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Securities Industry Has Less than a Year to Comply with Rules Regarding Research

On July 4, 2023, the European and U.S. financial regulatory bodies could be at odds with each other’s rules. The reason is a simple difference in how each believes compensation should be paid to brokers providing research on securities to clients. The conflict stems from a four-year-old rule instituted in the EU. At the time, it would have impacted U.S. securities brokers, but the SEC temporarily relieved the problem by signing a no-action letter saying they would not enforce the problematic areas immediately. The SEC no-action letter expires on July 3 of next year – the Commission has just indicated they will not renew it. This could create a very expensive problem for many U.S. brokers while leaving investors based out of the EU scrambling to locate institutional quality research. It could also mean fewer companies will get the attention they were once receiving as the information will not be distributed to EU buy-side shops. Worse yet, some of these companies covered by broker analysts may lose all sell-side research of their companies.

Specifics

In 2018 the EU created a rule whereby cost or fees associated with research provided to the buy-side had to be accounted for separately from transactional business income. It’s called The EU Markets in Financial Instruments Directive II (“MiFID II”), the effective date was January 3, 2018. That seems harmless enough; a broker can not provide “free” research to customers; they would need to charge them separately. However, in the US, if a broker or anyone else provides investment advice for a fee, they need to be licensed as an investment advisor. While securities brokers have licenses, this additional registration would change the framework of recordkeeping and allowed activities.

Brokers facilitate trades and are not permitted under their registration to recommend trades. Investment advisors can make specific recommendations. These are very distinct roles in a related field. Investment advisors are clients of brokerage firms.

U.S. registered broker/dealers have had an exception from the definition of investment adviser under the Advisers Act (in respect of research distribution). In the U.S., distribution of research must be advice incidental to the firm’s broker-dealer business, and the broker-dealer does not receive “special compensation.” If the broker gets paid to provide research (hard dollar payment) the SEC considers this “special compensation” for investment advice.

The EU, as of 2018, required a separate breakout fee associated with the “advice.” A separate breakout fee in the states would force the broker to reregister as an advisor if hard dollar compensation is exchanged.

Why is this Suddenly a Problem?

You could blame it on Covid, blame it on disbelief, blame it on forgetfulness, but the SEC issued a no-action letter to the Securities Industry and Financial Markets Association (SIFMA). The letter was renewed in 2020 to expire in July of next year. The essence of the letter is: It would not recommend enforcement action to broker/dealers accepting cash payments for research from investment managers who are required by Mifid II to pay for research with their own money as opposed to client commissions or soft dollars. This was even better for broker/dealers as they began charging these overseas clients or shrunk their research universe.

The original end date of the no-action stipulation was July 3, 2020. It had been extended for three years in order to allow more time for broker-dealers to alter their business to either receive compensation for research services or cease providing it, at least to EU clients.

A Director of the SEC Division of Investment Management recently indicated in a speech that after July 3, 2023, U.S. broker-dealers accepting MiFID II compensation can no longer rely on the no-action letter to escape classification as an investment adviser. The letter will not be renewed as many expected.

Take Away

Equity research, particularly on small and mid-size companies, is important for the buy-side investor, it’s a well-entrenched sales tool for brokers and is important to the covered companies that information is available for investors to better understand their business and outlook. In less than a year, the SEC will expect any broker offering research for pay (as required under MiFID II) to register as an investment adviser. Doing so would be very difficult for much of the U.S. brokerage community. 

Other providers of research include Independent Research (IRP), most often paid for by the investor, and Company Sponsored Research (CSR), where the analyst coverage is paid for by the covered company.  

Paul Hoffman

Managing Editor, Channelchek

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Sources

https://substantiveresearch.com/matter/substantive-research-survey-reveals-60-of-asset-managers-will-not-change-investment-research-processes/

https://www.evalueserve.com/blog/us-firms-need-mifid-ii-compliance/

https://www.kslaw.com/news-and-insights/broker-dealer-research-mifid-related-hard-dollar-sec-investment-adviser-status-relief-to-end-in-july-2023

https://www.investopedia.com/terms/m/mifid-ii.asp

https://www.irmagazine.com/regulation/week-investor-relations-buy-side-impact-sec-mifid-decision-no-good-or-bad-investments

https://www.thetradenews.com/sec-decides-not-to-extend-research-services-enforcement-no-action-letter-to-sifma/

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CSR Provides More Clarity for Investors

Company Sponsored Research or CSR is research used by professional and individual investors to better understand stocks they are interested in. The companies covered by CSR are typically small or microcap stocks that want investors to have a clearer unbiased understanding of their company and its prospects.

Companies that fall into the category of small-cap or microcap often suffer from being overlooked because there is not much information available that evaluates their earnings, business model, and growth potential. Not surprisingly, investors are much more likely to take an interest in a company whose business they understand, especially if there is a knowledgeable third party providing insight and guidance on where it may be headed. 

Management from companies that would benefit from CSR will get in touch with a research firm that provides the service. Providers of high integrity may turn down the public company for various reasons. And it may give it a “thumbs down” in some categories, but this is considered better for the company than no qualified third-party information at all. In fact, investors know there is risk in everything they own, and that at times with more risk comes more reward. Investors just want to understand the risk and trust those helping them to assess it.

Investors also may find that with more interest in a stock (at the right price), it is easier to buy and sell when they want. In fact, if more transactions result from greater visibility and information, the stock is more likely to trade at its “fair” price, which could reduce price risk and, as important, increase liquidity.

Company-Sponsored Research, when done well, is never paid for marketing. Investors should determine who they trust in the business; they can do this by investigating to see the credentials held by the analysts writing the report. Analysts are not likely to jeopardize a designation such as a Chartered Financial Analyst (CFA) or those holding FINRA registrations. Investors may also want to take a look at track records provided by services like TipRanks. Lastly, a research firm that only writes glowing reports on companies, and doesn’t write at least four a year on the company you’re interested in (usually after earnings are released), can be viewed as suspect.

CSR can be found on paid-for platforms such as FactSet, Bloomberg, Capital IQ, and Refinitiv Eikon. Channelchek is unique in that it is a no-cost platform that offers Company-Sponsored Research written by the FINRA licensed research analysts at Noble Capital Markets.

Paul Hoffman

Managing Editor, Channelchek

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Global Strength in the US Dollar Is Positively Correlated to Strength in Many Stock Sectors

The last time the U.S. Dollar was this strong against other currencies was October 2002. It reached a new high today (August 22) as the expectations surrounding the annual Jackson Hole Economic Symposium become more hawkish. Higher U.S. interest rates tend to place upward pressure on the dollar’s value measured against other currencies that have lower real rates (inflation less native interest rate). There are other global economic factors at play as well.

