The Breakdown - How Big a Deal Was Binance’s Previous $1B BUSD Collateral Gap?

Episode Date: January 14, 2023

Today on “The Breakdown,” NLW catches up on some crypto cleanup stories from earlier in the week. He looks at community reactions to research uncovering that at times in 2020 and 2021 Binance peg BUSD was undercollateralized by as much as $1 billion, as well as to the latest fire and fury around Silvergate Bank.  Enjoying this content?   SUBSCRIBE to the Podcast Apple:  https://podcasts.apple.com/podcast/id1438693620?at=1000lSDb Spotify: https://open.spotify.com/show/538vuul1PuorUDwgkC8JWF?si=ddSvD-HST2e_E7wgxcjtfQ Google: https://podcasts.google.com/feed/aHR0cHM6Ly9ubHdjcnlwdG8ubGlic3luLmNvbS9yc3M=   Join the discussion: https://discord.gg/VrKRrfKCz8   Follow on Twitter: NLW: https://twitter.com/nlw Breakdown: https://twitter.com/BreakdownNLW   - Join the most important conversation in crypto and Web3 at Consensus 2023, happening April 26–28 in Austin, Texas. Come and immerse yourself in all that Web3, crypto, blockchain and the metaverse have to offer. Use code BREAKDOWN to get 15% off your pass. Visit consensus.coindesk.com. - “The Breakdown” is written, produced by and features Nathaniel Whittemore aka NLW, with editing by Rob Mitchell and research by Scott Hill. Jared Schwartz is our executive producer and our theme music is “Countdown” by Neon Beach. Music behind our sponsor today is “Swoon” by Falls. Image credit: Antonio Masiello/Getty Images, modified by CoinDesk. Join the discussion at discord.gg/VrKRrfKCz8.

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. The breakdown is produced and distributed by CoinDesk. What's going on, guys? It is Friday, January 13th. Uh-huh, Friday the 13th. Hope nothing bad happens. Anyway, today we are talking about the hits that keep on coming in crypto. But before we get into that, if you are enjoying the breakdown, please go subscribe to it. 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. All right, folks, happy end of the week. So like I said, today, we are digging into some more big revelations from the crypto space over the past week or so, and we are going to start with Binance. A report from Bloomberg on Tuesday revealed that Binance's BUSD stable coin had become undercollateralized by at least $1 billion on three occasions across 2020. in 2021. Now, for background, BUSD operates across multiple blockchains. The Ethereum version of the stablecoin is fully collateralized by a process overseen by U.S. regulated stablecoin issue or Paxos and maintained its reserves at all times. At the same time, however, the BUSD, which

operates on Binance's BNB smart chain protocol, had its collateral maintained by an opaque internal process at Binance. This process consists of maintaining a cold wallet of Paxos audited Ethereum BUSD, which acts as a one-to-one collateral reserve for the stablecoin issued on the BNB smart chain, which are sometimes referred to as Binance PeggUSD. With this approach, Binance essentially piggybacked on the credibility of Paxos' stablecoin issuance for its own issuance. Paxos is one of the very few companies, for example, that actually has a New York bit license. Now, Jonathan Reeder and Patrick Tan of Blockchain Company chain Argos recently put out a report which analyzed the reserve cold wallets for

for Binance Pegg USD. They found that the reserves of Paxos issued BUSD held on the wallets were often lower than the amount of Binance PeggUSD circulating on the Binance smart chain. They noted three separate occasions where this discrepancy blew out to more than $1 billion before being addressed. Emily Nicole writes, Binance said operational delays meant that it didn't keep enough reserves to sufficiently back its own version of the BUSD stablecoin, finance peg BUSD, between 20 and 2021. On three occasions, that collateral gap topped $1 billion. The process is pretty simple.

Someone wants to buy Binance Pegg BUSD. Finance buys some BUSD to cover it, locks it in a wallet. Binance mince the corresponding amount of Binance Pegg BUSD. Except for most of that time, Binance was skipping a step. Data from John Rader at Chain Argos and Data Finnovation showed Binance hadn't followed its own procedures for Binance Peg BUSD reserves. This is crucial when BUSD issued by Paxos is a regulated token. Binance Peg BUSD isn't, but makes up almost a third of BUSD's total circulation.

