The Crypto Lending Industry Under Scrutiny by the U.S. Securities and Exchange Commission

editorOctober 10, 2024

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he Crypto Lending Industry Under Scrutiny by the U.S. Securities and Exchange Commission

For a long time, the U.S. Securities and Exchange Commission (SEC) has been targeting cryptocurrencies, and now the crypto lending industry (LendTech) finds itself at the forefront of this attack.

The SEC’s Rejection of Profiting from LendTechs

Decentralization, especially in finance-related industries, is one of the main advantages of cryptocurrencies, and this has caused concern among many governmental bodies. For a long time, the U.S. Securities and Exchange Commission (SEC) has been targeting the cryptocurrency and blockchain industries, which we discussed in previous issues, addressing their impact and role. These attacks are not limited to cryptocurrencies and exchanges; recently, the LendTech industry, which has merged with the world of cryptocurrencies, has also found itself at the forefront of the SEC’s attacks.

Crypto lending is recognized as one of the most attractive and widely-used applications of decentralized finance (DeFi), leading many cryptocurrency exchanges and platforms to venture into cryptocurrency borrowing and lending.

This report will examine the crypto lending industry within the cryptocurrency market and the actions taken by the U.S. Securities and Exchange Commission (SEC).

What is Crypto Lending?

Crypto lending is a decentralized financial service divided into two parts: borrowing through the platform and lending by the platform. This type of lending allows cryptocurrency holders to leverage their idle assets and generate passive income from them. Cryptocurrency borrowing through a platform allows investors to lend their crypto assets to borrowers or exchange platforms and earn interest in return. Conversely, borrowers can pledge their crypto assets as collateral in a smart contract and borrow a percentage of the value of their assets.

Crypto lending platforms can be centralized or decentralized, but generally, this process is recognized as one of the most important services in the world of decentralized finance.

Before explaining how the process works, let’s get familiar with some common terms in this industry:

Lenders: Individuals or entities who own cryptocurrencies and are willing to lend them in exchange for interest. They deposit their crypto assets into a lending platform or smart contract and receive specified interest at each due date.
Borrowers: Borrowers are individuals or entities that need access to more cryptocurrency for various purposes, such as trading, opening leveraged positions, or other reasons. They borrow from platforms or smart contracts by providing crypto collateral, which typically has a higher value than the amount borrowed.
Lending Platforms: Lending platforms or DeFi protocols facilitate the lending process. They connect lenders and borrowers, manage lending pools, and automatically calculate and distribute interest. These platforms are often built on blockchain networks like Ethereum and operate based on smart contracts.
Deposit: Lenders deposit their cryptocurrencies in exchange for interest, or borrowers deposit their crypto as collateral into the lending platform.
Collateral: The asset provided by borrowers to guarantee the repayment and prevent loan default. The collateral amount is always higher than the loan received. The type of collateral differs from the loan obtained.
Smart Contract: On the blockchain, smart contracts automate the lending process. These contracts hold the collateral until the full settlement is completed and return the assets to the collateral owner after repayment. All lending conditions, including interest calculation, installment payments, and settlement, are managed by smart contracts.
Interest: Lenders periodically earn interest from their assets, and borrowers must pay higher interest for the loan received. Interest rates are usually determined based on supply and demand and the asset’s specific conditions.
TVL (Total Value Locked): The TVL index refers to the total value of assets locked in a DeFi platform.
LTV (Loan to Value): The LTV index refers to the current value of the loan relative to the current value of the collateral provided. For example, an LTV of 60% means you can borrow only 60% of the value of your collateral.
Margin Call: At this level, the broker contacts you to increase your collateral to reduce the risk of default.
Liquidation Level: This level usually comes after the margin call level, and if you haven’t increased your collateral, you will be liquidated. All collateral is sold off at this level, and your debt to the lending platform is cleared.

How Crypto Lending Works

Crypto lending platforms allow users and cryptocurrency investors to access needed capital without selling assets. As previously mentioned, crypto loans are dual-sided: users can lend their cryptocurrencies to DeFi platforms in exchange for specified interest, and they can also borrow a certain amount of cryptocurrencies by providing some of their crypto assets as collateral. In general, there are four types of crypto lending, which are outlined below:

Collateralized Loan

Collateralized loans are the most popular type of loan in decentralized finance. You need cryptocurrency in your account to obtain such a loan, which will be used as collateral. On most lending platforms, the Loan-to-Value (LTV) ratio is less than 100, meaning the loan amount is lower than the value of the collateral provided.