Why is the Dollar at a High

The Euro lost relative value to the U.S. currency over the past month after Russia announced a three-day halt to European gas supplies flowing through the Nord Stream 1 pipeline. Europe is already experiencing an energy crisis that is inflating all related costs. Higher inflation weakens a currency against those with lower or no inflation.

Away from Europe, the world’s second-largest economy, China saw its Yuan sink to its lowest level in almost two years after the Chinese central bank cut key lending rates. China has been easing policy to shore up its weakened state related to its response to Covid-19 and crashing real estate values.

Source: Koyfin

US Stocks and a Strong Dollar

What does a rising dollar mean for stocks? The short answer is, as the value of the U.S. dollar rises in relationship to global currencies, the U.S. stock indexes statistically have risen along with it.

Over the last 20 years, the S&P 500 index has shown a positive correlation to the dollar about 40% of the time. While this may not seem huge, in stock market indicator terms, it is better than most and would be better if some sectors were excluded or given less weight. 

As with most everything else, the value of something will tend to rise with increasing scarcity or increased demand. The demand for the dollar has been increasing as the U.S. is perceived to have one of the stronger, safer economies relative to our trading partners. Additionally, as real rates are expected to continue to rise in the U.S., overseas investors will flock to dollars which they may then store in dollar-denominated assets, which adds to demand. 

What sectors have the highest propensity for positive returns? One obvious answer is companies that rely on imports. This is because they have an advantage when the U.S. dollar is strong. One caveat, many retailers that import their goods have been under a lot of strain because of built-up or mistimed
inventories. Manufacturing businesses that rely heavily on raw materials or commodities and get these products from overseas (steal, semi-precious metals, minerals, etc.) will benefit from paying in or exchanging from the stronger currency. This has the impact of reducing relative costs and helping the bottom line. Stocks do better with a growing bottom line.

Investors should be more cautious with companies that sell their products internationally. If there are alternative suppliers available to them that transact in non-dollars, these companies’ sales could suffer.

Companies that buy and sell only in dollars will not have the price advantage that importers do, but they avoid exchange rate factors altogether. Utilities and regional banks are on this list. A word of caution as interest rates are moving upward, utility stocks known for their dividends may begin to compete less effectively with bonds. Also, banks will generally earn more with a steep yield curve; this has been elusive so far in this tightening cycle.

Some investors increase the number of small companies on their watch list. This is because, as a rule, their sales are domestic, while they may or may not import. Large companies tend to transact internationally. Small-cap stocks are not typically at the multinational stage yet. Use the data available on Channelchek to better understand whether the small company stock you are interested in imports or exports internationally.

Take Away

There are many factors that move the market up or down. And there are factors that impact specific industries and individual stocks. Statistically, a stronger U.S. dollar is positive for US stocks. Companies that import could fair even better. Stocks least affected by currency shifts include utilities, regional banks, and small-caps in almost all industries. Each company should be vetted separately, but minimizing headwinds is a good step toward successful investing.

Paul Hoffman

Managing Editor, Channelchek

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Sources

https://www.cnbc.com/2022/08/22/forex-markets-dollar-federal-reserve-jackson-hole-monetary-policy.html

https://www.investopedia.com/ask/answers/06/usdollarcorrelation.asp

https://www.bbc.com/news/business-62629144

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Why Investors and Public Companies Rely on Company-Sponsored Research

Would you meet with someone from a dating app if they did not provide a clear photo?

Regardless of how fulfilling the future may have become with the person or how great they may or may not look, statistically, we know, without a clear picture,  the person is going to get passed over by all except for the greatest risk takers.

It’s easy to understand why even the least appealing dating site profiles with a clear image will attract more interest than the profile without a clear and updated picture. Similarly, product reviews on Amazon serve the seller. If there are two similar products, one with average reviews and another with no review, consumers are more likely to take a shot at the one with more available information – especially third-party reviews – even if the item has a higher price.

Small, lesser-known stocks also need a clear picture to attract broad attention. The broader the attention, the more potential suitors. This is why companies without a  clear picture or without an experienced third-party analysis cause investors to quickly “swipe left.” 

A stock with low third-party analysis available doesn’t serve the company well and is frustrating to investors with positions they may not be getting a fair valuation or adequate liquidity on.

Company Research

Equity research and analysis of a company from analysts known for their experience, industry knowledge, and integrity, provide a picture for investors. As mentioned earlier, without a picture, far less attention is paid. Companies with updated research will increase the number of investors looking at their stock because investors will feel they have more insight and understanding.

Company research is different than company information. Publicly traded companies are required to provide quarterly information to the public. This includes most categories of small-cap stocks and microcaps that are traded over-the-counter (OTC) and trading on a regulated exchange. These SEC-required reports provide a basis for investors to look back on company-provided data. When this financial data is compared to historical trends, weighed against industry growth and ratios, then subjected to “what-if” scenarios, the information derived becomes analysis.

To be deemed research, the analysis is put under a spotlight along with evaluating the strength of management, intangible assets such as patents, market positioning, and a variety of other considerations.

Importance for Smaller Companies

Awareness of the investment opportunities smaller companies represent is typically low. The stocks just aren’t talked about in mainstream financial news. For this reason, companies with a low market capitalization can benefit from any quality research published on their companies, their products, and their economic prospects. This is because any publication which provides a heightened understanding of a company may create interest that leads to added liquidity and aids the market’s price discovery of the stocks’ best valuation.

A Relatively New Gap to Fill

In the past, small and micro-cap companies have benefited from coverage at research departments of broker/dealers that had the capacity to provide investor research. The motivation for these research departments to provide in-depth expensive research was often to act as a door opener for other lines of financial business (quid-pro-quo). While this introduced some risk of compromised integrity, the practice of those that sell stocks (sell-side) providing analysis was common.

What could go wrong with investors relying on research from the company that sells the stock that is researched? Everyone involved in the markets in 2002 or who has read up on market history knows the Enron story. Enron was highly rated by sell-side analysts right up until the week the company collapsed. The event suddenly brought the sell-side research “conflict of interest” to the front pages. 

The New York Times reported: “Lawmakers investigating the collapse of Enron turned their attention to Wall Street today, criticizing financial analysts for continuing to urge investors to buy Enron stock even as the company headed toward bankruptcy. Several members of Congress suggested that Wall Street firms’ hunger for investment banking business and other conflicts kept them from leveling with investors.” (NYT 2/27/02) 

The Wall Street Journal echoed The Time’s sentiment: “Some financial firms have said they felt obliged to participate in the partnerships in order to remain in the running for underwriting assignments from Enron.” (WSJ 2/8/02) “Complimentary” broker/dealer research of smaller companies pose a similar risk, however, when problems occur for investors, they are unlikely to get the attention of large news outlets.

So complimentary research and analysis ran the risk of being partial. And only when a big company failed did the media and lawmakers take notice. This began to open the door to research that was subscribed to and paid for directly by investors. Larger investors that could afford it might still review sell-side research, but the research they paid for was less likely to have an undeserved positive bias. 