End quote. Now, Binance acknowledged this. A spokesperson said that despite delays in gathering appropriate collateral, the pegging process has now been corrected, saying, quote, recently the process has been much improved with enhanced discrepancy checks to ensure it's always one-to-one pegged. Following the release of the report in Bloomberg, Binance published a blog post which said, quote, from the data, it is clear that the rebalancing did not always keep pace with

the demand for Binance-Pug BUSD. Having identified this ourselves last year, we now rebalance more frequently to ensure that BinancePegg BUSD is transparently fully backed. Now, to be clear, it doesn't appear that user funds have ever been impacted by this lack of reserves. However, it does put a magnifying glass on the issues of stable coins in terms of how they should be issued and backed. This is one of the key regulatory topics on the slate for this year, and in fact might be

the one to see legislation in the U.S. first. Now, in terms of responses, Paxos sort of disavowed the thing. On January 10th, they tweeted, BUSD on ERC 20 issued by Paxos is the largest regulated stable coin in the market. It is always backed one to one and offers the highest level of transparency and oversight. Wrapped versions are not issued by Paxos, consumers should educate themselves on how these wrapped assets are managed. Paxos then points to a Binance post with info on the Binance Pagg BUSD. Now, Paxos is of course factually correct here, but at the same time, these are assets that have the same name, BUSD. It's not unreasonable for casual consumers to not exactly know that there are actually different flavors

and varieties of BUSD that could be opening themselves up to totally different circumstances when they hold them. Then again, Paxos might be pretty upset right now, which is something we'll get into in just a minute. Now for CZ's part, he said more fud in coming, we'll ignore, but others were kind of skeptical. My as a hobby writes, let's be clear. The whole idea of wrapping Paxos stable coins into BUSD is to obfuscate how the peg is managed to cross chains. The fact that we just saw a DPEG and BUSD last month under that scenario reaffirms that, just because Binance claims that doesn't make it so. Lee Drogan went a little broader, saying how much actually reported FUD has ended up not being true in crypto in the last 12 months? None?

Travis Kling clapped pretty hard saying, Changpang, please explain to the market how it is when a Binance spokesperson confirms to Bloomberg that BUSD had a greater than $1 billion hole in its collateral value. I've had Binance Apologist up my ass since I first spoke out about the risks present a month ago, and that's fine, I can take that. In the past, I haven't been vocal enough in calling out bad actors. Not going to make that same mistake again. The entire industry is at stake. I think, though, that Adam Cochran really sums up the issue nicely in this thread. He writes,

Yeah, so like people thought, BUSD on Ethereum by Paxos likely fine. BUSD on B&B chains and on their exchange? Who the f*** knows? But Binance flat out admits that it wasn't always a one-to-one. Peg. Could have easily led to inflated or fictional assets on Binance or Binance chain. CZ really shouldn't have front-run this announcement, as market might have overlooked it, but it's bad. Basically means they didn't slash don't have a reputable process in place, use their Paxos partnership to make it seem legit, and had a sloppy human process managing BUSD. Remember, it was cross-chain settlement of different types of stable coins in a basket

that did FTX in. It's how we found out they were so short on assets. There is no legitimate reason to have ever been off peg here, though, as Binance was the only other issue. For it to have been off, that means Binance issued BUSD when it did not have the fiat to do so, either by issuing against collateral and not telling anyone or issuing out of thin air. Their stable coin should have been one of the assets you trust the most when interacting with the exchange. Instead, this leaves us with huge questions that we won't ever get straight answers on. Instead, we'll get vague human error claims as they try and sweep it under the rug. I'd also be pissed if I was Paxos, as until recently, most people didn't realize that BUSD

