From Amy Castor And David Gerhard
We’ve been saying for a while that everyone in crypto is in everyone else’s pockets – and that this makes the 2022 crypto meltdown very much like the 2008 financial crisis. In an article lamenting the issue, CoinDesk provided a helpful chart! [CoinDesk]
The SEC wants to change crypto custody rules
The SEC wants crypto to reach out to adults and work like real finance. Specifically, the SEC wants to update the 2009 Custody Rule to require almost all assets that an adviser might hold on behalf of a client — including cryptocurrencies — must meet qualifying custodian requirements. [Press release; fact sheet, PDF; proposed rule, PDF; FT, archive; WSJ]
If you give your bitcoin to someone else for safekeeping — or even trading on your behalf — that person must meet the standards to be a “qualified” custodian.
A qualified custodian is a federal or state chartered bank, trust, registered broker-dealer, registered futures broker, or foreign financial institution. The definition is found in 17 CFR §275.206(4)-2. [LII]
Qualified custodians must properly segregate all assets in individual accounts per client. Advisors and Qualified Trustees must enter into written agreements. Custodians are also required to undergo annual audits, provide bank statements and provide records upon request.
These rules apply even if the assets themselves aren’t securities – because the rules apply to mutual funds, which are firmly under SEC jurisdiction.
National banks have been able to hold crypto since the OCC allowed it in July 2020. This allowed existing custody giants like Fidelity to enter the crypto custody market. But banks are now being actively discouraged from touching crypto in any form.
The new rule uses the legal powers granted to the SEC under Dodd-Frank following the collapse of the Madoff Ponzi scheme.
The SEC proposal speaks of “recent events in the crypto asset markets” — the failure of Voyager, Celsius, FTX and others where customers thought they owned their crypto, but turned out they didn’t , and their funds ended up as part of the bankruptcy estate.
Another reason is that crypto is extremely brittle, making it difficult to store. When you have a crypto asset, you have the cryptographic key to an address on a specific blockchain – that key is the crypto. The proposal notes that keys are very difficult to keep secure. Transactions are irreversible – one mistake or hack and your cryptos are gone. You have to be careful with backups because every backup is also the key. And every hot wallet is a target for attack.
Custody is big business in crypto. This is also how crypto has managed to attract billions in institutional money. As of January 2022, the top five US crypto custody firms were Coinbase ($100 billion in assets under custody), BitGo ($40 billion), Gemini ($30 billion), Kingdom Trust ($12 billion), and NYDIG ($7 billion). Other US firms are on the list but are not disclosing assets held in custody. [FintechNewsCH]
Coinbase insists that its Coinbase Custody Trust Company is already a qualified custodian. However, this does not tally with cryptos in custody potentially being part of the estate if Coinbase goes bankrupt. But we are sure that Coinbase Custody will fix itself as soon as possible. [CoinDesk]
The tricky question is what happens when crypto sits on an exchange to trade, such as B. at Coinbase, Gemini or Kraken. Does the exchange have to be a qualified custodian? If it involves trading assets on behalf of the client, then almost certainly. New Canadian rules in the wake of FTX require all exchanges to segregate customer cryptos in individual accounts with a custodian.
We suspect crypto custody will reach the stage where you deposit cryptos with a custodian and what you trade on an exchange is claims on the crypto in that account much like stock trading works.
In stock trading, all shares are owned by the Depository Trust and Clearing Corporation. Your broker has an interest in that stock of DTCC and you have an interest in that stock from your broker. This arrangement was made precisely so that stockbrokers didn’t have to constantly send paper certificates around just to trade – which is where crypto is currently stuck.
You may be wondering why you should care about the blockchain bit. The blockchain was sold in a way that bypassed all of these middlemen by trading these bearer assets directly. But it turns out that’s a bad idea and the middlemen do useful things.