Reduced Research Available

For small and microcap companies, both the sell-side research and the paid-for research began to get much less interest as investors changed their focus. 

One overshadowing reason complimentary small company coverage dropped off and quality paid for research became less sought after by investors is that index fund popularity increased. That is, the popularity of investment funds that are managed with the objective of providing returns mimicking a stock index was being advertised as the ideal way to gain diversified exposure to “the market.”  These indexed Mutual Funds (MF) and Exchange Traded Funds (ETF) provide close tracking of an equity index largely by owning the companies within the index. Individual stock selection became less common. This reduced research coverage has shut out companies and particularly hurt those not in a major index. As important, it lessened the number of stock pickers, as many money managers and self-directed investors instead became index pickers. 

From the point of view of investors reviewing stocks and looking to get involved with “the next big thing,”  there was less information to go by. Arguably worse, there were and are still many companies, some of which literally have life-saving products, that aren’t getting the capital flows they would have to manage their needs.

Company-Sponsored Research

Needs have a way of being filled in an open economy. Active research is still highly needed by those that transact in the microcap and small-cap sectors. And top-tier research coverage is still crucial for small public companies looking to expand their visibility among investors trying to unearth and understand companies. With fewer sell-side firms covering stocks, and subscription based-research attracting fewer subscribers, an evolution took place in how institution-quality research is provided.

Filling the gap left by the large bulge bracket broker/dealers and niche subscription services is what has, over the past few years, become the preferred model of equity research and analysis. Company-sponsored research (CSR) sprang from the need for small companies to again provide a clear picture to investors. 

This new model borrowed heavily from the well-established bond market services where firms like Moody’s and S&P provide research and credit analysis on public company debt. CSR providers were able to hire the very best analysts released by the big sell-side shops, and in some cases, subscription-based services converted to the CSR model. The institutional quality research is now compensated by the company that knows it will benefit from an unbiased evaluation from respected analysts. This new practice eliminates the past conflict of interest of investment analysts that may have experienced pressure to err on the side of a favorable outlook to help smooth the way to additional higher-paying services from the client.

A few of the research firms providing company-sponsored research to companies have taken an additional measure. These firms are requiring their analysts to pass FINRA (Financial Industry Regulatory Authority) qualifying exams in order to become registered securities professionals. The exam(s) and ongoing continuing education required to maintain the professional registrations, ensure a high level of understanding, further promotes ethical behavior, and provide for punishment, including loss of career, if some guidelines are not adhered to.

This new standard in who provides research and who it is available to clearly benefits the professional investor who may have always had access. But some firms providing company-sponsored research now make it available to all investors of any size. This was most often not the case as sell-side broker/dealers often only allowed timely access to their buy-side customers, and subscription services were too pricey for small investors. 

The largest CSR provider in the U.S. and Canada today is the research provided by analysts at Noble Capital Markets on a no-cost investor platform Channelchek and various subscription platforms used by institutional investors.

Take Away

Investing goes through regular incarnations and reinventions. The use of technology has provided an environment where passive investing gained in popularity. Just as other trends in investing have fallen out of favor, disruption or innovation will one day turn the tide toward another trend. Fortunately, some of the research activities that have been dropped by the sell-side broker/dealers, effectively decreasing resources to their customers, have been replaced with company-sponsored research. This evolution is growing in appreciation by both those raising capital and those investing assets.

Investors in companies covered by CSR have the benefit of an additional pair of trained eyes on companies they own, the companies benefit from not being overlooked from lack of coverage, and the world benefits as companies that will provide tomorrow’s life-saving drug, mining discovery, medical apparatus, storage innovation, or anything else may now better rely on being able to tap into capital and liquidity.

Paul Hoffman

Managing Editor, Channelchek

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Sources:

https://www.cnbc.com/2019/03/19/passive-investing-now-controls-nearly-half-the-us-stock-market.html

https://www.morningstar.com/news/dow-jones/201909182571/index-funds-are-the-new-kings-of-wall-street

https://channelchek.com/about

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Source: Bloomberg TV (August 17, 2022)

Meme Stock Frenzy 2.0 – WallStreetBets Founder Thinks it Will Continue

Is Bed Bath and Beyond (BBBY) going to rebound? Are AMC Theatres (AMC) and GameStop (GME) just beginning to make another attempt at reaching the moon. In a Bloomberg interview on Tuesday (August 17), WallStreetBets’ founder Jaime Rogozinski shared his thoughts. The interview is made more interesting in that it was conducted before news that Ryan Cohen, GameStop chairman and Chewy (CHWY) founder, filed to sell his entire stake in meme stock BBBY. This move gives pause to meme investors because the value of Cohen’s holdings in Bed Bath and Beyond was roughly 10% of BBBY market value. Rogozinski said he believes meme stock investors are “probably aiming to the moon.”

Meme Momentum

Rogozinski was asked if he was at all surprised to see so much trading come back in light of the lull in self-directed investor activity and inflation-related financial concerns. “I’m not really; summer vacation is over,” he then continued, “that’s when the activity gets to kick back up.” Jaime recognizes the momentum we had seen previously from WallStreetBets had “whimpered down” but he said goes in cycles just like the regular economy. He also pointed out that it would be impossible to retain momentum and make the kind of moves stocks like Bed Bath and Beyond and other meme stocks make without shifts in cyclical momentum.

Image: A Section of Ryan Cohen’s (RC Ventures) SEC form 144

Different Drivers?

Responding to a question about whether the drivers are different this time, Mr. Rogozinski said, “The drivers appear to be the same.” He pointed out that it is early in the cycle, but “we have the meme component that, everyone’s talking about it, the chatter and enthusiasm, you have a stock from a company that is relatively distressed, you have a high short float,” then he said something that may cause an investor in at least one of the current meme stocks to pay more attention, Rogozinski continued, “you have Ryan Cohen dipping his hands into this particular stock and giving his Midas touch to it,” as he expressed that the moves again have a lot of the same components.

WallStreetBets Leader

He was asked specifically about Ryan Cohen, which is interesting to review the morning after the activist investor filed to sell his shares of BBBY and a move to own calls that would expose him to gains for far fewer shares. Rogozinski, without knowledge of Cohen’s plans, said, “There is no one individual. I think that if a high-profile individual decides to get into a stock or just to add to the thesis or find some confirmation bias, then it’s always helpful.” The WallStreetBets founder added, “It could be him, or it can be Elon Musk,” or any one of a number of “quirky public figures or CEOs” that have stock market influence, so it’s hard to pinpoint.

“The thing about retail trading or WallStreetBets is that it’s a collective, right – there is no captain of the ship saying ‘this is where we’re sailing’ the power comes from the numbers, the power comes from the fact that there are collective decisions that are made.” He reemphasized, “There is no individual that makes that choice.”