issued on other chains wasn't backed by Paxos. It's pretty clear that Binance was less leveraging that relationship for legitimacy on its stable coin while not having solid operations. All of that said, Binance did win one battle this week. The judge overseeing the Voyager digital bankruptcy case has taken meaningful steps towards approving a bid from Binance to buy out the bankrupt crypto lender's assets. Judge Michael Wiles, hearing the case in the Southern District of New York, has approved disclosure statements explaining various aspects of the proposed plan to sell Voyager assets during a hearing on Tuesday afternoon. However, he requested revisions to the order documents before he approves them. The deal will also

also need approval from a majority of Voyager creditors. Now, obviously, the Voyager sale has been a pretty torturous process. After the lender filed for bankruptcy in July, a successful bid on the assets was made by FTX in September. For some reason, that bid fell through with the collapse of FTX, and Binance U.S. subsidiary put in an offer to purchase the assets for a little over a billion dollars. This raised objections from the U.S. trustee, a division of the DOJ, the SEC, numerous state regulators in Alameda research, even, who said they had a claim on the assets. U.S. regulators centered around ensuring that Voyager customers, the majority of creditors, would be dealt with reasonably in the process, as well as questioning the ability of Binance U.S. to close the deal.

Notably, the U.S. Committee on Foreign Investment is also taking a look at the deal, with Voyager attorney saying they are currently working with the committee to speed this process along. Joshua Susborg, a Kirkland and Ellis attorney representing Voyager, asserted in Tuesday's hearing that approving the finance deal would be in the best interest of Voyager's creditors, stating, quote, we do not want to delay getting money and getting crypto back into our customers' hands. we also took a very hard look at a standalone self-liquidation. The self-liquidation auction is not an option that is going to put the most money in our customers' pockets. Regarding the laundry list of objections, lawyers for Voyager said that objections made by the SEC and the state of New Jersey are,

quote, resolved for the purposes of today, while the judge stated that the issues raised by a review from the committee on foreign investments are, quote, really non-issuesues for today. When it comes to Binance U.S.'s ability to close the deal, lawyers for Voyager said, quote, the debtors submit that we have performed due diligence on Binance U.S. And Binance U.S.'s financials show that it has ample cash on hand to pay the debtors up to $35 million in cash, the maximum amount that may be due. Join CoinDesk's Consensus 20203, the most important conversation in crypto and Web3, happening April 26 through 28th in Austin, Texas.

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Next up, let's talk Silvergate. Last week, we covered the huge bank run, which saw Silvergate experience a withdrawal of 53% of total deposits and a staggering 68% of digital asset deposits in Q4 of last year. Details of the run were disclosed by Silvergate and prematurely updated SEC filings. Now, one of the details in those filings, which was largely ignored at the time, was that Silvergate had expanded their wholesale borrowing from the Federal Home Loan Bank of San Francisco,

the FHLB, from $700 million in Q3 to $4.3 billion in Q4, in order to cover liquidity needs during the bank run. This detail was highlighted in an American banker article published on Tuesday. And to be clear, this article wasn't really about Silvergate. It was, in some ways, a hit piece on the Federal Home Loan Bank in general. In fact, the article pointed to Silvergate accessing liquidity from the FHLB as further evidence of the crypto ecosystem becoming increasingly enmeshed in the traditional financial system, but it was more targeted at questioning the appropriateness of the FHLB as an institution.

The FHLB was set up during the Depression in 1929 to support housing finance. It is a public-private partnership which provides loans against mortgage bonds and other financial securities, which are used as collateral on bank balance sheets. It wasn't designed as a lender of last resort, but is frequently used by all sorts of banks as a source of wholesale funding in the ordinary course of business. However, the American banker article said that, quote, some experts suggest the funding to Silvergate is an example of mission creep. Now, this article caused a rush of blood to the corners of Finuit who are critical of crypto. Ben Hunt writes, Silvergate received $4.3 billion from the federal home loan bank of

