The Breakdown - A Contentious House Hearing on the SEC

Episode Date: September 21, 2024

The House Financial Services Committee held another contentious hearing around the SEC. The battle continues between pro- and anti-crypto forces heading into the election. Enjoying this content? SUBSCRIBE to the Podcast: https://pod.link/1438693620 Watch on YouTube: https://www.youtube.com/nathanielwhittemorecrypto Subscribe to the newsletter: https://breakdown.beehiiv.com/ Join the discussion: https://discord.gg/VrKRrfKCz8 Follow on Twitter: NLW: https://twitter.com/nlw Breakdown: https://twitter.com/BreakdownNLW

Welcome back to The Breakdown with me, NLW. It's a daily podcast on macro, Bitcoin, and the big picture power shifts remaking our world. What's going on, guys? It is Friday, September 20th, and today we are talking about all sorts of legal wranglings and government panels and all sorts of that stuff. Before we get into that, however, if you are enjoying the breakdown, please go subscribe to it, give it a rating, give it a review, or if you want to dive deeper into the conversation, come join us on the Breakers Discord. You can find a link at the show notes or go to bit.ly slash breakdown pod. Hello, friends. Well, on Wednesday, the House Financial Services Committee assembled a panel of industry experts and academics to discuss the wisdom of the SEC's crypto enforcement policy. Entitled, and perhaps giving you a sense of the framing from the people who set this up,

dazed and confused, breaking down the SEC's politicized approach to digital assets, the premise of the hearing was extremely clear. French Hill, the chairman of the Digital Assets Subcommittee, explained that the, quote, pro-regulatory framework views of the majority and many bipartisan does not mean we're going against the SEC going after bad actors, or modernizing existing rules to incorporate digital asset securities or other unique instruments. We're against SEC enforcement abuse and making it hard for legitimate actors who are trying to follow the rules to do a fine job and bring innovation

and technology to our markets. Michael Liftick, a former SEC deputy chief of staff, gave testimony that, quote, the SEC has refused to issue new rules or meaningful guidance relating to digital assets and, at the same time, has engaged in whackamol enforcement that the C holds up as a replacement for rulemaking. Rather than being an epicenter of financial innovation, as it should be, and as it is in other contexts, the U.S. has turned itself into a crypto-no-fly zone. Daniel Gallagher, the head of compliance at Robin Hood, and former Republican SEC Commissioner, was also present to give a firsthand account of his experience engaging with the SEC. Quote, we heard Chair Gensler's call to come in and register loud and clear.

Admittedly, I scratched my head a bit because there was no established regime, at least published regime, but being seasoned securities lawyers, we thought we'd just roll up our sleeves. According to Gallagher, Robin Hood were committed to doing things the right way and attempted to secure a special-purpose crypto-broker dealer license. This license was established in late 2020, but out of the dozens of applications, only two firms have managed to acquire it. Prometheum is, of course, the most notorious and hasn't managed to launch a successful product despite holding the license for over a year. He continued, one thing that became very obvious to us is that the special purpose broker regime doesn't work for digital assets. So we recommended modifications that would make it work. We were submitting to full regulation by the commission, who was very core.

with the SEC staff until about early 2023, when we got a very perfunctory note from the chairman's office telling us that there's no reason to talk anymore. Clearly then, this hearing was all about the politicization of the SEC, and lawmakers were more than willing to get political in their own right. Rather than a partisan squabble, the battle lines were drawn between pro-crypto and anti-crypto Democrats. Wiley Nichols said, not only is Gary Gensler's approach to digital assets politicized, it's just downright wrong. He's hurting consumers, innovation, American competitiveness, and the Democratic administration. Richie Torres questioned. in the origin of the term crypto asset securities, which the SEC has used to assert their jurisdiction.

He queried somewhat rhetorically, if it appears nowhere, neither in rule nor statute, did the SEC invent the term out of thin air? Regular listeners will know that the SEC recently apologized to the court for using the term, acknowledging that it's misleading. On the anti-crypto side, however, ranking member Stephen Lynch was having none of it, stating, industry advocates continue to push a false narrative that the SEC is politicizing the regulatory framework by picking winners and losers and unfairly targeting crypto firms. I find this deeply ironic, given that a 119 million was just used by crypto corporations to contribute and influence federal elections just this year alone. If anyone is playing politics, it's the crypto industry, and it appears they're playing it well.