Will Meme Stock Frenzy Continue?

Jaime Rogazinski thinks the current meme stock resurgence has room to continue. He said, “As long as we don’t disable the BUY button, we probably have a decent chance to keep going forward.” He said he is not active in this move himself; the reason given is that to be profitable, he thinks he would need to have a strategy, and he personally doesn’t have a strategy yet for these markets.

Asked if meme stock frenzy sustainability expectations should change with an entirely different economic backdrop, Rogozinski said he believes there is a bit more of an eye toward the big picture this time. But the fundamentals and price discovery that meme stock investors are adhering to are supply and demand. Standard fundamentals, in his analysis, don’t seem to support GameStop’s price sustainability he used as an example.

Paul Hoffman

Managing Editor, Channelchek

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Sources

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Michael Burry’s Portfolio is Creating More Speculation than Usual

Four times a year, the quarter-end holdings of famous hedge fund manager Dr. Michael J. Burry become public from his firm’s 13-F filing with the SEC. It’s newsworthy because people are interested in this extremely successful investor’s thinking. Of course, the list of public market positions is just a snapshot in time. One day in time, to be exact, so it is possible to read too much into it. The latest 13-F filing, which became public on Monday (August 15) is especially interesting; his entire stock portfolio is one stock. Channelchek featured this company in an article last month; referring back to the article and also a recent Noble Capital Market’s research report, we offer our own three potential reasons why, out of all the securities available on the planet, he may favor this one.

About Scion Asset Management’s One Position

According to the June 30, 2022, SEC filing, Michael Burry’s fund held one position, Geo Group (GEO). These shares represent 0.404% of GEO’s outstanding stock or 501,360 shares. The average price was listed as $6.42 per share.

The quarter-end market value of Scion’s GEO position was $3,309,000. According to Scion’s Form ADV, filed on April 18, 2022, Scion had assets under management of $291,659,289. The GEO position is not likely a significant portion of his entire portfolio, but it represents 100% of the firm’s 13F reportable securities.

Michael Burry first reported owning GEO Group during the fourth quarter of 2020.

The GEO Group, based out of Boca Raton, FL, specializes in owning’ leasing, and managing secure confinement facilities, processing centers, and reentry facilities in the United States and globally. As of December 31, 2021, the company’s worldwide operations included the management and/or ownership of approximately 86,000 beds at 106 secure and community-based facilities, including idle facilities and projects under development.

In addition to owning and operating secure and community facilities, GEO provides compliance technologies, monitoring services, and supervision and treatment programs for community-based parolees, probationers, and pretrial defendants.

For the year ended December 31, 2021, The GEO Group generated approximately 66% of its revenues from the U.S. Secure Services business, 24% from its GEO Care segment, and 10% of revenue from its International Services segment.

 

Company Trajectory

On August 3, in a research note titled, Continuing
to Outperform Expectations, Noble Capital Markets, Senior Research Analyst Joe
Gomes set a price target of $15.00 and reported on above-expected operating results during Q2 2022.

Mr. Gomes’ report discussed the drivers of GEO’s growth, “Many parts of GEO’s business continue to show operating strength, driving the better than expected performance.” The analyst also discussed the exceptional growth in revenue of the company’s electronic monitoring division.

The report describes management guidance as “upbeat” for the remainder of 2022. The company could get an extra benefit in the coming months if COVID-related restrictions on occupancy are lifted, thus allowing higher capacity within the same facilities.

Michael Burry’s position is not huge compared to his firm’s AUM. However, what is drawing attention is that out of the universe of stocks, GEO Group is a company he finds interesting enough to have as his only position. It would seem appealing to an investor that the clarity of the company’s direction seems to be improving and positive.

 

Political Winds

Will the mid-term elections in November usher in leadership more friendly to GEO’s business? Six days after President Biden was inaugurated, he signed an executive order to eliminate the use of privately operated criminal detention facilities. Section 2 of this order specifically prohibits renewing any contracts with criminal detention facilities. It looked bleak for the two largest private prison (GEO, CXV) operators in the country.

After the order, the private prison industry shifted gears and focused on the $3 billion market of detaining immigrants. This shift has been positive, and things don’t look as dark for the two largest for-profit prison companies in the U.S., CoreCivic (CXW) and Geo Group (GEO). Each is now making 30% or more of its revenue from U.S. Customs and Immigration (ICE) contracts.

If the Democrats lose the significant power they now have in the legislative branch, it would seem that the party that takes power would almost have a mandate from the public to make changes to many of the less popular moves made over the past year and a half. The southern border situation may be one of the reasons Democrats are likely to have fewer seats.

An argument can be made that new doors may open for private prison companies, and there is not a lot of public competition. Perhaps this is the appeal that keeps Michael Burry involved in GEO Group and why his fund has in the past owned CXW.

 

Portfolio Management

As of the end of Q1 2022, the value of Burry’s position in GEO Group was almost twice as large as shown in the current filing. So the hedge fund manager has liquidated a portion of his GEO position along with all other holdings. This unwinding may not be driven by anything more than what he sees as better opportunities elsewhere. He has also complained in tweets about how much attention his activities generate. It may very well be that with all the shifting in economies, in the U.S. and worldwide, that Burry has taken positions in non-reportable investments.

Earlier this year, after the first quarter, when Michael Burry released his holding information, the headlines all read that he hated Apple (AAPL). This was because he held puts on the company. There can be many
reasons a hedge fund would own puts on a company without hating the stock. This latest release brought alarmist headlines about Michael Burry “slashing stocks” in his portfolio and “dumping” everything he owns. He may very well be bearish on every U.S. stock except for one, but this isn’t likely.  As a reminder,  June 30 is just one day on the calendar; his U.S. stock positions could have been quite different by the fourth of July.

Take Away

Michael Burry’s 13F filing for the second quarter showed one holding, an under-the-radar company that has a significant upward trajectory in earnings and growth. The company’s industry had also become challenged when the Biden administration took office since it has successfully found a way to build in a slightly different direction. All indications are that, at minimum, the House of Representatives and possibly the Senate will be more heavily weighted with Republican lawmakers after the upcoming election, the private prison industry could benefit from contracts they may receive with a change in legislative priorities.

If you have not already signed up to receive email from Channelchek with up-to-the-minute research reports on companies like GEO Group and insightful articles, sign-up here.

Paul Hoffman

Managing Editor, Channelchek

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Sources

https://www.channelchek.com/company/GEO/research-report/3910

https://whalewisdom.com/filer/scion-asset-management-llc#tabholdings_tab_link

https://channelchek.com/news-channel/What_Might_be_in_a_Portfolio_Allocated_for_a_Republican_Majority_in_the_House_

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Image Credit: Laura Pontiggia (Flickr) 

Has the Bear Market Left a Permanent Mark on Indexed Investments?