San Francisco in December. A, what the actual f-b? B, this is the contagion that the Fed, FDIC, OCC, were warning about last week and will be used to spur crushing Bitcoin regulation. The issue isn't the FHLB did some underhand deal with Silvergate. The issue is that as an ordinary operation, the federal home loan bank provides billions in non-penalty discount window liquidity to a bank under multiple federal investigations with no mortgage business. The mission creep of the FHLB into roles it has zero business having, like providing billions in penalty-free emergency liquidity to a crypto version of a BCCI is a microcosm of our insanely financialized world. John Reed-Stark, a former chief at the SEC's Office of Internet Enforcement, says,

crypto-friendly bank Silvergate received $4.3 billion loan from the federal home loan bank to stave off a bank run. U.S. taxpayers are now officially subsidizing crypto fraud and grift in the first U.S. crypto bailout, all done in plain view. So this is how Liberty dies. Jim Kramer says this is extraordinary, a bailout loan from the federal home loan bank for a crypto bank to stem the run. I wish people knew how dangerous this is all getting, not business as usual. However, this wasn't the only take. Guy LaBoss, the chief fixed-income strategist at Janney, who has experienced managing liquidity in the balance sheet of a large New York bank, was quick to pour cold water on some of these more vitriolic takes. He pointed out that access to wholesale funding is an entirely normal and

necessary part of banking infrastructure. He tweeted, FHLB advances are not bailout loans. Loaning money to small and mid-sized banks against collateral is the FHLB's congressionally defined mandate, you mope? That was said in response to Kramer. Now, in defense of their actions, the FHLB of San Francisco pointed out that they do not take government funding being entirely funded by private lenders. They also noted that in the more than 90-year history of the FHLB, there has never been a single recorded loss from lending activity. Now, at the end of the day, the thing that's important to keep in mind here is that while Silvergate may, yes, have a specialty servicing crypto firms, it is a state chartered bank in

California, with all of the same access to wholesale funding and banking infrastructure as any other chartered bank. Silvergate holds mortgage bonds as collateral on its balance sheet, which is why they argue that FHLB is an appropriate institution to be involved. The alternative to these loans would have been Silvergate dumping their mortgage bonds in a fire sale, which would have impacted the market and insured more significant losses than the 718 million in losses Silvergate incurred as they slowly sold off collateral to meet withdrawal demands. Now, the implication that all these critics are making is that Silvergate should not be afforded the same access to the financial plumbing and funding as every other bank because they are somehow besmirched with crypto. Although the

media cycle has fixated on the idea that crypto is bad, and that because of that, and because of their potential complications with Sam and Alameda, that Silvergate is a bad actor, that doesn't mean they should be summarily cut off from funding during a bank run. Now, if banking regulators decide that Silvergate should no longer hold a banking license, there's an established way of doing that, with checks and balances as well as safeguards to ensure it doesn't result in a systemic contagion event. And listen, we could find out more about Silvergate being dubious in the weeks and months to come. I'm not sitting here defending them. I just think the way this story has been characterized for clicks reflects more that being involved

in crypto is being treated like it's a crime in and of itself. I don't think it should be super surprising to us that that's the case, given what we've seen over the last year. But here we are. Now, one more investigation before we check out today. The Justice Department is investigating the two brothers behind the Salana DFI Stack Saber Labs, according to two people familiar with the investigation. In August, it was revealed that Ian and Dylan Masselino had used a web of 11 pseudonymous identities

to build interlocking DFI products on Solana and counted assets multiple times in an effort to boost Solana Defi's total value-locked metrics. I never published blog post from Ian said, quote, the metric to optimize for in summer 2021 was total value locked, or TVL. TVL can only count if protocols are built separately, so I devised a scheme to maximize Solana's TVL. I would build protocols that stack on top of each other such that a dollar could be counted several times. The post also mentioned his thought process behind using multiple identities to cover his tracks. If an ecosystem is all built by a few people, he wrote, it does not look as authentic. I wanted to make it look like a lot of people were building on our protocol rather than ship

20-plus disjointed programs as one person. This is just another unbelievable one to me. And a great example of what I think will be one of the biggest lessons from this whole bull run. Just because you can doesn't mean you should. Until tomorrow, guys, be safe and take care of each other. Peace.