Maxine Waters argued that the SEC has been active in crypto enforcement under both parties and asked for a single case where the regulator was clearly in the wrong. Lee Rayner, a lecturer at Duke University with an anti-crypto stance, was the only one given an opportunity to respond. Shocking. He suggested the ripple case is the SEC's only loss in court. He framed it as only a partial loss and said the decision was later repudiated in other cases. Republican Warren Davidson suggested this was, quote, willful ignorance. He brought up the grayscale and debt box cases when the SEC was told they were wrong by the courts. Debtbox was a particularly egregious case, where SEC lawyers were found to have purposefully misled the court. Davidson commented, lawyers would usually be disbarred

for that conduct. Ultimately, nothing will be resolved by these hearings. However, some lawmakers are still holding out hope that sensible legislation can advance when Congress returns after the election. The hearing also serves to lay the groundwork for next Tuesday's SEC oversight hearing. All five commissioners will be present to give testimony for the first time since 2019. Republican Commissioner Mark Uaida is getting in a little early, sitting down for an interview with Fox business reporter Eleanor Territ. The interview will be released on Monday, but Territ provided a short preview. In the context of Trump's recent foray into Defi, Ua said,

The Commission is a disclosure regulator, not a merit regulator. We do not judge the merits or risks of any one project, so I am concerned with any call for us to do so. The commission's war on crypto has contributed to the perception that we have become so politicized in recent years. If I were talking to President Trump or any other crypto entrepreneur, I would tell them to hire good lawyers because they will have to navigate the same confusing and opaque process that every other entrepreneur in the space has faced because the commission has not offered clear guidance. Godspeed to them. Hello friends, before we get back to the rest of the show, I want to implore you to join

me at Permissionless. Permissionless is the conference for crypto natives by crypto natives, and the reason it's so important this year is that despite regulators' best attempts to push industry founders, devs, and executives out of the U.S., the United States remains the beating heart of crypto. Today, the tide is turning. Policymakers have pivoted from fighting crypto to embracing it. Literally now we are in a major political party's platform, which will lead ultimately to the creation of new financial products, new applications, and ultimately new adoption. Permissionless is the conference for those using and building on-chain products. It's home to the power users, the devs, and the builders. And perhaps more importantly,

I will be there. The location is Salt Lake City, the dates are October 9th to the 11th, and tickets are just $499. If you want to get 10% off, use code breakdown 10. Go to the Blockworks website, blockworks.com. There will be links to register for the conference, and again, you can use code breakdown 10 to get 10% off. Unfortunately, for those on the anti-SECC side of this, a Texas-Fourkes federal court has dismissed the lawsuit brought by blockchain infrastructure firm Consensus against the SEC. Consensus filed the lawsuit back in April of this year, claiming that the SEC had engaged in, quote, overzealous regulatory overreach. The lawsuit alleged that the commission had approved a formal investigation into Ethereum in March 23. The investigation was based

on the theory that the transition to proof of stake had somehow transformed ETH into a security, with the SEC specifically targeting what they called Ethereum 2.0. SEC staff were authorized to issue subpoenas against parties involved at buying and selling ETH, whispered. and the industry suggests this power was used liberally, with the SEC peppering individual devs, companies, and venture firms with demands for information. Consensus portrayed this behavior as baseless harassment, designed to create a chilling effect for the Ethereum ecosystem. In their lawsuit, Consensus had asked the court for a declaratory judgment that Eith is not a security. Further, they asked for a declaration that their metamask wallet is not an unregistered

securities broker. Consensus had already received a well's notice from the SEC, warning them of incoming enforcement action. Finally, consensus requested an injunction that would bring an end to the Ethereum investigation. The lawsuit was viewed as a preemptive strike with consensus looking to get in front of a judge to defend the Ethereum ecosystem before the SEC could make their move. Since then, a ton has changed. In May, the SEC approved spot Ethereum ETFs, which most viewed as tacit recognition that ETH is a commodity. In June, the SEC gave formal notice that the Ethereum 2.0 investigation had concluded, and they would not pursue enforcement action. Later that month, the SEC filed their lawsuit against consensus regarding metamask, swap, and staking

functions. As the subject matter for the case has been more or less resolved, the court found there was nothing remained to contest. The judge ruled that the lawsuit was moot and dismissed it, writing, because plaintiff has not identified final agency action that would render the claim fit for judicial review, and because withholding consideration subjects plaintiff to scant, if any, hardship, the claim lacks a ripe case or controversy. This essentially means that the SEC's use of Wells notices and investigations to intimidate the industry, as consensus claimed, is not able to be challenged in court. In a statement, consensus said, Unfortunately, the Texas court today dismissed our lawsuit on procedural grounds without looking at the