Crypto Line of Credit

Instead of offering traditional loans with a pre-determined time frame, some platforms provide users with a crypto line of credit. This is essentially a collateralized loan that allows users to borrow a specific percentage of their deposited collateral without a fixed repayment period. Users only need to pay interest on the funds they have withdrawn based on the time period. An important point in this model is that you don’t need to settle the loan as long as the value of your collateral doesn’t reach the liquidation level.

Uncollateralized Loan

In addition to collateralized loans, there are uncollateralized loans, although they are not widespread in this industry and function similarly to traditional ones. In this process, the borrower must fill out a loan application, undergo identity verification, complete a credit check, and ultimately receive approval. These loans carry more risk for lenders because no collateral covers potential defaults.

Flash Loan

Flash loans are typically available on cryptocurrency exchanges, taken out, and settled in the same transaction. These types of loans are hazardous and are generally used to take advantage of arbitrage opportunities in the market.

Cryptocurrencies and the Howey Test

According to the official website of the U.S. Securities and Exchange Commission (SEC), the mission of this organization is to “protect investors, maintain fair, orderly, and efficient markets, and facilitate capital formation.” The SEC strives to promote a market environment that fosters public trust. As explained by the SEC, “We require public companies, fund managers, investment professionals, and other market participants to regularly disclose financial and other significant information so that investors have timely, accurate, and complete information to make informed investment decisions.” In alignment with these core goals, the SEC has taken a relatively aggressive approach to enforcing regulations on crypto assets, likely based on concerns that the general public lacks sufficient information to invest in this market.

The SEC has repeatedly emphasized transactions related to crypto assets, believing that almost all cryptocurrencies should be regulated as securities under federal law.

Jay Clayton, the SEC chairman from May 2017 to December 2020, frequently asserted that every Initial Coin Offering (ICO) constitutes the sale of securities. After Clayton’s resignation in late 2020, Gary Gensler was sworn in as chairman of the SEC on April 17, 2021. Although crypto enthusiasts were briefly hopeful that Gensler would take a more favorable approach towards cryptocurrencies than his predecessor, those hopes did not materialize. On August 3, 2021, Gensler explicitly stated that he shared Clayton’s views and that he believed most cryptocurrencies and ICOs violate U.S. securities laws.

“If something is deemed a security today, it may not always be recognized as a security.”
– Jay Clayton, Former SEC Chairman

The SEC’s first official report on applying the Howey Test to crypto assets was published in 2017, when the commission concluded that tokens issued by the DAO (Decentralized Autonomous Organization) should be classified as securities. Since DAO tokens were unusual and specifically designed as a means to invest in other projects, this report was considered sufficient to avoid widespread confusion at the time.

Despite confusion over whether many tokens should be classified as utility tokens or securities, only those recognized as securities fall under the SEC’s jurisdiction. Despite differing views on the issue, SEC officials believe the Howey Test is a proper tool for identifying whether a cryptocurrency is a security. Since lending these types of assets also needs to be regulated by the SEC, this is why the commission has significant issues with crypto lending platforms.

SEC vs. Coinbase

In June 2021, Coinbase announced a plan to allow cryptocurrency holders to earn interest by depositing a specific crypto asset on the exchange—or, more simply, by lending it to Coinbase. Initially called Coinbase Lend, this program would enable users to earn returns on their assets, offering higher interest than traditional financial institutions, particularly on Coinbase’s stablecoin, USDC.

Despite initial positive customer reactions, Coinbase publicly revealed on September 7, 2021, that it had received a Wells Notice from the U.S. Securities and Exchange Commission (SEC). The SEC had indicated that it intended to initiate enforcement action against this new program. It stated that the interest-generating system was akin to an investment contract and should be classified as a security. Notably, the SEC did not release any public statements about the specific nature of its investigation, leaving its decision somewhat unclear. Under mounting pressure from the SEC, Coinbase ultimately abandoned the Coinbase Lend program to avoid potential legal battles.

Despite Coinbase’s decision to drop its plans, crypto lending programs continue to expand rapidly, prompting some regulators to call for stricter oversight to protect consumers better. One such figure pushing for more stringent regulation is Gary Gensler, the current SEC chairman. However, even with these strict measures, crypto entrepreneurs still question when or how securities laws will apply to crypto-based products.

