How do SEC enforcement actions move markets?

On January 4, 2018, the Texas Securities Commissioner entered into an emergency cease and desist order to halt BitConnect’s lending and staking programs, its impending ICO, and its BitConnect Coin (“BCC”), alleging that BitConnect’s products were unlicensed, unregistered securities offerings.

As I read tweets of the news, I loaded up CoinMarketCap. There should be carnage in the BCC markets, I thought. After all, BitConnect was notorious for being a literal Ponzi scheme. Even though the Texas Securities Commissioners’ powers were theoretically limited to Texas, this action would obviously open the floodgates to scrutiny and enforcement from other regulators.

Despite that several hours had elapsed from the announcement, the BCC price had dropped less than 4%.

BCC price stayed relatively stable for three days before commencing on a slow decline. On January 9, as the North Carolina Securities Division also ordered a cease-and-desist. At the end of the day, BCC had dropped 20% from the January 3 closing price, and the gradual downward trend continued. Ultimately, on January 16, prices nosedived over 80% — from $200 down to $30 — as BitConnect announced that it would shut down its operations given these cease & desist orders.

If there were an accessible way to short BCC upon news of the Texas cease and desist, a knowledgeable trader could’ve done well on a short. BCC crashed from ~$450 to ~$7 in the course of a single month.

Can a trader learn anything from this episode? The BitConnect saga occurred when the crypto market was less sophisticated and derivatives were still immature; nowadays, traders are generally more knowledgeable and derivatives exchanges provide a much wider scope of products. Does that still provide positive-EV trading opportunities based on securities enforcement news?

While BitConnect terminated operations based on state security regulators’ orders, the US Securities and Exchange Commission (“SEC”) is undoubtedly the most active and wide-reaching securities regulator in the U.S. and has significant impact on US-exposed crypto projects. This article analyzes whether it could be profitable to short crypto assets based on SEC enforcement news.

The answer? Maybe sometimes.¹

Fundamentals

First things first, why would prices dip if the SEC sues a project for conducting an unregistered, unexempt securities offering?

First, litigation is a costly and time-consuming process. Most projects already aren’t able to deliver code, products, or partnerships fast enough, and litigation is a black hole for the company’s time between discovery, depositions, negotiations, court appearances, and everything else. Additionally, the initial stages of securities litigation could cost hundreds of thousands to millions of dollars, leaving much little in the treasury for actual development.

Second, an SEC lawsuit tarnishes a project’s reputation, often rightfully so. Potential business partners, investors, and employees are hesitant to work with a company that is allegedly operating illegally and may need to imminently shut down. Community members may decide that they do not want to bear the regulatory risk of the project and take their talents elsewhere.

Third, as most cryptocurrency exchanges are not securities broker-dealers, exchanges will likely delist the token to minimize securities risk. This will hurt liquidity and make it more difficult for people to access and use the token.

Fourth, the SEC may demand that a project register sales of their token as securities offerings. If the project does so, transactions of the token may only be allowed to take place on securities exchanges and ATSs, and they’d be subject to securities trading restrictions. If the token is a payment token or used for decentralized activity, the friction of registration will almost completely kill its utility.

In short, there’s good reason for the value of a token to drop upon news that the SEC has sued a project.

That said, if a project reaches a favorable settlement with the SEC that’s a different story: if the settlement requires a monetary fine but otherwise allows the token to trade like normal today, it may cause temporary brand harm, but at least the project can continue development. Arguably, the project can even continue its course with greater regulatory certainty.

Analysis

I tracked SEC announcements against certain projects and these projects’ tokens’ subsequent price movements in a 1 day, 7 day, 30 day, and 90 day timespan. Since a rising market lifts all boats (and vice versa), I examined token prices in both USD and BTC.

Since this analysis is focused on longitudinal market price impact, I excluded tokens that were required to repay investors’ contributions, offer rescission to token purchasers, and/or register with the SEC as a security, such as Bitclave CAT, Dropoil DROP, Gladius GLA, Paragon’s PRG, and Airfox’s AIR. These tokens are not currently publicly traded so there’s no market price.

I broke down the remaining tokens into two categories: news of a “favorable” resolution (i.e., a settlement or final judgment that does not require rescission or registration of the token) and news of a SEC complaint. I include Kik’s KIN in both categories since Kik progressed in litigation prior to a final judgment.