As much as 25% of the S&P 500 index is comprised of only five stocks. Most active investors can guess them easily enough: Apple (AAPL), Microsoft (MSFT), Amazon.com (AMZN), Tesla (TSLA), and Alphabet (GOOG). As of the end of the second quarter (2022), 7.1% of the S&P 500 index was allocated to Apple alone. Funds that mimic indexes have done extraordinary up until now as the trend has been toward index investing. In the first quarter of this year alone, which includes IRA season, these funds took in $8.5 trillion in retail investments. According to Morningstar, this is more than all active management strategies combined. They have been the go-to investment idea for financial advisors and the way this generation has learned to think about investing.

What Might Change?

The persistent sell-off in the markets earlier this year, and the surprise geopolitical events, may cause investors to question if these funds are properly diversified. Even an allocation of 60% stocks and 40% bonds would place an investor’s exposure, using an S&P 500 fund, to nearly 5% of AAPL. Worse yet, the top five, comprising 25%, often trade in lock-step, both up and down.

They are, after all, the big guys. They certainly have the power to grow further but also much further to fall than most. Will recovering from the bear market, with lessons learned, cause the popularity of these funds to lessen? The funds were viewed as ideal diversifiers when they first gained popularity, but their own success, that is, the amount of money that poured into this good idea, has given them weaknesses. An unsettling weakness is much higher average valuations among holdings than stocks just outside of any large index.

History Until Now

The history of Index funds’ popularity is easy to understand. For financial advisors, they found it provided low-cost diversification for their clients. They got this by placing assets in an indexed ETF; as a bonus, they avoided what were then large transaction fees with individual stocks. 

For most individual investors, transaction fees are no longer a barrier to personally managing accounts; the costs simply aren’t as high.  For individual self-directed investors, buy-and-hold and diversification have been drilled into their heads. So these indexed funds easily accomplish this set-it and forget-it (buy and hold) position. But, the level of diversification isn’t what it once was, and investors forgo the nimbleness of taking individual stocks out of their portfolio or more heavily weighting better risk/reward alternatives. 

For the fund managers themselves, especially those benchmarked off an index, no one can tell you you’re performance is horrible if it is in line with the index. It’s an easy job; just own the index in the same ratio the index weights the underlying stocks. With today’s computers, it is almost a back-office clerical function.

Lifecycle of Investment Products

But, like many products, they may have run their course, something better could replace them, or they more likely start to slide under the weight of their own success.

Index funds, especially those that mimic the large-cap Nasdaq100 or S&P 500, are in theory diversified as to names, but they are also capitalization weighted, which means even new money flows unevenly into the larger, more popular stocks. Over time, the combination of index fund popularity together with index construction favoring the more popular stocks has meant that more has flowed into fewer and fewer stocks. Therefore, capitalization-weighted equity indexing adds to the momentum of stocks that may not be worthy.

Much of this money might not otherwise be in these companies if not for the popularity of index funds and the self-perpetuating, dare I say bubble, that is the result of this setup.

According to an article in Barron’s this month, “The purveyors of indexes, being human, tend to make the concentration in a few expensive stocks even worse.” Barron’s wrote. The article then explains that the committee that oversees the S&P 500 has changed the make-up often, “and in the process tended to add stocks with price/earnings ratios more than twice that of those deleted.”

Are Investors Ready to Transition?

With more new money, in unfathomable amounts, reaching these funds each quarter and then being dispersed into the underlying stocks, weaker stocks fall even farther and strong stocks rise more than they may otherwise have risen. This undermines the efficient market theory as stocks that have sunk low enough to be worthwhile for many investors are not considered. The efficient markets theory is supposed to take into account all available information. Over the years, investors have set their portfolios on “in the market” or “out of the market,” with the market being one of the major indexes.

Could it be that as the market turns around and heads up, value hunters in individual stocks will lead, and indexes and index funds will not have as high relative performance?

Index funds, now that they have grown to the size they have, have developed other contradictions. Aside from ignoring the principle that the price paid represents a key determinant of long-term return, indexing ignores the flexibility to reward. Companies in an index that find themselves in trouble will keep receiving new money as investors add funds to their indexed accounts. This is without regard to how undeserving some companies in the fund are or whether they even will be in business in a year. In the meantime, companies not in the index find inclusion gets further out of reach.

Will Stock-Pickers Replace Index Funds?

In an ideal world, there is a selection of suitable products that all have similar results. For commuting, some take the bus to work, others drive, and still, others Zoom in. No one method of commuting is ideal for everyone. Those that wish to not worry about what many individual stocks are doing but instead concentrate on “the market” will keep adding money to these indexed products. Others that realize that they may be full of relatively expensive stocks will gravitate to old-fashioned stock selection – this time without all the commissions. And there will be those that keep their money in low-interest savings accounts that knowingly lose buying power to inflation.

The next “Apple stock” surely has more potential for growth than today’s top five stocks. Currently, the company may be just a hand full of people working out their idea from a handful of remote locations. Finding that company in the initial public offering stage (IPO) or after it has gone public is the dream of most active investors. It can’t be found in an indexed fund.

There is no functioning crystal ball, but there are resources, including no-paywall  Channelchek to help investors quickly review data on over 6000 small and microcap companies. And access the same research professionals consult with before making decisions. In addition, Channelchek has helpful videos and articles sent to your inbox daily to alert you to new perspectives and actionable opportunities.

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here.

Paul Hoffman

Managing Editor, Channelchek

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Sources

https://www.morningstar.com/articles/1087146/us-value-funds-beat-growth-in-the-first-quarter

https://www.barrons.com/articles/the-bear-market-could-finally-break-index-funds-51660287600?mod=hp_LEADSUPP_1

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Private Funds May Soon be Mandated to Disclose Digital Asset Holdings and Performance

The Securities and Exchange Commission (SEC) and Commodity Futures Trade Commission (CFTC) have issued a joint proposal to better “assess systemic risk” of private fund advisors. The proposal includes language that would require reporting of cryptocurrency positions and performance measures of large hedge funds.

What is Form PF?

The form is a jointly adopted requirement used by both the SEC and CFTC. It’s a regulatory filing that mandates private fund advisers report regulatory assets under management to the Financial Stability Oversight Council (FSOC). The purpose is to monitor risks to the US financial system. Form PF affects SEC-registered managers of private equity funds, real estate funds, hedge funds, and liquidity funds with at least US$150 million in private fund assets.

 

The Proposal

Both Commissions settled on the proposed inclusion after consulting with the Treasury Department and Federal Reserve on potential financial-stability risks in the private-funds industry. SEC Chairman Gary Gensler noted that private funds’ total assets are nearing the size of the banking sector’s assets. “In the decade since the SEC and CFTC jointly adopted Form PF, regulators have gained vital insight with respect to private funds. Since then, though, the private fund industry has grown in gross asset value by nearly 150 percent and evolved in terms of its business practices, complexity, and investment strategies,” said SEC Chair Gary Gensler.

