Coinbase’s Broker Was Censured and Fined by the SEC for Using Customer Funds for Personal Gain

I’m pretty sure that most of us had the feeling that most of the exchanges in the space use some sort of fractional reserve for customer funds. But, this tweet from Nathaniel Popper (NYT writer), surprised me a bit.

Check it out below:

https://platform.twitter.com/widgets.js

So, naturally, I had to look into this claim and see what this SEC statement was all about.

However, before we get into that — let’s make sure that we’re all on the same page first.

What is a Fractional Reserve?

(Here’s a definition of what a ‘fractional reserve’ is, below, for those that do not know):

Source: https://www.learningmarkets.com/understanding-the-fractional-reserve-banking-system/

Translation

The way that this would relate to cryptocurrency exchanges is that, when you put in 20 BTC, they don’t actually reserve those 20 bitcoins for you to come get later, they use some of it and just keep a fraction of it.

Now, this is just a theory because, to my knowledge, no exchange has come out and stated outright, “Yes, we have a fractional reserve here.”

A Fractional Reserve is NOT Legal for Crypto Exchanges

For the record, no cryptocurrency exchange is allowed to run a fractional reserve. This is a special privilege that only banks and huge financial institutions are allowed to enjoy — especially in the aftermath of the financial crisis of 2008/’09 and the financial regulations that followed (see: Dodd-Frank).

I am Not Accusing Coinbase of Running a Fractional Reserve

I had to put a big title over this to make it known that this is not an accusation, charge, or claim that Coinbase or any other cryptocurrency exchange is running a fractional reserve.

I’m just trying to brief everyone on what the law is and how it applies to different entities in this space.

The Dangers of a Fractional Reserve in Crypto (if there are exchanges running this way)

To my knowledge, Coinbase is the only exchange with any level of reliable ‘insurance’ (in the form of FDIC) in the event that client/customer funds are lost, hacked, or stolen due to negligence on their behalf/hacking/natural disaster or some other event outside of the control of the investors that would lead to a loss of their funds.

Here’s a press release from the company on this:

https://www.coinbase.com/legal/insurance?locale=en-US

However, it is worth noting that there are some limitations to this FDIC coverage (note: it is not the same coverage that banks and other financial institutions in the United States have).

Source: https://www.coinbase.com/legal/insurance?locale=en-US

So, that means only the cash would be insured on Coinbase’s platform (hypothetically; whether you trust that FDIC will actually cash out everyone in the United States in the event some sort of apocalyptic financial event occurs is another story).

So, all the actual cryptocurrency (which is what you use the platform for in the first place), like Bitcoin, Ethereum, Bitcoin Cash, Litecoin, and whatever else they add/added/will add/owe you/or will hold, has zero insurance behind it.

This is why I feel that it would be dangerous for any cryptoexchange to be running such a reserve.

However, without any transparency in the crypto space it is almost impossible to tell whether a fractional reserve is being ran or not.

Thus, we have no idea if customer funds are being kept 1 to 1 or not and, because of that, it really begs the question of whether people are being ‘hacked’ or whether $30M+ (or whatever random amount was hacked) was necessary to be taken from customers in order to pay others that were trying to withdraw from the exchanges.

Just thought that I would drop that information above as food for thought and knowledge for all cryptocurrency investors.


Back to That SEC Ruling

When I clicked on the link provided by Nathaniel Popper (here it is again — https://www.sec.gov/news/press-release/2018-45 ) this is what came up, below:

The first thing that I noticed is that this press release was issued on March 19th, 2018, which is over 3 months ago!

What makes this interesting is the fact that the company, Electronic Transaction Clearing (the company that the SEC wrote that report about), is a new partner of Coinbase. And they also picked this partner AFTER they had received this fine from the SEC.

Source: https://www.bloomberg.com/news/articles/2018-05-15/coinbase-goes-after-wall-street-with-new-cryptocurrency-tools
Source: https://blog.coinbase.com/coinbase-custody-is-officially-open-for-business-182c297d65d9

ETC Censure

At the end of the article posted by the SEC, it is also noted that Electronic Transaction Clearing was also censured for their actions as well:

So, this begs the question for me (to a certain extent) as to why Coinbase would ink a partnership with a broker-firm that has recently been censored.

However, that is nothing that I can answer and a better question for Coinbase to respond to.

I just felt that this was some news that was worth delivering to you all.

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