Coinbase Caves to SEC Pressure, Drops Lending Product. Will Others Follow Suit?

Is this the beginning of the end for crypto lenders?

Two weeks ago, Coinbase was in fighting form. Its CEO Brian Armstrong blasted the Securities and Exchange Commission (SEC) for what he labeled "sketchy behavior."

The SEC demanded that Coinbase drop its Lend product, which would have allowed borrowers to use crypto as collateral on loans. It would also have paid investors 4% APY on deposits in the stablecoin USD Coin (USDC). The SEC threatened to sue if Coinbase persisted with the offer.

After publicly lambasting the regulator's demands, Coinbase has now quietly shelved the controversial project. In an update to an old blog post, the popular crypto exchange said: "As we continue our work to seek regulatory clarity for the crypto industry as a whole, we’ve made the difficult decision not to launch the USDC APY program announced below." It added, "We have also discontinued the waitlist for this program as we turn our work to what comes next."

Why is the SEC concerned about DeFi lending products?

Decentralized finance (DeFi) is an umbrella term for a host of services that cut the middleman (often banks) out of financial transactions. These include savings, loans, trading, and even insurance.

Investors can earn 8% APY or more, which is a great deal higher than a traditional savings account, but savers don't have the same protections. For example, these accounts are not protected by FDIC insurance in the event of platform failure or bankruptcy.

Many DeFi lending products use stablecoins -- cryptos that are pegged to another commodity such as the U.S. dollar. Concerns have been raised about stablecoin Tether (USDT) because it hasn't always had enough funds in reserve to cover the coins in circulation. And SEC Chair Gary Gensler has also already said he believes stablecoins may be securities.

If stablecoins are securities, they come under the SEC's jurisdiction. That would mean they have to follow strict rules on how they can be traded and how information is shared with investors.

Another issue is that the SEC may consider Coinbase's Lend product to be an investment contract. This is an agreement where one party invests money with the expectation of getting a return, and it also comes under the SEC's oversight.

SEC will pursue crypto industry

The spat with Coinbase is the most recent indication that the SEC has set its sights on the "wild west" of stablecoins, crypto lending, and crypto platforms.

In Gensler's testimony before the Senate Committee on Banking, Housing, and Urban Affairs last week, he said, "Right now, large parts of the field of crypto are sitting astride of -- not operating within -- regulatory frameworks that protect investors and consumers, guard against illicit activity, and ensure for financial stability.

He encouraged platforms to come forward and talk with the commission, and he reiterated that any platforms trading securities have to register with the SEC.

Will U.S. crypto lenders drop DeFi products?

A number of crypto apps and exchanges in the U.S. offer these types of lending and earning products. The premise is that the platforms lend out investors' assets and use the proceeds to pay high interest rates.

Regulators worry that these are bank-like products that lack the customer protections of traditional banks. It's too early to know whether these products will be forced out or forced to adhere to stricter rules. But it's worth noting that the SEC is not the only authority making moves.

At a state level, five states -- Alabama, Kentucky, New Jersey, Texas, and Vermont -- are taking action against popular crypto platform BlockFi because of its lending product. And New Jersey recently took steps against Celsius, another lending platform.

Bloomberg warned last week of an upcoming reckoning. It said Treasury officials are poised with new policy regulations, which, according to those close to the issue, will be released in the coming weeks. And the Financial Stability Oversight Council is also said to be close to a decision on whether stablecoins pose a threat to the financial system -- which could be a game changer.

There are still many questions to answer as the net tightens on crypto lenders, not least is how U.S. authorities will tackle international exchanges that offer the same products on U.S. soil. But for investors, it's important to be aware of the potential impact on both lending platforms and the cryptocurrencies that power the DeFi industry.