The SEC/CFTC Proposed Amendments to Form PF include a number of amendments designed to enhance the FSOC’s ability to monitor systemic risk and bolster regulatory oversight of private fund advisors. Beyond crypto, the proposal would require hedge funds with more than $500 million of net assets to report more information on Form PF about their investment exposures, portfolio concentrations, and borrowing arrangements.

Image: Selection from

The proposal on Wednesday (August 10) would add “digital assets” for the first time on Form PF. It also defines what a digital asset is in the eye of the regulators. It has opened a 60-day comment period on whether funds should report detailed information about the cryptocurrencies they hold. This includes identifying specifically or describing their characteristics.

The proposal notes that many hedge funds have been formed recently to invest in crypto, while some other existing funds have added the asset class to portfolios.

 

Expected Benefit

The recent drop in the prices of digital tokens like bitcoin and Ether has not spread to other asset classes. But the implosion of a crypto-focused hedge fund earlier this summer created a chain reaction that dragged a number of its creditors into bankruptcy.

Regulators want to get ahead of any chain reaction that could extend into traditional markets if mainstream financial institutions increase their adoption of cryptocurrencies before additional guardrails are put in place. “Gathering such information would help the commissions and [financial-stability regulators] better to observe how large hedge funds interconnect with the broader financial services industry,” Mr. Gensler said.

Paul Hoffman

Managing Editor, Channelchek

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Sources

https://www.sec.gov/rules/proposed/2022/ia-6083.pdf

https://www.sec.gov/files/formpf.pdf

https://www.wsj.com/articles/regulators-weigh-asking-hedge-funds-to-report-crypto-exposure-11660140000?mod=djemalertNEWS

https://www.wsj.com/articles/mainstream-hedge-funds-pour-billions-of-dollars-into-crypto-11646808223?mod=article_inline

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Image Credit: Alexandra Maria

Are Consumer Price Increases Negatively Correlated to Stock Market Price Levels?

Does inflation lift stock prices? It has been long thought that stocks are a better hedge against inflation than cash, which loses purchasing power with rising prices, or even bonds, which lose value when inflation leads to higher interest rates. Excessive consumer price increases (defined as over 2% CPI YoY) come from either hypergrowth where demand outstrips supply or reduced supply while demand has changed little. The current inflation spike appears to be a mix of both supply issues from disruptions during the pandemic and demand issues from a dramatic increase in the money supply.

What Does Inflation Do to the Stock Market?

The answer is not straightforward as it depends on all of the contributing factors. If those factors can be easily modified, the markets are likely to react, in advance, to what it will be that changes them. If monetary policy is expected to be tightened, this can slow economic growth and weigh on equity prices as capital will not be as free-flowing. If it is because there is a shortage of supply, the market is likely to react to how quickly the condition will resolve itself. A shortage of supply could come from short-duration events like weather that impacts agriculture, or shipping, which is usually short-lived – also resource shortages result from a supplier not being available. This could be related to embargos, logistics, etc. Price increases from an imposition of tariffs are one-time additions to prices and don’t lead to prolonged inflation. 

Stock market participants are forward-looking. On an ongoing basis, they monitor current and expected conditions and react to how they will impact company earnings. The sweet spot is when inflation has no risk of dropping below zero and is stable within a percentage point of 2%.

Sources: NYU.edu (Stocks), BLS.gov (Consumer Prices)

The markets clearly dislike deflation or negative price growth. The chart above demonstrates that each time inflation went negative that same year or the following year, stocks dropped. So deflation has a positive correlation to stock index levels (decreasing inflation = decreasing stocks). From the chart, we also see when inflation approached or breached 10%, the markets also gave up ground that year or the following year.

A healthy market comes from a healthy economy; a healthy economy is one where supply is meeting demand. This makes growth more predictable, and the markets enjoy predictability. A lack of being able to assess what the future is likely to bring issues in periods of volatility where bulls and bears are most at odds.  The 40-plus year high in CPI has ushered-in the kind of whipsaw volatility that can hurt active investors and traders.

Some investors may seek stock ownership as a hedge against inflation. Companies that own assets that are rising in value help offset the erosion of the native currency. Alternatively, some investors may also find that fixed return investments like those that pay a known interest rate compete much better than the uncertain returns in stocks. Dividend stocks like utilities are often held by income investors like retirees. These stocks are particularly vulnerable should lower-risk bonds offer the same or higher yield than the expected dividends.

Take Away

Markets react to future earnings expectations. If the demand for a company’s product is little changed as prices increase, its earnings should stay relatively stable (food, medicine, government contractors, other non-discretionary). If the product or service will see reduced demand as prices increase, the company is likely to see reduced earnings and lower stock valuations.

Markets also react to expectations of future conditions. If it is expected that whatever the cause of inflation is, is transitory, market participants may look past current conditions. If instead, the expectations are that an aggressive and prolonged tightening stance will shrink the entire economy, then the markets are likely to respond negatively.

The high inflation the U.S. has experienced over the past year has resulted from both supply and demand-related factors. The supply issues are out of the Fed’s control, but it is presumed that these are transitory and related to the pandemic and war in Europe. Current price increases are also the result of trillions of dollars pumped into the economy over a short period of time. The Fed does have more control over this. If they act with aggressive monetary policy, the markets may initially pull back, if it appears the Fed is winning the battle, markets may become more bullish.

Paul Hoffman

Managing Editor, Channelchek

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Sources

https://pages.stern.nyu.edu/~adamodar/New_Home_Page/datafile/histretSP.html

https://www.usinflationcalculator.com/inflation/historical-inflation-rates/

https://investorplace.com/2022/06/what-does-inflation-do-to-the-stock-market/?utm_source=Nasdaq&utm_medium=referral

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Who will Regulate Cryptocurrencies? The Senate May Have a Favorite

One ongoing cloud over cryptocurrency exchanges, crypto creators, and even the NFT market is the uncertainty of future regulations. Regulation, while seen as restrictive, would also mean acceptance of the asset class. Acceptance coupled with a more certain playing field would benefit all stakeholders, from the crypto investor to the business that allows purchases in crypto, all the way through to the blockchain companies that are necessary for its digital existence.

SEC vs CFTC

Crypto interests have had a favorite among two potential oversight bodies, the Securities and Exchange Commission (SEC), versus the Commodities Futures Trading Commission (CFTC). And the stakeholders have been vocal to lawmakers in Washington as to the preference.

