The Breakdown - How Compliance Costs Could Kill Crypto Innovation

Episode Date: January 7, 2020

In their annual transparency report, Kraken reported seeing a 50% increase in regulatory inquiries as compared to 2018, which CEO Jesse Powell later revealed cost the exchange more than $1m. Between this and stories like the $2m it cost Blockstack to raise $23m in an SEC compliant token sale (8.7% of the raise), it begs the question: will compliance costs fundamentally limit innovation by demanding big war chests to play? Will the most successful companies be those who (like Block One) simply raise enough to pay off the regulators on the back end?  We also look at new mining interests in Texas and what it means for Amiercan mining and bitcoin mining in the lead up to the halving more broadly, as well as dissect an op-ed from the IMF’s chief economist on the strength of the dollar over digital alternatives.

Welcome back to The Breakdown, an everyday analysis breaking down the most important stories in Bitcoin, crypto, and beyond, with your host, NLW. The Breakdown is distributed by CoinDesk. Welcome back to the Breakdown. It is Tuesday, January 7th, and today we're going to be talking about the cost of compliance and what it means that there are pathways now for crypto projects and crypto-related organizations to. do well by the regulations of the jurisdictions they participate in, but at a certain significant cost. What's that going to do to the crypto economies? Second, we're going to talk about mining and the recent actions that are interesting in the context of the having coming up. And third, and finally, we're going to be looking at an op-ed from the IMF's chief economist on

digital currencies. So first, let's dive into this question of of the cost of compliance. So Cracken released its annual transparency report. The long and the short of it is, is that the cost of compliance is increasing. So let's look at some of these statistics. Cracken, the banner statistic was that Cracken received almost 50% more law enforcement inquiries

from global regulators as compared to 2018. So they received 710 requests in 2019 as compared to 475 in 2018. That's almost two per day, and almost three per day if you take out the weekends. Of that, 61% came from America. That's down as a total percentage. Last year, 66% came from America. So other jurisdictions are growing as well.

The folks that had the greatest number of requests included the FBI with 116, the DEA with 73, the Homeland Security with 65, and the SEC made 20 requests. So still, again, a lot about law enforcement. Now, importantly, in tweet exchanges with Preston Byrne, who had written an essay about this, or more an essay about just what to do if your company is subpoenaed or is targeted with legal action, Jesse Powell, the CEO of Cracken, said that the cost to service the 2019 request was actually over a million dollars. This is a substantial cost.

A lot of folks reacted kind of with depression to this news. So Eric Voorhees, who's the CEO of Shapeshift, wrote, Cracken has to deal with two formal surveillance requests per day. This is so sad that the productive industry is being diverted like this. It makes a poorer world. The government is spending Cracken's money to do police work. So obviously a very libertarian take, which is authentic to Eric, but still, I think that a lot of folks feel like this is a huge burden as well.

The challenge here is that maybe this is just the cost of doing business in the crypto industry, but if it is, it has really big implications. So the thing that it made me think of was in July of last year, Blockstack made news when it hosted or held the first officially SEC qualified reg A plus exempt token offering. And it was heralded as a major moment in the industry, right? It showed that there was a path to work with the SEC in the context of the constraints that were already set up to actually access U.S. public markets, which is a powerful thing. There's huge opportunity. And so for a company like Blockstack, it says, hey, we can do this. And if you

participate with us, you're fully compliant. For the SEC, it says, hey, look, here's a path to compliance. However, there's a catch to all this. And so this is a tweet from Kerman Kohli, who says, this is great to see, but isn't practical for most startups. Blockstack had to spend close to $2 million on lawyers and accountants. Maybe it makes it easier for future startups, but this still means you need to raise a bunch of VC money to get crypto money, which screws token distribution. So the point here in that he's raising is that this cost of compliance actually has a deterministic impact on the range of available experimentation because you simply cannot go through this funnel without doing fundraising and capital formation in the same old way that you did before, right?

You have to sell either pre-mines or equity in some centralized entity in order to even get to the point where you can sell tokens, which the whole idea of that was to, in some ways, break apart and separate the distinction between a network's owner and a network participant. If all of a sudden you have to have network owners simply to pay for the cost of compliance, Well, all of a sudden, the cost of compliance, even if theoretically it makes viable the ability for these crypto projects to function within the existing legal apparatus, effectively it means they can't actually change an experiment within that structure particularly because of the

constraints of capital formation. So this is a cost of compliance that is not just in terms of the $2 million it's spent to actually make this all work, but in terms of the limitation and the fundamental limitation of the experimentation inherent in this industry. So this is one big cost of compliance. Blockstack came up again in a tweet from Larry Sermak when the news broke around Block 1, which is the company behind EOS, their settlement with the SEC. So Larry Sermak from the block says, this is October 1st of last year, or just after the news had broken. If I was Blockstack, I'd feel like shit right now. Blockstack raised 23 million in a compliant utility token offering.

