Fintech ETFs Feel the Heat as a New Era of Oversight Takes Shape

A report from short-seller Hindenburg Research on Block (SQ) and a Securities and Exchange Wells Notice directed at Coinbase (COIN) hammered the stock of both companies Thursday, but after it was reported that Cathie Wood and three of her ARK ETFs had swept in to buy the dip, a strange calm ensued for most of Friday.  

This placidity might be short-lived, however, as a few eye-raising aspects within the otherwise sensationalist Block report and COIN’s legal struggles suggest that a new level of scrutiny might put pressure on the fintech industry this year.   

Last Thursday, Coinbase and Block both crashed around 20%, and because these companies are sizable and established within a nascent industry, they make up sizable allocations in several fintech ETFs.  

SQ is in 177 different exchange-traded funds and COIN is in 113. In a few of the ETFs, the overlap is stunning: SQ is 15.55% and COIN is 16.07% of the Fidelity Crypto Industry and Digital Payments ETF (FDIG); SQ is 15.81% and COIN is 14.28% of the Global X Blockchain ETF (BKCH); and SQ is 8.57% and COIN is 10.82% of the ARK Fintech Innovation ETF (ARKF).  

This concentration should give investors pause, as the leverage that catapulted these ETFs for years might be boomeranging.  

Shifting Regulatory Tides 

“Run fast and break things” has long been the mantra of America’s startup culture, and the federal government—under several administrations—certainly obliged the crypto and fintech industries with a “let the garden grow” approach so far. The FTX debacle, however, crystallized for many the dangers of regulators being too hands-off.  

While several bills languished on the vine in 2022, both crypto and fintech should see new federal regulation this year. With growing bipartisan support, Congress clearly wants to bring them more in line with the traditional banking system.  

What Fintech ETF Investors Should Be Looking For 

On the federal level, there are numerous bills seeking to regulate the crypto and fintech industries. These include the Digital Commodities Consumer Protection Act, the Responsible Financial Innovation Act, the Digital Commodity Exchange Act of 2022, as well as Senator Elizabeth Warren’s far more stringent and industry-altering Digital Asset Anti-Money Laundering Act of 2022.  

In addition, there are regulatory developments at the agency level: a change in the Securities Exchange Act’s Rule 3b-16; a new scrutiny of the interchange fee by the payment companies; and the Treasury’s accelerating takedown of “staking” and “mixing.”  

There are also a few important legal judgments, including Grayscale Investments’ case against the SEC regarding its spot bitcoin ETF.  

Hindenburg’s Attack  

Hindenburg pushed the “cash app” rap lyrics front and center to be racy and make the headlines, but it was the weakest part of its report published last week.   

From a legal perspective, the work had two serious elements that should get the attention of both regulators and legislators who are focused on money laundering and the evasion of the Durbin Amendment, which requires the Federal Reserve to limit fees charged to retailers for debit card processing. It was passed as part of the Dodd–Frank financial reform legislation in 2010. 

This could get complicated for Block. In 2010, the Durbin Amendment capped interchange fees to help make them “reasonable and proportional” to the cost incurred and specifically provided an exemption for card-issuing banks with less than $10 billion in assets under management.  

Hindenburg suggested that the fintech company not only doesn't comply with know-your-customer bank law (which it is presently not obligated to), but that based on more than a dozen interviews with former employees involved in Cash App, pressure from management has resulted in a pattern of disregard for anti-money laundering.  

Whether or not this is true, it will become a matter of explicit public discussion. Block avoids the word “users,” in its reports, instead using “transacting actives”, because there are clearly people with several accounts.  

This in itself is not problematic, but may suggest one way criminals can use the app like a “burner phone,” with rolling aliases and stolen social security numbers.  

Hindenburg claims that the category "spend"—estimated to be 34% of Cash App's revenue—largely consists of interchange fees.  

Whether this is true or not, the report might trigger a governmental judgment on the issue, with both industry giants pushed to a capped interchange fee and lower profits.  

Staking and Mixing 

On Thursday evening, Coinbase CEO Brian Armstrong took to Twitter to share his view regarding the Wells Notice received by the company the day prior to drum up political support.  

The notice from the SEC alleged that Coinbase’s “staking” products, which offer investment returns to U.S. users who commit their digital assets to the company–constitute unregistered securities. This clearly ties back to the $30 million settlement the SEC finalized with cryptocurrency platform Kraken in early February, which forces it to unwind its staking program.  

According to the SEC, Kraken failed to adequately disclose the risks of the program, which had advertised juicy 20% annual yields. As retail trading has dried up with last year’s downdraft, staking has become an important aspect of profitability for many crypto firms.  

Staking at Coinbase arguably accounted for 11% of net revenue in the third quarter last year, though a Jefferies note issued two days ago suggested that an SEC enforcement could put 35% of COIN’s net revenue at risk.   

While the attack on staking is relatively new, the government takedown of “mixing” started last year. The Treasury’s shutdown of Tornado Cash—a virtual currency “mixer” whose software creates full anonymity in blockchain transactions—may well be viewed as a defining legal moment for digital assets.  

One SEC proposal that will likely become law in 2023 is a change in the Security Exchange Act’s Rule 3b-16. This will greatly expand the definition of an “exchange,” making it any entity that “makes available” established, nondiscretionary methods or trading or provides the capability to be a “communication protocol system.” The entity would be required to register with the SEC as an exchange or as an alternative trading system.  

The Blockchain Association and other industry lobbyists seethe at the proposal, suggesting it would improperly apply regulations crafted for institutional “intermediating” platforms like the New York Stock Exchange to tiny software developers.  

The counter argument, however, is that the legal framework is simply catching up with the software platform realities of contemporary finance and that writing up loose language is the best way to ensure future relevance.  

For more than a decade, ETF investors enjoyed the innovative “tech” aspect of the fintech equation. But now it is the legal hazards and cyclicality of the “fin” component on which they must focus their attention. There are many more moving parts this year as the industry struggles to absorb these new legal efforts.  

What we know for certain is that by 2025, the regulatory environment will be very different. Certain ecosystems will be eliminated, and certain aspects of profitability might be pinched.  

Even President Biden’s seemingly benign March 2022 executive order on a potential “central bank digital currency” competitor could whack the industry with unintended consequences.