The SEC Chair Gary Gensler once taught cryptocurrency at MIT, a top school helping to design and study the future of crypto. However, this is not the regulator most crypto interests would prefer. Instead, they prefer oversight from the CFTC. The CFTC Chairman Rostin Behnam is advocating his agency provide the biggest role in cryptocurrency regulation. In a speech last month, he said federal and state regulators sharing responsibility in a “patchwork blanket” approach “is increasingly proving inadequate” as the crypto market rapidly evolves. Lawmakers in the Senate must have been listening.

Senate Crypto Bill

Under a new bipartisan bill from Sens. Debbie Stabenow (Mich) and John Boozman (Ark), the CFTC would take the lead role in overseeing the two largest cryptocurrencies and the platforms where they are traded under the bill. Oversight of the remaining cryptocurrencies would be divided between the CFTC and the SEC – the methodology to be used in determining who has higher jurisdiction is not yet fully specified.

The two agencies have been positioning for more authority over digital assets. As the assets are still very new to the world, there has certainly been confusion in Washington over how to classify and regulate cryptocurrencies and its digital ecosystem. While lawmakers looked to the regulators for guidance, in the end, the official determination is the responsibility of lawmakers. The major goal of the Stabenow/Boozman bill is to provide some clarity by deeming as commodities both bitcoin (BTC.X) and ethereum (ETH.X), which account for roughly two-thirds of the cryptocurrency outstanding.

If passed by the Senate and House and signed into law, both bitcoin and ethereum would primarily fall under the CFTC, which already oversees futures markets for both. Online platforms that allow investors to trade the coins, such as Coinbase (COIN), would be required to register with the agency.

Two other members of the panel, Sens. Cory Booker (D-N.J.) and John Thune (R-S.D.), are co-sponsoring the measure. Stabenow, said the committee could mark up the bill as soon as September.

The bill comes after another introduced by Sens. Cynthia M. Lummis (Wyo) and Kirsten Gillibrand (N.Y.) in June unveiled what they announced as a comprehensive plan to regulate the industry. Their proposal outlines primary responsibility for the industry to the CFTC, but unlike the bill from Stabenow and Boozman, it would make it optional for crypto exchanges to register with the agency.

 

Related News

This week Gary Gensler who Chairs the SEC, is facing massive criticism after being accused of being complicit in criminal activities “perpetuated by Citadel Securities & Citadel Market Maker. He is being accused of “obstruction of justice due to his lack of enforcement of the laws pertaining to naked short selling and lack of competent oversight of the market makers activities,” according to the petitions home page. The petition also demands, “Mr. Gensler needs to step down as the chairman, and a thorough, detailed, forensic analysis and investigation into Citadel Securities and Citadel Market Maker. This cannot go unpunished.”

 

Take Away

Both Senate bills would allow the CFTC to assess fees on crypto industry players to fund an expanded agency budget. The agency, roughly a sixth the size of the SEC, is already tasked with overseeing a section of financial markets, from grain and oil futures to more complex products.

The SEC has been seen as regulating without proper authority. Agencies can not overstep the powers granted to them by Congress. Members of the Senate, to their credit, have been looking to determine how best to develop oversight between these two agencies and the others that are also impacted.

Paul Hoffman

Managing Editor, Channelchek

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Sources

https://www.stabenow.senate.gov/news/stabenow-boozman-booker-and-thune-introduce-legislation-to-regulate-digital-commodities

https://www.change.org/p/retail-investors-fire-gary-gensler-as-sec-chairman-for-obstruction-of-justice

https://www.cryptotimes.io/sec-chair-gary-gensler-accused-in-citadel-market-maker-manipulation/

https://cointelegraph.com/news/senators-stabenow-boozman-introduce-crypto-bill-that-extends-cftc-s-regulatory-powers

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Image Credit: Jernej Furman (Flickr)

Why Alibaba and Other Companies are Changing Their Primary Listing to the Hong Kong Exchange

Will there be a mass delisting of Chinese companies from U.S. stock exchanges? A deadline clock is ticking on an elusive agreement between the SEC and Beijing. Once thought to be assured, the possible negative outcome has now caused companies to resign themselves to the idea that an agreement to prevent mass delistings of Chinese companies from U.S. exchanges may not happen. The companies involved are already preparing for this potential.

Most recently, the highly recognized e-commerce giant Alibaba (BABA) said it will be applying for a primary listing on the Hong Kong exchange. BABA is currently listed on the NYSE (since its IPO in 2014) and has had a secondary listing in Hong Kong since 2019.

 

At
Issue

Under a U.S. law that took effect last year, companies whose auditors are not permitted to be inspected by U.S. regulators for three consecutive years will be delisted from U.S. exchanges. The Securities and Exchange Commission (SEC) has already named more than 150 Chinese
companies that may be removed from trading in the U.S. as early as 2024, or sooner if U.S. lawmakers have their way by shortening the deadline. Alibaba will likely join this growing list after it publishes its 2021 annual report this month.

Beijing and Washington have been negotiating to try to avoid the need to delist, but there hasn’t been noticeable progress. SEC Chair Gary Gensler said two weeks ago that he isn’t confident the two sides can reach an agreement.

The
Benefit to Listing on a U.S. Exchange

Although being listed in the U.S. often means learning new processes and more paperwork for foreign companies, it is considered worth it for the longer term. Although they may be subject to increased scrutiny and transparency, the SEC oversight requires, investors take comfort in the strict regulatory compliance.  

A company like Alibaba can use the extra protection provided by its NYSE listing to position itself as a rival to U.S.-based companies like the online retailer Amazon (AMZN). The listing elevates shares of companies on the “radar” of U.S. investors if they are looking for exposure to, in this case, online retailers. Investors can also be assured of a certain level of uniformity in reporting.

The NYSE states the benefits of their exchange include improved branding and visibility, access to capital, and increased liquidity opportunities.

 

Take
Away

Time is running out for more than 150 Chinese companies listed on U.S. exchanges as the SEC and Beijing are failing to come to terms with U.S. compliance requirements.

Alibaba is likely to be added to that list after its annual report is made public this week. Many of these companies have had a vibrant relationship with the U.S. capital markets but are now preparing to list Hong Kong as their primary market.

This is important for U.S. investors of Chinese ADRs to see coming well in advance. Being delisted from U.S. exchanges could substantially reduce global interest in these stocks and subject holders of the companies to lower transparency standards.

Paul Hoffman

Managing Editor, Channelchek

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Sources

https://www.nyse.com/why-nyse

https://www.wsj.com/articles/alibaba-to-pursue-primary-listing-in-hong-kong-11658794611?mod=article_inline

https://www.investopedia.com/articles/investing/112614/alibaba-ipo-why-list-us.asp

https://www.wsj.com/articles/u-s-listed-chinese-firms-get-a-new-lease-on-lifemaybe-11649073448?mod=article_inline

https://www.wsj.com/articles/alibaba-prepares-for-its-u-s-divorce-11658832946

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Company Reporting Investors Follow Closely

Four times a year, companies that issue shares of stock release financial statements covering the prior three months. The publicly traded companies are required to disclose, among other things, their quarter-end balance sheet and income statement information. There is a big focus from investors on the companies’ income numbers. These reporting periods have come to be known as “earnings season.”

