As cryptocurrencies rise in popularity, the Securities and Exchange Commission (SEC) faces a new battle to determine its reach and jurisdiction over the new asset class. In its latest confrontation with the crypto market, the SEC will be evaluating whether Coinbase (COIN -1.73%) listed cryptocurrencies that technically met the criteria of being a security. If so, it would mean Coinbase could face fines and possibly even a hit to its business model. 

Based on reports, there are two facets to the investigation. First comes the insider trading allegations. In an SEC filing, the complaint stated that a former Coinbase manager conducted insider trading by tipping off family and friends about new tokens planned to be listed by Coinbase in the near future. The recent announcement made by authorities claims that the group of traders made roughly $1.5 million in gains from trading 25 different cryptocurrencies. Two of the three of the individuals in the scheme have already been arrested.

The second part of this issue is that the SEC alleges that the nine of the cryptocurrencies that were a part of the insider trading met the criteria of being a security. In the formal complaint, the SEC went through the nine cryptocurrencies one by one and described how it believed the assets passed the Howey Test.

Based on a Supreme Court case from 1946, the Howey Test has been used by regulators to determine whether an asset meets the specifications of a security. Straight from the SEC itself, for an asset to pass the Howey Test, there must be an "investment of money in a common enterprise with an expectation of profits to be derived from the efforts of others". The kicker here is the so-called "efforts of others" and "expectation of profits". Most new cryptocurrencies that come out are created and promoted by a group of blockchain developers. Its typically expected that the asset will produce profits or else no one would purchase these new cryptocurrencies. 

The SEC's natural territory is regulating the stock market. In order for a stock, mutual fund, or ETF to be listed on an exchange, it must be registered through the SEC. If the investigation finds that the cryptocurrencies meet the definition of a security, it would mean that Coinbase listed unregistered securities and could face serious consequences. 

Amid the prolonged discourse, Coinbase lawyers have repeated that they feel the allegations will be resolved quickly due to the company's long-standing history of cooperation with the SEC.

Despite optimism from Coinbase executives, the recent news shook investors and caused some of its most high-profile investors to dump Coinbase stock. Three of Cathie Wood's notable Ark ETFs (Ark Innovation (NYSEMKT: ARKK), Ark Fintech Innovation (NYSEMKT: ARKF), and Ark Generation Internet (NYSEMKT: ARKW)) are some of the largest shareholders of Coinbase, with nearly 9 million shares owned between them. In response to the news breaking, Ark sold 1.4 million shares, according to daily trade information it released last week.

The road ahead

With the stock already down more than 60% in 2022, an ongoing legal battle with the SEC surely won't help it rebound from its woes. To add more ominous news, it was recently announced that the SEC is investigating every crypto exchange that operates in the United States. Although Coinbase continues to assure customers and investors that it is within the bounds of regulatory framework, an investigation of this magnitude could spell trouble for Coinbase in the future. 

A looming confrontation with the SEC means there should be an abundance of caution around Coinbase's stock. Depending on your risk exposure, it could be smart for investors to follow Cathie Wood's lead. For those with a little more risk tolerance, I suggest waiting for the dust to settle and seeing how the SEC proceeds before adding more Coinbase shares to your portfolio.