The Breakdown - A Soft DeFi Ban in the USA?

Episode Date: July 21, 2023

This week saw a number of crypto-related legislation introduced in Congress -- sometimes as amendments to other important bills. NLW breaks down why some think at least one of them amounts to a soft DeFi ban in the US. Today's Episode Sponsored By: In Wolf's Clothing -- The first startup accelerator exclusively for Bitcoin and Lightning startups -- Applications for Cohort 3 open NOW -- https://wolfnyc.com/apply ** Enjoying this content? SUBSCRIBE to the Podcast: https://pod.link/1438693620 Watch on YouTube: https://www.youtube.com/nathanielwhittemorecrypto Subscribeto 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, July 21st, and today we are catching up on what is kind of a lot of interesting regulatory developments this week. 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 in the show notes or go to bit.ly slash breakdown pod. Hello friends, happy Friday, happy almost the weekend.

Today we are catching up on a number of different regulatory developments from earlier this week. They are on the one hand small, but at the same time, showed just how much is happening in this sphere, even outside the big headline grabbing stuff. However, oh so briefly, before we get into all that, I want to tell you about today's sponsor. In Wolf's Clothing is the first startup accelerator focused entirely on Bitcoin and Lightning. If you are a listener of the Bitcoin Builders show, you will have heard from a number

of companies in their first cohort. People who are building lightning infrastructure, integrating Bitcoin into games, thinking about new financial instruments that can work in the Bitcoin ecosystem. And if you have a Bitcoin or Lightning startup idea, you should absolutely apply to their third cohort. The Accelerator program takes place in New York City in person and features mentorship, guaranteed funding, and so, so much access and insight. Go to Wolf and Lysse. to check out the program, and of course, to apply for cohort three. Applications are open from now until August 4th. Thanks again to Wolf for sponsoring the breakdown, and now let's talk some regulatory updates.

First up, a bipartisan group of senators have introduced a bill which would tighten up anti-money laundering and sanctions compliance requirements on defy protocols. The Crypto Asset National Security Enhancement and Enforcement Act can see, which was introduced on Wednesday also designates a range of parties that could be held responsible for non-compliant platforms. Democrat Senator Jack Reed, one of the co-sponsors of the bill, said, quote, this legislation bolsters the Treasury Department's tools to protect our national and economic security. Drug cartels, sex traffickers, and the like, shouldn't be able to use DFI platforms to avoid justice. Their victims deserve better.

Fellow Democrat Senator Mark Warner, as well as Republicans Mitt Romney and Mike Rounds, feature his co-sponsors of the bill. So what's actually in here? The bill is, bill would require defy protocols to identify users, maintain anti-money laundering policies, block sanctioned individuals from access, and report suspicious activity to the government. Now, you may be noticing the tension here. This set of compliance requirements is similar to those imposed on banks. However, unlike a bank, most defy platforms do not have a central entity capable of satisfying these surveillance and reporting requirements. Never fear, however, in recognition of this issue, the bill proposes that the requirements should fall on,

anyone who controls a defy protocol or makes available an application to use the protocol. Now, that last section likely refers to developers who offer a user interface front end to access permissionless defy protocols, which is a proposal that has featured in numerous defy policy discussion papers, as the industry and lawmakers grapple with how decentralized protocols could be made to fit within the modern banking compliance norms. From there, if no group could be identified for compliance enforcement, the bill appears to suggest that venture investors could be held responsible. The bill reads, If nobody controls a defy protocol, then, as a backstop, anyone who invest more than 25 million

in developing the protocol will be responsible for these obligations. Paraphrasing investor Mike Dutas right here, going to be a lot of $24.99 million checks going forward. Miller Whitehouse Levine, the CEO of the lobbying group, the DeFi Education Fund, said that the legislation would simply put, effectively ban defy development in this country. More than that, he pointed out the transparency of Defi already acts to deter illicit use. Indeed, one of the most striking developments in crypto law enforcement recently is that criminal use of protocols has dropped precipitously. Chainalysis reported that losses to crypto crime had fallen by 65% for the first half of this year. White House Levine said,

Unfortunately, Kansi's approach is not only a disproportionate response to the illicit use of defy, but also risks undermining U.S. law enforcement's existing insight and reach into peer-to-peer crypto activity. Yanofonosi, director of anti-money laundering and cyber at the Crypto Council for Innovation, called the bill, quote, arbitrary and ill-defined, noting that it is primarily an attempt to cram decentralized protocols into ill-fitting regulations designed for traditional firms. Indeed, the Crypto Council for Innovation had a long threat about this. Excerpting that, they write, today a group of senators intro a bill to apply AML and sanctions obligations to, quote, backers and quote, quote, facilitators in the defy space, along with new and onerous requirements