There are no official or specific dates that mark the beginning or the end of the period; however, the majority of publicly traded U.S. companies disclose their quarterly earnings more or less around the same time. The only official requirement is that the earnings reports be released within 45 days of the end of each of the company’s quarter-ends.

When is It?

Most companies follow a fiscal calendar from January 1st through December 31st, with the earnings season being the weeks following the calendar quarter-ends (March, June, September, and December). The end of each month will mark the “beginning” of earnings season for that quarter; at this time, company earnings reports begin hitting the tape, and markets begin to react accordingly.

Why it is Important

By the time a company’s financial disclosures are released, expectations from analysts and market participants have already been baked into the stock price. Earnings season has the power to dramatically move stock prices by how expectations match up with reality. If a company’s results beat or fall short of analysts’ expectations, then its stock may experience an unexpected price move as the market adjusts the price to what it is now believed to be worth with the updated financials.

Volatility in the market tends to be higher during these periods as a higher number of stock prices readjust dramatically. Market sectors may do better or worse if several companies in the sector beat or miss expectations. Others in the industry that haven’t yet reported may trade in anticipation of also performing similarly. There is a ripple effect one company’s results may have on others in its sector and even the broader market.

Earnings Season May Affect Your Stock-Level Investment
Decisions

If you are considering buying a company’s stock, earnings reports and earnings trends offer a way to gauge the health of its business. Channelchek is a resource for financial
information on over 6,000 small and microcap companies, not often reported on mainstream financial news.

Paul Hoffman

Managing Editor, Channelchek

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Image Credit: Ivan Radic (Flickr)

The New Coinbase Insider Trading Case May Finally Define Crypto Tokens

Whether cryptocurrency tokens are securities or should be treated as securities by regulators is being tested yet again. This time a Coinbase (COIN) employee and two others are being charged with insider trading by the Securities and Exchange Commission (SEC). The outcome of this legal disagreement could have industry-changing ramifications for the crypto industry.

 

Details
of Case

In a press release last week, the SEC alleged that, while employed at Coinbase, Ishan Wahi helped to coordinate the platform’s public listing announcements that included what crypto assets or tokens would be made available for trading. According to the SEC’s complaint, Coinbase treated such information as confidential and warned its employees not to trade on the basis of, or tip others with, that information. However, from at least June 2021 to April 2022, in breach of his duties, Ishan repeatedly tipped off the timing and content of upcoming listing announcements to his brother, Nikhil Wahi, and his friend, Sameer Ramani. Ahead of those announcements, this usually resulted in an increase in the assets’ prices. Nikhil Wahi and Ramani allegedly purchased at least 25 crypto assets, at least nine of which were “securities,” and then typically sold them shortly after the announcements for a profit. The long-running insider trading scheme generated profits totaling more than $1.1 million.

The tokens in question would be considered outside of the Securities and Exchange Commission’s jurisdiction if they are not securities. The SEC alleges that they fall within that classification.

The chief legal officer at Coinbase, Paul Grewal, issued a statement in response where he said, “Seven of the nine assets included in the SEC’s charges are listed on Coinbase’s platform. None of these assets are securities. Coinbase has a rigorous process to analyze and review each digital asset before making it available on our exchange — a process that the SEC itself has reviewed. This process includes an analysis of whether the asset could be considered to be a security and also considers regulatory compliance and information security aspects of the asset. To be explicit, the majority of assets that we review are not ultimately listed on Coinbase.”

Grewal’s statement says these charges put a “spotlight on an important problem: the US doesn’t have a clear or workable regulatory framework for digital asset securities.” He continued, “And instead of crafting tailored rules in an inclusive and transparent way, the SEC is relying on these types of one-off enforcement actions to try to bring all digital assets into its jurisdiction, even those assets that are not securities.”

“Coinbase does not list securities. End of story” wrote the chief legal officer.

Struggle to Define

The question of whether tokens should be classified as currencies, commodities, or securities has created a cloud of uncertainty over the industry. According to the SEC, some tokens most likely meet the definition of a security.

One legal battle involving the SEC is the payments network Ripple’s token (XRP.X). According to the SEC, the payments token is a security. Ripple Labs and the Commission are engaged in a legal battle over the distinction.

Bitcoin (BTC.X), according to SEC Chairman Gensler, is a commodity.

The definitions help compartmentalize the assets. If the crypto tokens are not securities, then the SEC isn’t likely under its current mandates to have much jurisdiction over exchanges like Coinbase – then it wouldn’t be in a position to regulate the listing and trading of tokens.

Image: Tweet from Coinbase co-founder and CEO.

Coinbase does not support wrongdoing; according to management, however, they want a clear set of legal guidelines for their industry.

As part of a string of Twitter posts, CEO Brian Armstrong wrote, “we actively monitor for illegal activity and investigate any alleged misconduct.” The company launched an investigation in April after being tipped off about possible frontrunning, Armstrong said the company provided the names of three individuals to law enforcement and terminated an employee.

However, Coinbase intends to strongly dispute the SEC’s premise that some tokens on its platform are securities.

The SEC’s insider-trading case also seems to be at conflict with the beliefs of other regulators. CFTC Commissioner Caroline Pham said that the SEC’s move was an example of “regulation by enforcement.” The SEC’s allegations “could have broad implications beyond this single case,” she called on regulators to work more closely.

Take Away

On the road to defining and classifying digital tokens, the industry is likely to experience higher levels of regulatory scrutiny. The Department of Justice is beginning to get more involved in prosecuting crypto crime; the DOJ filed criminal charges in the Coinbase case, and it has filed insider trading charges against a former employee of the largest NFT platform, Opensea.  

The SEC has said it aims to beef up its crypto
enforcement. The Commission added 20 positions to its crypto asset and cyber unit in May, bringing its dedicated headcount to 50.

The outcome of defining the asset class and proper jurisdiction and rules surrounding cryptocurrency is a process. During the early stages of this process, investors in tokens tolerate an added level of uncertainty surrounding the outcomes.

Paul Hoffman

Managing Editor, Channelchek

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Sources

https://www.sec.gov/news/press-release/2022-127

https://blog.coinbase.com/coinbase-does-not-list-securities-end-of-story-e58dc873be79

https://twitter.com/CarolineDPham/status/1550159347984044033/photo/1

https://www.breakingviews.com/considered-view/bidens-sec-pick-is-ominous-sign-for-wall-st/

https://www.reuters.com/legal/government/gary-gensler-has-set-sec-perilous-path-2022-07-22/

https://www.barrons.com/articles/sec-says-ripple-improperly-sold-cryptocurrency-51608675654?mod=article_inline

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