OpenSea, Custodia, and the revival of Operation Choke Point 2.0

Could Operation Choke Point 2.0 and the SEC’s focus on OpenSea and Custodia corner the crypto industry?

SEC has dealt another blow to the crypto industry…

As the upcoming presidential election in the United States approaches, the cryptocurrency industry once again finds itself at a crossroads.

While Democratic candidate Kamala Harris is seen by many as a potential ally, the current administration, led by SEC Chairman Gary Gensler, appointed by President Joe Biden, has stepped up its regulatory actions and has now turned its eye to the non-fungible token market.

The SEC sent a Wells notice to OpenSea, the largest NFT marketplace, on August 28, notifying it of its intent to take enforcement action against the platform.

A Wells notice is a formal communication from the SEC stating that the agency is considering taking sanctions against a company or individual and provides an opportunity to respond before a final decision is made.

According to OpenSea CEO Devin Finzer, the SEC is alleging that certain NFTs on the platform could be classified as securities, a claim that could have drastic ramifications for the entire NFT space.

OpenSea received a Wells notice from the SEC threatening to sue us because they believe the NFTs on our platform are securities.

We are surprised that the SEC would take such a sweeping action against creators and artists. But we are ready to stand up and fight.

Cryptocurrencies have long been…

— Devin Finzer (dfinzer.eth) (@dfinzer) August 28, 2024

The announcement comes just a day after former cryptocurrency President Donald Trump launched his fourth digital trading card NFT collection, featuring unique perks like pieces of his debate suit and exclusive experiences at Trump National Golf Club.

OpenSea isn’t the only company facing scrutiny from the SEC. In April, decentralized exchange Uniswap (UNI) also received a Wells notice, with the SEC alleging it was operating as an unregistered securities broker.

Other major players like Coinbase, Kraken, and Robinhood have also faced similar actions in the past.

These moves suggest that Operation Choke Point 2.0, believed to be a strategy by the Biden administration to sever the crypto industry’s ties to traditional banking services, is still in full force. What’s really going on?

Examining the OpenSea saga

Finzer expressed deep concern about the SEC’s approach in his tweet, calling it a “sweeping move against creators and artists.”

According to Finzer, the SEC alleges that the sale of NFTs on OpenSea violated securities laws because NFTs are considered securities and these transactions constitute unregistered securities sales.

The CEO noted that this action could stifle innovation in the NFT space and potentially impact hundreds of thousands of online artists and creators. The crux of Finzer’s argument is that NFTs are fundamentally different from financial securities.

“NFTs are fundamentally creative goods: art, collectibles, video game items, domain names, event tickets and more,” Finzer said, arguing that they should not be regulated in the same way as traditional financial instruments.

OpenSea disputes the regulator’s claims, arguing that they are not valid and that the platform is “ready to stand up and fight”.

From student artists finding full-time careers selling their digital art to indie game developers creating open markets for their in-game products, NFTs have enabled new opportunities that would otherwise be at risk if the SEC’s actions continue unchecked.

As Finzer puts it, “It would be a terrible outcome if creators stopped making digital art because of threats from regulators.”

Finzer also noted ongoing legal battles that mirror OpenSea’s woes. He cited a lawsuit filed against the SEC by musician Jonathan Mann and conceptual artist Brian Frye, who feared that sales of their artwork and music could be classified as unregistered securities offerings.

In response to the SEC’s latest move, OpenSea has pledged to donate $5 million to support NFT creators and developers who may face similar legal challenges.

Regulatory uncertainty surrounding NFTs

When it comes to NFTs in the US, the regulatory landscape remains unclear. This lack of clear rules has created confusion and uncertainty not only for creators and buyers, but also for the platforms that facilitate NFT transactions.

There are currently no specific laws governing NFTs in the U.S. Instead, regulators like the SEC are trying to fit NFTs into existing laws that were primarily designed for traditional financial products.

The big question regulators are asking is: Are NFTs securities? If so, they fall under the same stringent SEC regulations as stocks or bonds. But here’s where things get tricky.

According to the Howey Test, a legal standard the SEC uses to determine whether something is a security, an asset is considered a security if it involves investing money in a joint venture with the expectation of profits from the efforts of others.

This test was originally designed for traditional investments, but the SEC now applies it to NFTs, which are typically purchased for nonprofit purposes, such as collecting or supporting an artist.

The fundamental problem with applying current regulations to NFTs is that they fail to account for the diversity and complexity of the market.