Gary Gensler wrote up the 2009 custody rule changes and posted a video! It’s a great explainer if you don’t mind dad jokes. [SEC; Twitter]
SEC Commissioner Mark T. Uyeda writes that this is a blanket ban on crypto as an investment – “The proposed disclosure goes to great lengths to portray a ‘no-win’ scenario for crypto assets. In other words, an advisor can hold crypto assets in custody at a bank, but banks are warned not to hold crypto assets by their regulators.” But he supports the move nonetheless. [SEC statement]
Commissioner Hester Peirce obviously doesn’t like a new rule on crypto and has waved various objections to it. Of the five commissioners, Peirce is the only one who voted against the changes. [Statement]
The new rule will not exist in the foreseeable future. The proposal will be published in the Federal Register, there will be a 60-day comment period, and then SEC officials will work on the final version of the rule.
Binance – the mystery of Catherine Coley
After former Binance US CEO Catherine Coley was abruptly replaced in May by former Comptroller of the Currency Brian Brooks in April 2021, she disappeared. Coley has not been heard from the public since her last tweet on April 19, 2021. As recently as the last month, crypto outlets were asking: what happened to Catherine? [Cointelegraph]
Now some clues have surfaced. In the months leading up to her sudden disappearance, Coley had been raising questions about large money transfers from Binance US to other CZ entities. [Reuters, archive]
Binance has claimed that Binance US is separate from Binance International. That’s not the case. CZ withdrew $400 million from Binance US and sent the funds to its market-making firm Merit Peak via Signature Bank. The money started moving in late 2020. The SEC is also investigating these transactions. [WSJ, paywall]
No one’s quite sure what the money was for – but Coley knew something was wrong. She wrote to a Binance finance executive in late 2020 asking for an explanation, calling the transfers “unexpected” and saying “no one mentioned them” and asking “where are these funds coming from?”
We’re assuming Coley just got out of crypto and sees no benefit in speaking to the press. We also assume that she is speaking to the authorities.
BUSD – why you can’t withdraw
Paxos closes BUSD. Now it must allow for an orderly redemption of its $16 billion stablecoin of $13.3 billion. This creates new problems.
Paxos only redeems the official Ethereum BUSD token. If you have a Binance-issued wrapped BUSD, these are non-redeemable.
If you have Paxos-issued BUSD and you fail Know-Your-Customer checks, you will not be able to redeem them either.
Customers unable to redeem their Binance BUSD use them to buy bitcoins or tethers or any other liquid coins they can get their hands on. Because of this, Bitcoin is pumping again and is now bouncing around the $24,000 range.
Paxos holds cash at Silvergate, Signature, State Street and BMO Harris. All of these banks are feeling the pain of the BUSD redemptions. Silvergate was already hit with $8 billion in withdrawals in the panic following the FTX implosion and had to be bailed out to handle the withdrawals.
Paxos BUSD support is not fully insured according to Paxos. “Not all deposits are covered by the FDIC or private insurance, and Paxos can still suffer losses in the event of a bank failure.” [Paxos, archive]
SEC blames Terraform Labs
The SEC finally charges Terraform Labs and Do Kwon with securities fraud. [SEC press release; complaint]
The SEC alleges that Terraform and Kwon marketed a number of unregistered “crypto-securities” as investments to retail clients in the United States, knowingly and repeatedly lying about the operation, losing everyone’s money, and ending up stealing the reserve bitcoins.
Luna meets all the criteria of the Howey test, so it’s a security. Packaged Luna is a receipt for a security, so it’s a security too. Luna’s 2018 ICO and Luna’s 2019 bulk sales were obvious offerings of securities. And Kwon pumped Luna hard into retail.
The tokenized stocks of Terraform’s mAsset mirror protocol were security-based swaps and therefore subject to SEC jurisdiction. MIR tokens have been promoted by Terraform as the best way to invest in the Mirror protocol.
UST was a dollar stablecoin – but as of September 2020, Kwon and Terraform were heavily promoting it as a “high-yield” stablecoin, the ticket to an investment opportunity in the anchor protocol that was paying 18-20%. Approximately 74% of all UST were located in Anchor.
The complaint states, “Many domestic retail investors purchased UST solely for the purpose of earning a return from the anchor protocol developed and maintained by the defendants.”
UST could also be freely converted to or from Luna at any time, again making it a security.
But Terraform didn’t just break the SEC’s registration rules. Kwon and Terraform knowingly and actively deceived investors.