merits of our claims against the SEC. The court recognized that the SEC already gave consensus the relief it sought on that critical issue for the Ethereum ecosystem. They pledged, however, to continue pushing for reasonable treatment from regulators, adding, outside of court, we have also seen signs of what could be a momentous step change in Washington's sentiment towards cryptocurrencies and digital assets during a crucial period for U.S. politics. We are on the right path, but must remain vigilant. For the SEC's part, it continues to clear the decks in September, wrapping up another crypto settlement. This time, the enforcement action deals with defunct Defy platform Rary Capital. Rari launched in 2020 as Defi hit high gear, and the projects in the space were moving

fast and breaking things. The platform offered automated yield farming strategies, which was really part of an era featuring constant product launches, which frequently offered yields over a thousand percent annualized. These yields were either introductory offers that disappeared quickly or outright Ponzi schemes that detonated just as fast. Rari positioned themselves as a way to automate. automate the degeneracy. The platform burned extremely bright in early 2021, but was destroyed by a pair

of eight-figure hacks later that year. Rari ultimately merged with another Defi protocol and has fallen out of favor now that yield farming is a much less prominent strategy. The SEC settlement contains the now familiar claim that Rari was operating as an unregistered securities broker. However, the regulator is leaning on a new legal theory to arrive at that allegation. They claim that the tokens minted on the platform when users made a deposit are subject to securities law. These tokens function in much the same way as LP tokens on a Dex, which raises a new class of regulatory exposure for D5 protocols. The tokens were launched by third parties using the platform to set up their own pools, which were governed by smart contracts.

The SEC notes that Reri took fees from this activity and retained the ability to alter the smart contract. For this reason, they claimed that Rari had control over the platform enacted as a broker. For good measure, the SEC also alleged that the platform's native token was offered as an unregistered security. Where it got a little tricky to parse, though, is that the SEC is also making a number of fraud allegations to go alongside. They claim that Rary, quote, falsely told investors that the earnpools would automatically and autonomously rebalance their crypto assets into the highest yield generating opportunities available when, in reality, the rebalancing mechanism often required manual input, which Rary Capital sometimes failed to initiate.

Furthered the SEC alleged that Rari, quote, misleadingly touted the high annual percentage yield that investors would earn, but they failed to account for various fees and ultimately a significant percentage of earn pool investors lost money on their investments. Monique C. Winkler, director of the SEC's San Francisco office, said, we will not be deterred by someone labeling a product as decentralized and autonomous, but instead we'll look beyond the labels to the economic realities as we did here and hold the individuals behind crypto products and platforms accountable when they harm investors and violate the federal securities laws,

where we founders agree to an undisclosed settlement but will not pay a fine at this stage. They will serve a five-year ban from acting as a corporate officer or director. Still, the obvious centerpiece of the SEC's regulation by enforcement strategy is the coin-based lawsuit. After a few early skirmishes, that case is now on its way to trial. But first, the parties need to exchange all relevant documents during the discovery process. Coinbase chalked up a major win earlier this month with the court accepting the majority of their document requests. They had made a sweeping demand for all documents related to how the SEC had developed

their theory that tokens are covered by securities law. We're now getting a sense of just how comprehensive this discovery will be, with the SEC requesting a four-month delay due to massive scope. The regulator wrote that they are, quote, undertaking a review of at least 133,582 unique documents. The requested extension will provide the SEC the necessary time to comply with the court's order. This is by far the largest cache of SEC documents to be sifted through as part of a crypto lawsuit and will no doubt contain a huge amount of information. The delay will push the discovery deadline into next February. Both parties have agreed so it should be granted. After this round of

discovery, the parties will need to present expert witnesses for deposition, a process that will run until April. This suggests that the case won't go in front of a jury until the second half of next year at the very earliest. However, it might not even get there. During this, their case, Ripple managed to gain the upper hand after forcing discovery. Their process uncover the notorious Hinman emails, which explained the backstory of how the SEC had formulated their theory of sufficient decentralization. One of the arguments Ripple leaned on was that the SEC had not provided fair notice, which was evident from the confusion expressed in the documents. If the SEC themselves did not have a consistent legal theory, it's difficult to claim that the crypto industry

had fair notice. That case was decided without going to trial, with the judge finding the documents sufficiently detailed to base a ruling upon. Coinbase could take a similar route but won't be able to do until the discovery deadline is up. And I think the lesson here in the reminder is that while all eyes are on the election as the next big event in crypto, which I think is completely reasonable and correct, there is still so much lingering that could have a big deterministic impact on how this industry works in the United States. As frustrating as it may be, it is worth our time to stay involved and stay engaged and stay on the fight because it's not over yet. For now, though, that is going to do it for today's breakdown. Appreciate you listening as always.

And until next time, be safe and take care of each other. Peace. Thank you.