this is pretty key. There’s two securities acts; the Securities Act of 1933 and the Securities Exchange Act 1934, which makes a list of things that are securities like notes, bonds, stocks, options, you know the usual things. And then it says, “investment contracts.” And “investment contract” wasn’t really defined that well. But there’s this famous (Supreme Court) decision, called the Howey Test that defined what an investment contract actually was.
In my opinion, this is not about the Howey Test, this is not about an investment contract, this is about a note as defined in the act. There is an equivalent of the Howey Test decision for notes and that’s a decision called Reves (v. Ernst & Young) and it goes through, in much more detail, what a note is. But in my opinion, and again this is just kind of my thinking here, people are thinking that well, if I deposit my money at a bank in a savings account or by certificate of deposit, and I might be able to lock in, well I can’t get 4%, but I can lock in something, that’s not a security. So why should Coinbase’s 4% yield product be a security?
So you think about what’s happening, you put your money to the bank and what does the bank do with it? It doesn’t put it on reserve at the at the Fed. Maybe it puts part of it there. But it rehypothecates that money. So it uses that money and engages in risky activity, lending it out to others. So now think about what Coinbase is doing. Same idea. You’re depositing dollars — effectively, with a USDC token — and you’re getting a rate of return. And then what is Coinbase doing with your USDC? Well, they’re taking the USDC and they are investing in these different protocols to try to earn some reward and savings rates and that’s basically how they’re going to make more than 4% but they’ll pay you 4%. So it seems really similar to what the bank is doing.
Q. So it sounds like if they were to be regulated, it should be more from a banking regulator than the SEC?
A. So there’s this really important case, and this is what I think the SEC is going to base their case on, and the case is called Marine Bank v. Weaver. And it’s 1982. And the case was whether a certificate of deposit, a CD, was a security. And in this case, the court decided that a certificate of deposit issued by an FDIC-insured bank was not a security. OK, so the key thing is that the bank is FDIC-insured, FDIC-regulated. And this case is very clear that, in other contexts, the CD could be considered a security. So this, in my opinion, is going to be the key thing that Coinbase has to overcome, because they are not FDIC-insured. And what they’re doing is definitely risky, so you cannot say that the rehypothecation is not without risk.
Maybe this pushes Coinbase to the spot where they have to become a bank. And I’ve long thought that it would make sense for them to have a banking operation, given they’re a centralized exchange.
Q: This event this week, the Wells notice, do you think it’s a game changer for DeFi at all, and this whole notion of yield farming?
So this is really a key question and it’s really important to realize that the SEC is going after a centralized exchange/broker. And that’s Coinbase. It’s more difficult to go after an algorithm. To go after a decentralized exchange is like going after an algorithm.
Q. I’m curious, if you got a call from the White House or Congress and the question was, basically, Cam, what should we do about this? What’s your take on what the regulation approach should be to this whole industry?
A. It is a balancing act. So the regulators want to do the right thing by reducing the chance that unscrupulous people take advantage of the uninformed. And indeed, that was the genesis of the Securities Act of 1933, as to what happened in the run-up before the crash of 1929. So I totally understand that and the regulators are motivated to do that. But they fully realize, if they are too harsh in terms of their regulation, then they stifle innovation or make the U.S. so unattractive that the good ideas move offshore. And they realize that the U.S. has been a leader in innovation for quite a long time. If you look at the companies that have had the growth over the last 20 years or 10 years, they’re U.S. companies. So there’s a strong incentive to keep that entrepreneurial environment alive.
You need to balance. For example, to eliminate all of the risk would be a disaster of a strategy. There has to be some risk here. You can’t cover everything. If you cover everything, then the regulations are going to be so harsh that you move offshore. So my advice is basically that balancing act. The way that you need to evaluate this is, well, what are the real downsides to the consumers? And actually some of the downsides are much greater, in my opinion, outside of what Coinbase is offering. So you see some ridiculous yields that are advertised. And look, anything above 10% you need to be very skeptical about and you’re just inviting like Ponzi-sort of schemes.
And I would go into the negotiation wanting to maintain that balance. That you don’t want to do something that hurts the growth opportunities for the whole country. … And It might be, as we’ve talked about, that this would be better served, not from the SEC’s point of view but maybe the FDIC.
(Editor’s note: Coinbase co-founder Fred Ehrsam is a Duke alumnus who wrote a review blurb on the flap of Harvey’s book. Duke’s endowment also was an early investor in Coinbase, according to CoinDesk.com.)
(Adds editor’s note about Duke endowment’s Coinbase investment in final paragraph.)
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