By Hannah Lang and Chris Prentice

(Reuters) -Coinbase and the U.S. securities regulator faced off in a federal appeals court in Philadelphia on Monday as the cryptocurrency exchange pressed the agency to create new rules for digital assets.

Coinbase, the largest U.S. crypto exchange, sued the Securities and Exchange Commission last year in an effort to compel the regulator to act on a petition for rulemaking Coinbase filed in 2022.

In that petition, it urged the SEC to provide clarity on circumstances under which a digital asset is a security and create a new market structure framework compatible with cryptocurrencies.

The SEC denied Coinbase's petition for new rulemaking in December 2023, saying it fundamentally disagreed that current regulations are "unworkable" for the crypto sector.

Coinbase on Monday asked a federal appeals court to overturn that denial, saying the SEC has made it impossible for the crypto firm to operate and comply with U.S. regulations.

Eugene Scalia, a lawyer for Coinbase, told the three-judge appeals court the SEC had been arbitrary and capricious in not giving Coinbase more answers on how to register with the agency and comply with U.S. laws.

A lawyer for the SEC argued that the agency is not required to create a new rule for the sector, and that existing regulations should suffice.

"If Coinbase wants to arrange its business in a way that does not comply with the existing regulatory framework, that does not establish a right to have the framework adapted to meet their business," SEC lawyer Ezekiel Hill said.

The three appeals court judges heard arguments from both sides, noting the SEC does have discretion in rulemaking priorities but also pressing the regulator on why cryptocurrency was not one of them.

The dispute is the latest in a broader tug-of-war between the crypto sector and the top U.S. markets regulator, which has repeatedly said most crypto tokens are securities and subject to its jurisdiction. The agency has sued several crypto companies, including Coinbase, for listing and trading crypto tokens which it says should be registered as securities.

Coinbase denies those allegations and is fighting them in a separate court case.

The crypto industry largely believes it operates in a regulatory gray area not governed by existing U.S. securities laws, and that new legislation is needed to regulate the sector.

(Reporting by Hannah Lang in New York; Additional reporting by Chris Prentice in New York and Mike Scarcella in Washington; Editing by Chizu Nomiyama and David Gregorio)