NFTs can represent anything from digital art to in-game items, each with their own unique properties and value proposition. Applying a uniform regulatory approach could stifle innovation and limit the potential of NFTs.

For example, if all NFTs were classified as securities, platforms would have to adhere to the same regulations as exchanges, which could be incredibly costly and complex.

Smaller creators and developers may find it impossible to meet these requirements, potentially driving them out of the market entirely. This could limit the diversity and creativity that makes NFTs so popular.

There is also a global aspect to consider. The US is only a part of the global NFT market, and excessive regulation in the US could push NFT activity to other countries with more favorable regulations.

The SEC’s recent actions, including the Wells notice sent to OpenSea, signal a more aggressive approach to regulating the NFT space. The SEC is attempting to expand its regulatory reach by potentially classifying certain NFTs as securities, which could increase costs for users and reduce the number of new NFTs entering the market.

Ripple effects across the industry

The ongoing operation under Operation Choke Point 2.0 is creating shock waves not only in the NFT market but throughout the entire cryptocurrency industry.

A clear example of this is the recent restructuring at Custodia Bank, a small but influential financial institution based in Wyoming that serves crypto companies.

Custodia Bank, once a major provider of banking services to crypto businesses, recently announced the layoffs of nine of its 36 employees. The difficult decision was made to preserve capital as the bank battles the Federal Reserve in court, Fox Business reported.

At the heart of the legal battle is Custodia’s effort to open a master account at the Fed, a vital asset that would give the bank access to the central bank’s liquidity facilities and payment services.

Without this account, Custodia is forced to operate through other institutions that have a primary account, resulting in much higher operational costs.

Banking regulators have become increasingly cautious about allowing traditional banks to engage with crypto companies. This increased scrutiny has made many traditional banks hesitant to pursue relationships with crypto companies, contributing to a growing sense of isolation in the industry.

Despite assurances from government officials, including Deputy Treasury Secretary Wally Adeyemo, that there is no coordinated effort to exclude the crypto industry from the broader financial system, the experiences of industry participants point otherwise.

Custodia Bank also faced this harsh reality; it terminated its relationships with two of its partner organisations, making its fight for survival even more vulnerable.

The crackdown under Operation Choke Point 2.0 reflects the real-world impact of regulatory pressure on the crypto industry. Even a small, state-chartered bank like Custodia, which plays a critical role for businesses without other banking options, is struggling to stay afloat.

The SEC’s recent decision against OpenSea has sparked a wave of frustration and anger on social media, with many users expressing disbelief and concern over what they perceive as a heavy-handed approach to regulating the NFT market.

One of the angriest critics pointed out the absurdity of labeling NFTs as securities. The user questioned whether the SEC would start classifying “artworks” or “Beanie Babies” as securities as well, sarcastically asking whether “eBay” could be next on the SEC’s list.

Claiming that NFTs in general are securities is ridiculous. Are images securities now? Are Beanie Babies? Is the SEC going after eBay? It’s ridiculous.
Sure, you can make an NFT, which is a security, but you can also turn pieces of paper into securities (“shares”).

— Emmett Shear (@eshear) August 28, 2024

Another user expressed his disbelief in the SEC’s ongoing actions against the cryptocurrency industry, describing the measures taken by the institution as a direct attack on innovation.

Wow. The SEC continues to crack down on innovation.

— Steve 🤙 (@SteveKBark) August 28, 2024

The frustration isn’t just limited to the SEC’s actions; it extends into the political arena as well. One user even expressed his disappointment with the Democratic Party.

Crypto belongs to Harris, my ass. If you want crypto and American innovation, don’t vote Democrat.

— cryptopainter 🐯🍌 (@painter_crypto) August 28, 2024

Drawing a historical parallel, another user noted that in 1976 the SEC ruled that art galleries did not need to register as securities dealers, even when promoting and selling art as investments.

In 1976, the SEC ruled that art galleries did not need to register with the SEC, even when promoting and selling to investment buyers.

Galleries = ok
NFT marketplaces = not suitable 🤡 pic.twitter.com/kRMxdZaL0Q

— cryptopainter 🐯🍌 (@painter_crypto) August 29, 2024

The tweet sarcastically points out the inconsistency in the SEC’s stance, implying that “galleries” are acceptable but “NFT marketplaces” are not.

The rising tide of voices on social media reflects the widening gap between the crypto community and regulatory bodies like the SEC.

As these discussions continue, the debate over how to regulate digital assets is far from over, with many in the industry calling for greater clarity and fairness.