Maintaining UST’s $1 peg took a lot of effort. In May 2021, Terraform got an outside trading company – apparently US-based Jump Capital [The Block] – to secretly buy a bunch of UST to boost the price. Jump was paid in Luna tokens at $0.40 when the market price was above $90 and apparently made $1.28 billion from the deal. Terraform said this shows how UST/Luna would “automatically heal itself”.
When Anchor couldn’t make its interest payments, they were matched by the Luna Foundation Guard, the “decentralized” nonprofit behind the collapsed Terra “ecosystem” — led by Kwon.
Terraform falsely claimed that Korean mobile payment app Chai used the Terraform blockchain. Terraform then used this false claim of endorsing Chai to promote his crypto assets in the US.
In fact, Terraform had access to a server with Chai’s transaction stream and replicated Chai payments from that stream to the Terraform blockchain! By early 2020, Kwon was on Chai’s board of directors, and Terraform and Chai shared office space.
When all of Terraform’s cryptos crashed in May 2022, Kwon and Terraform took over 10,000 BTC from Luna Foundation Guard. They have since deposited bitcoins from that pile into a Swiss bank account and have withdrawn more than $100 million from that account since June 2022.
Many small investors have lost everything. Institutional investors lost billions – and that marked the end of the crypto bubble of 2021 and ushered in the great crypto meltdown.
Voyager – almost up in smoke
Will the Voyager purchase be handled by Binance US? The numbers just didn’t add up. And CZ said on Twitter that Binance “has withdrawn some potential investments or offers for bankrupt companies in the US for the time being.” [Twitter, archive]
A Binance US spokesman insists that the Voyager deal has not been abandoned: “We would like to clarify that Binance.com was not involved in the bidding process and the Binance US-Voyager deal is moving forward with all necessary verification processes. ” [FT, archive]
FTX – SBF back in court
Nishad Singh, a former chief technical officer at FTX, is close to reaching an agreement with prosecutors, “according to people familiar with the matter.” No further details yet. He will be the third FTX Insider to turn against Sam. [FT]
Judge Lewis Kaplan has had to review Sam Bankman-Fried’s bail restrictions for the second time in two weeks and he’s running out of patience. The judge doesn’t think Sam needs a VPN to watch football and neither do we. He wants the lawyers to work out stricter bail limits – even stricter than the US government has called for. [CNN]
Nicholas Weaver presented Judge Kaplan with an amicus brief explaining VPNs. [Amy Castor, PDF]
The Life of Gary Wang and Sam Bankman-Fried, High School Mathematicians. Fraternity and Treason! [Bloomberg]
More good news for Bitcoin
Blockchain.com has a $270 million hole in its accounts due to the collapse of Three Arrows Capital and is trying to sell assets to fill the hole, according to multiple sources. Blockchain.com denies everything, saying it is “an asset buyer, not a seller.” [Decrypt]
Coinbase is in the process of filing even more detailed figures with the SEC on how completely the crypto market has collapsed. Coinbase’s revenue in 2022 will be less than half of what it will be in 2021. [CoinDesk]
Caitlin Long’s Custodia Bank is suing the Kansas Federal Reserve to obtain a Fed account, claiming that the Fed has no discretion over whether or not to allow banks access to the Fed. [CoinDesk; American Banker]
Long tweeted about notifying unspecified authorities last year of unspecified wrongdoing on the part of an unspecified failed crypto company. Therefore, the regulators should give Custodia Bank anything it asks or they will shoot the messenger. It’s not like there’s a bunch of people who said this is all garbage that’s going to explode, but who didn’t also start a shady crypto bank. [Twitter, archive; blog post, archive]
The FDIC is furious with crypto exchange CEX.io’s claim that customers’ deposits are FDIC-insured. Of course this is not the case. [FDIC]
The SEC has indicted and settled basketballer Paul Pierce for his role in pumping Ethereum Max, similar to what happened against Kim Kardashian last year. Pierce will pay $244,116 in severance pay, $15,449 in prejudice interest and a $1,150,000 fine. [press release; complaint, PDF]
New article by Martin Walker: “Decentralization is simply a technological facade over the for-profit organizations that exist in the industry and exercise a high degree of control.” [Thomson-Reuters]