for crypto ATMs. TLDR, the proposal fails to provide a workable framework to actually address it illicit finance in these sectors. Elicit finance is a legit national security concern, and while its volume is tiny in crypto compared to Tradfai, leveraging the transparency and programmability inherent in blockchain systems to derive appropriate compliance measures unique to crypto is a good idea. Unfortunately, this bill goes the opposite direction. It places legal obligations arbitrarily on persons who have no actual way to influence protocols once they are deployed, and completely fails to account for the unique attributes of blockchain-based systems. From there, the thread goes into the weirdness of some of the definitions,

how it's strange that the Treasury Department will decide what constitutes control, how the proposal offers no actual guidance on how exactly these decentralized protocols would comply, and basically the whole thread amounts to, this is an important area to regulate, but this ain't it. Now, the thread concludes, we should emphasize that this bill is in early stages, and that the authors are interested in a constructive dialogue on how best to mitigate illicit activity in crypto. We expect plenty of edits to this language and approach before it moves through full consideration. And that to me is the real question any time we get new legislation in crypto right now is how good faith or bad faith the efforts actually are. We've dealt with a lot of bad faith

efforts over the last couple years, but there will need to be a good faith conversation about how to make Defi work within the existing system or adapt the system so that the benefits of defy can work in new ways. Now, one interesting theory that I read put the whole thing in the context of other actions, and specifically this major questions doctrine which is coming up more and more in the courts. Larry Floreo, the general counsel at 1KX Network, wrote, another day, another proposed crypto regulation. So much of this bill maximally defers to the discretion of treasury and the SEC, so it's not really known how implementation will end up looking or how long before they change things around again. My pet theory is that all this deference to Treasury and the SEC in the ACS language itself

is meant as a preemptive defense against the Major Questions doctrine if and when it's challenged at the Supreme Court. So basically, one of the arguments that people like Coinbase are making in their fights against the SEC is that when it comes to crypto regulation, the SEC or any non-elected body doesn't really have the authority to be making rules. Major questions doctrine refers to the idea that when it comes to major questions, that's where those words come in, authority has to be dictated and determined by Congress. This would obviously put a real crimp in, for example, the way that SEC Chair Gensler has handled things. Now, another interesting conversation came from consensus lawyer Bill Hughes. He tweeted,

Crypto's biggest enemies right now, Gary Gensler, and the Lazarus Group. Take away them both, and the regulatory environment in the U.S. is 180 degrees different. Something to keep in mind is that it's most probable that Gensler is going to leave the SEC before the Lazarus group stops pillaging Defi. Lazarus is a much bigger challenge and a much bigger threat to P2P being allowed in the U.S. Now, Lazarus that he's referring to here is, of course, a cybercrime syndicate that is run by individuals connected to the government of North Korea. They've been involved in numerous crypto hacks, although there hasn't been a highly publicized one for about a year, and effectively what Bill's arguing is that they are, in the case of D5 being used for crime, the big boogeyman.

In a separate thread, Hughes writes, unless Lazarus magically disappears tomorrow, whether because they move on to hacking drones or AI, or because Kim Jong-un has a change of heart and drops the whole communist dystopia thing, then some legislation in the U.S. that seeks to solve for a growing national security problem will probably, eventually, get enough support to go through. And the risk that something squeaks through on a must-approved vehicle goes up as the status quo progresses. Unless, of course, P-to-P and D-Fi become so popular that this can't happen politically. So in one way of thinking, perhaps it's a race. Now, speaking of this idea of sneaking things in on a must-pass bill, a weird set of odd fellows has introduced an amendment to the must-pass National Defense Authorization

Act, which would introduce sweeping new anti-money laundering requirements for the crypto industry. The amendment was introduced on Wednesday by Senators Kirsten Gillibrand and Cynthia Lummis. Nothing weird there. But then also Elizabeth Warren and Roger Marshall, two of the biggest antagonists of crypto. The amendment would require that the Treasury Department, the SEC, and the CFTC, within two years to, quote, adopt financial institution examination standards relating to the prevention of money laundering and sanctions evasion. In addition, FinCEN would be called upon to produce a report on the use of crypto asset mixers and tumblers, presenting policy recommendations to lawmakers. The amendment takes components from both the Lummis Gillibrand Crypto Market Structure

bill, as well as last year's Warren Marshall crypto anti-money laundering bill. Gillibrand said in a press release, prohibiting the use of cryptocurrencies for money laundering and illicit finance is critical to both our national security and economy. This amendment will require federal regulators to enact strong examination standards that will help prevent the utilization of cryptocurrency in illegal activities. Marshall said that the bipartisan amendment, quote, will set common-sense standards to ensure that proper guardrails are in place

as crypto use continues to grow across the world. So how concerned should we be? Well, fight for the future tweets, Red alert, Senator Warren is trying to tie a dangerous bill that attacks our right to privacy to the NDAA and force its passage seemingly to ensure that sanctions on Russia are not circumvented using crypto, but it is a bad solution. Experts, including Fight, have spoken up about the danger of this bill. The crypto industry needs regulation that protects users from bad actors, but this is not it. The bill is so broad that it could classify creators and developers as financial institutions