BlockFi Interest Accounts (BIA) and the SEC’s Reaction

BlockFi Lending LLC, a subsidiary of BlockFi Inc. (which filed for bankruptcy last year), began offering interest accounts to its customers worldwide in March 2019. According to a blog post published by BlockFi, users could earn up to 6.2% annual compound interest by lending their crypto assets—a return previously unheard of in the financial market. However, BlockFi’s strong emphasis on this program’s profitability caught the SEC’s attention.

Regulator’s Response to BlockFi

Interestingly, state authorities (in New Jersey) responded to BlockFi before the SEC did. On July 22, 2021, New Jersey ordered BlockFi to stop offering interest accounts in the state. Less than two weeks later, on July 30, 2021, the Kentucky Department of Financial Institutions Securities Division issued a cease-and-desist order against BlockFi. Following New Jersey’s lead, Alabama, Texas, and Vermont also took enforcement actions against BlockFi.

U.S. authorities concluded that customers depositing assets into the platform were “passive investors.” This led to the cessation of transactions under New Jersey law, effective July 19, 2021. Additionally, Gurbir Singh Grewal, New Jersey’s former Attorney General, was appointed as the SEC’s Director of Enforcement just before this order was announced, making the SEC’s subsequent actions even more predictable.

“This is the first case of its kind against crypto lending platforms,”
– Gary Gensler, SEC Chairman

On February 14, 2022, the SEC formally entered the fray, charging BlockFi with failing to register the sale of its retail crypto lending products. This was the first action of its kind, accusing BlockFi of violating the Investment Company Act of 1940. To resolve the charges, BlockFi agreed to pay $50 million in fines, halt its unregistered offerings and sales, and comply with securities laws. Additionally, BlockFi’s parent company announced it would register new crypto lending products under the Securities Act of 1933, and BlockFi had to pay another $50 million in fines to 32 U.S. states.

Are Crypto Lending Products Promissory Notes or Investment Contracts?

One of the most critical and challenging questions is how exactly the U.S. Securities and Exchange Commission (SEC) determines that crypto lending-related products qualify as securities. The SEC references two different tests—the Howey Test and the Reves Test—each applied to various areas, creating complications since these tests are usually designed for other asset classes. This suggests that the SEC must clarify which test applies rather than implying that a single asset could be governed by both methods. While the Howey Test generally controls the classification of crypto assets, the Reves Test requires a more detailed examination.

The Reves Test

The Reves Test specifies that a promissory note can be considered a security based on what is called the “family resemblance test.” The Reves Test evaluates assets based on four main factors:

The intent behind selling and buying, including whether there is an expectation of profits.
The scope and scale of how the contract is sold.
How the contract is marketed and whether the public perceives it as an investment.
Whether there are other regulatory systems in place to reduce investment risk.

Why the SEC Has Issues with Crypto Lending

The SEC’s concerns regarding crypto lending fall into two categories: protecting the U.S. economy and consumer rights.

The commission seeks to identify investment contracts under the Howey and Reves tests that violate regulations, particularly those from the Investment Company Act 1940. Many crypto lending programs, where users lend their crypto assets in exchange for interest, likely violate these laws, hence the SEC’s scrutiny.

One major issue is the lack of a clear regulatory framework for crypto lending. Crypto lending platforms are not insured by agencies like the Federal Deposit Insurance Corporation (FDIC), which insures bank deposits in the U.S. This means that if a platform is hacked or goes bankrupt, users cannot be guaranteed to recover their assets.

Many crypto lending platforms lack transparency regarding their lending practices, how they generate profits, repayment methods, and associated risks. This makes it difficult for investors to make informed decisions, a key concern for the SEC, which requires full disclosure for consumer protection.

Conclusion

The SEC’s concerns with crypto lending stem from two main reasons: Economic and Legal Compliance and Consumer Protection and Transparency

First, the concerns of this institution pertain to compliance with laws and regulations related to cryptocurrency-based investments and lending. This institution seeks to identify and manage investment contracts that may violate the relevant laws; as many cryptocurrency lending platforms utilize users’ cryptocurrency assets, this could lead to breaches of existing regulations.

Second, the lack of sufficient transparency in cryptocurrency lending activities and the violation of consumer rights protection principles are other reasons for the U.S. Securities and Exchange Commission’s concerns. The opaqueness of lending practices, interest rates, repayment processes, and associated risks complicates investors’ decision-making and investment decisions. These concerns indicate that the fintech and cryptocurrency lending industry requires clearer regulations and laws aligning with public rights and interests to preserve economic stability and consumer rights.