Favorable Resolutions:

• EOS (“In the Matter of Block.one”)
• SALT (“In the Matter of Salt Blockchain Inc. f/k/a Salt Lending Holdings, Inc.”)
• KIN (“SEC Obtains Final Judgment Against Kik Interactive For Unregistered Offering”)

SEC Complaints:

• LBC (“Securities and Exchange Commission v. LBRY, Inc.”)
• XRP (“Securities and Exchange Commission v. Ripple Labs et al”)
• KIN (“Securities and Exchange Commission v. Kik Interactive Inc”)

Results

I tracked the closing price of each token on T-1, T, T+1, T+7, T+30, and T+90, with T being the date of the announcement. Afterwards, I calculated the percentage change of the price at each date from the close at T-1 to track the delta over time. To illustrate, a 0.00% change at T+7 would mean that the price did not change from T-1.

Favorable Resolutions

Complaints²

To view the data in table form, see here.

Findings

Projects that achieve a favorable resolution end up maintaining or exceeding the price of their tokens in BTC terms at T+90. They may even see an increase in price on the day of announcement, since a favorable settlement may be perceived as a “victory” and clears up regulatory uncertainty surrounding the token.³

On the other hand, projects that are actively undergoing SEC litigation tend to suffer the day of announcement and end up suffering a drop in T+90 price relative to BTC, though in USD terms, they could be up due to overall market forces. This weakening against BTC suggests that these projects may be losing market share and the strength of their ecosystems.

A caveat here that there aren’t enough cases to form a rigorous finding. The analysis also doesn’t isolate other shocks that could’ve happened, such as new releases or key executives leaving. It could also be that the SEC was more eager to take favorable-resolution during different periods of market activities. That said, a pattern does seem to emerge.

The goal of this article is to provide a surface-level analysis. For those that want to perform a more rigorous analysis, I’d recommend analyzing how a basket of 10 or 20 top tokens may move against BTC during the same time period as a control, and factoring in each token’s average volatility via tests of statistical significance.⁴

Conclusion

Perhaps due to the increasing popularity of global derivatives exchanges and the rise of institutional traders and professional market makers in the past two years, markets have become more efficient at incorporating regulatory news than in the days of BitConnect.⁵ In and after 2019, it seems large-cap projects move in rational directions after announcements of regulatory action. However, note that it’s difficult to quantify what should be the true price impact of any such announcement, thus it’s difficult to say when a piece of news is “efficiently” priced in.

Market composition also matters. Most cryptocurrencies trade globally and different regulators have different definitions of what constitutes a security.⁶ Global traders may not care about the SEC’s designations if they reside in countries where securities laws are more lax regarding crypto. Therefore, if the primary trading base of the token are non-US users, prices may justifiably not move as much upon SEC news compared to tokens primarily traded by US users.

As institutional holders, professional market makers, professional traders, and more conservative investors (e.g., pensions and endowments) enter the industry and become a more dominant presence relative to retail, it’s likely that the SEC complaints may become more impactful. Few parties subject to reporting and/or licensing requirements would want to assume the risk that they may be unlawfully performing unlicensed, unregistered securities activities.

In conclusion, SEC announcements do seem to matter to markets and in directionally rational ways. As the SEC enters a new period of enforcement with Gary Gensler at the helm, it’ll be interesting to see whether these trends persist.

Special thanks to Celia Wan and Haseeb Qureshi for their feedback on this piece.

¹ Nothing in this article is or should be construed as legal, investment, or financial advice. Dragonfly Capital does not hold a position in any of the cryptocurrencies discussed.

² Since LBC’s action is recent, 90 days have not yet elapsed and thus there’s no data point for T+90.

³ There was certainly a plethora of congratulations to Block.one upon news of their $24 million fine settlement for their $4 billion dollar ICO.

⁴ If you’re interested in writing an academic piece analyzing these effects, contact me, and I can help.

⁵ Though, to be fair, state securities regulators arguably do not have the direct scope of the SEC.

⁶ For example, the U.K. Financial Conduct Authority has a narrower definition of what constitutes a security than the SEC, and acknowledges that transactions that the SEC would consider to be securities offerings may not be securities offerings under the FCA’s jurisdiction. Another example, the Japan Financial Services Agency has declared that XRP does not meet the definition of a security under Japanese law, in contrast to the SEC’s stance under US law.