the same as banks. If it passes, it could limit those building and the privacy-protecting tools we need to circumvent creepy and dangerous surveillance? Why would Senator Warren want to expose abortion patients, people seeking gender-affirming health care, sex workers, and other vulnerable communities, who are constantly under attack to more risk instead of protecting them? Now, Bill Hughes again sums up in a little bit more of a dispassionate way. He said, in short, the legislation requires the U.S. Treasury, SEC, CFTC, and FinCEN, among others, to set up in the next two years a process to examine money service businesses, broker-dealer, futures commission merchants, and other regulated entities to ensure their AML programs are sufficiently robust to address risks presented by

crypto-assid activities, including reporting obligations. It also puts AML regulatory reporting burdens on operators of crypto kiosks. It further requires U.S. Treasury to issue guidance in 120 days after enactment on stablecoin issuer sanctions compliance responsibilities and stablecoin issue reliability for user transactions that violate sanctions regimes. It further requires FinCEN to submit a in one year on the operations in use of crypto asset mixers and tumblers. Kne-jerk reaction? Actually, not all that unreasonable. I'm sure stablecoin issuers are going to take some serious issue with any notion that they will be held responsible for downstream elicit use of their stablecoins, but that's the only thing that jumps out as controversial here.

It's ultimately unclear whether this amendment, which is one of literally hundreds, will ultimately be taken up by the must-pass legislation's handlers, so it is to be seen whether there is a chance this becomes law. The odds are generally against any single amendment to be added. Speaking around Stablecoin legislation, during a live stream event hosted by the Atlantic Council on Monday, a pair of congressmen from across the aisle both emphasized the need to keep stablecoin legislation moving forward. One of the sticking points in negotiation has been how to divide up oversight between state and federal regulators.

Republican French Hill, the chair of the Digital Assets Subcommittee, said, quote, We do want to facilitate a state pathway, but to quote my colleagues on the other side of the aisle, we don't want any race to the bottom. He noted that under the current draft of the legislation, Staplecoins would fall under review or enforcement by the Federal Reserve. On top of that, during congressional testimony last month, Fed Chair Jerome Powell suggested that the central bank should play a role in regulating stablecoins. Now commenting at the same event, Democrat Jim Himes, a senior Democrat on the Financial Services Committee, said that the division between state and federal oversight should not be an

insurmountable barrier to getting legislation done. Himes said we always have these arguments with the regulation of any financial product. He said that the choice of regulator was ultimately secondary to ensuring that stable coins are fully backed and are required, to prove their reserves. In his opinion, stablecoin legislation is moving along, and Himes was optimistic about the progress made so far. He said the conversation happening right now is more between the committee and the regulators, and the conversations are happening, I think, formally and informally, as we all work, I think, in good faith. Himes even recognized that there is an incredible amount of value to be unlocked in permitting stable coins to exist within a regulatory perimeter. He said,

I am a skeptic on areas of mechanisms of exchange in stablecoins, but I also know that I'll be wrong in certain areas, and that there is a huge amount of value there waiting to be innovated into existence. And we need to make sure that happens here rather than somewhere else. Now, the Staplecoin bill had been scheduled for a committee vote this week, but has now been pushed back till next Wednesday. Hill said the postponement could be a sign of continued last-minute negotiation changes, but that he's optimistic the bill will make it out of committee and onto the House floor. Now, this bill could be passed in the Republican-controlled House strictly along party lines, but would need the bipartisan support of Democrats to pass in the Senate.

Meanwhile, the McHenry-Thompson Digital Assets Market Structure Bill continues to be debated in the House. Debate and a vote on the market structure bill has been delayed to be held alongside a vote on stablecoin legislation next week. Now, it's a little unclear at this stage how the ripple decision will change or if it will change thinking in Congress. However, many are suggesting that it will encourage Democrats to come to the table on negotiations for the market structure bill. Basically, the idea is that Judge Torres' decision in that case has dramatically shifted

the assumption that the SEC has sufficient power to regulate the industry. after it was decided that XRP tokens are not in and of themselves securities. And so, friends, that is the regulatory view from here. Lots going on, and frankly, it's nice to have things that are detailed, specific, battleable, againstable, instead of big showy press getters. So I don't know. We got a lot of work ahead of us, but it does feel different that it did three or six months ago. Anyways, for now, I want to say a big thanks one more time to our sponsor for the show in Wolf's

clothing. As you guys have heard, applications are open for Wolf's third cohort. go check it out at wolf nyc.com, get some funding for your Bitcoin or Lightning startup and go build something amazing. And for all of the rest of you, until next time, be safe and take care of each other. Peace.