They spent $2 million to comply with all the regulations, which is 8.7% of the total raise. They also can't list their tokens on cryptocurrency exchanges, meaning no liquidity. Eos, on the other hand, didn't ask anyone for approval, skirted all regulations, imaginable, and ended up allegedly raising more than $4 billion. The SEC slapped them on the wrist and they paid a $24 million fine. That's 0.6% of the total raise and they are listed everywhere. Eos has a huge advantage over block stack in nearly every way. The SEC's fine yesterday sets a horrible precedent.

Why would anyone do what BlockSack did, struggle for cash and get no liquidity if they can go for a mega raise, advertise on Times Square, and get away with it? To demonstrate how ridiculous the $24 million fine is, EOS issuer paid $6 million more for a website this year. The SEC's fine was a smaller sting to them than buying voice.com. This is another aspect, I guess, of this cost of compliance, which is that, like every other old world system, there's an argument to simply raising so much that you can fight legal. battles on the other side, right? The cost of compliance actually creates incentives in some ways to not comply so aggressively that you can deal with the cost of compliance on the backside as a fine. And Larry points out just what a big deal this is. Zero.6% of your raise, which was the fine that Eos had to pay, versus 8.7% of your raise, which is the cost that Blockstack had to pay to wait

around to have a more constrained set of opportunities. Now, of course, there are other things, other benefits that you get with compliance theoretically, but it makes it really difficult. I think that the point in why this Cracken story is interesting is not just about Crackin itself. I think that there is inevitability around the cost of compliance increasing for anything touching cryptocurrencies, anything touching digital assets, because we're moving from an era where cryptos to regulators were a pesky law enforcement problem to something that in the wake of Libra and Central Bank digital currencies and IMF chief economist articles like we're reading, governments are paying attention and not just governments in general,

but specific bodies within governments. And as we've seen over and over again in the US, every government body thinks that cryptocurrencies are somehow under their jurisdiction, right? The CFTC thinks their commodities, the SEC thinks their securities, the IRS thinks their property, and so on and so forth. So this is a reality of the crypto-war. world, that the cost of compliance is just going to go up and up and up and up. Two big negative externalities that I can think of. One is that a real fundamental limitation of the Overton window for experimentation, I guess you could say. And second, a real incentive to leave the most regulated places and just play the regulatory arbitrage game, which while not new for crypto, I think

as a net loss for the jurisdictions that don't find ways for companies to be there. and comply without overly burdensome rules. So to me, this crack in story is much more about a reflection of, I think, a larger trend and a new set or a growing set at costs, at least, that this whole industry faces that will have serious implications for where things happen and how. With that, actually, let's get to another question about where things happen and how and talk about Bitcoin mining in Texas. So in October of last year, a story went up about Bitmain and Rockdale, Texas. So the story was on Coin Desk, and it was called Why Bitmain is building the world's largest Bitcoin mine in rural Texas.

So basically, Bitmain has chosen old Alcoa aluminum smelting plant in Rockdale, Texas for a new Bitcoin mine. The initial power size is supposed to be 25 megawatts, which will quickly be expanded to 50 megawatts and potentially then 300 megawatts. And this brought up a huge amount of attention to mining coming back to the US and the idea of mining being back in the US and also just mining heating up again, particularly in the lead-up to the Bitcoin happening, which happens in the first half of this year. The story is amazing. It goes through a lot of just why Texas has become an interesting destination for Bitcoin mining in terms of the low cost of energy, in terms of how most of it is kept in state, in terms of the availability of space.

It goes into why locals are skeptical, right? A lot of the folks who are in this town of just under 6,000 lost their jobs about a decade ago when this smelting plant went out of business and that most of them don't understand Bitcoin. There's a fascinating larger context, I think, in terms of the globalization of the world and how this company that's based outside the U.S. is coming to the U.S. to Texas specifically for Bitcoin mining. And this story was made even more interesting today by news that in that very same town, there will be new customers at a massive Bitcoin mine.

So SBI Holdings and GMO, Japanese corporate giants, are going to be renting mining capacity at a Rockdale, Texas facility that was recently put into construction by Weinstone. This facility, when it will be up and running, will be the biggest Bitcoin mine in the world, which will start at 300 megawatts and expand to one gigawatt. by the end of 2020. So you have two of the biggest Bitcoin mines in the world, both setting up shop in this same little town in Texas. There's a couple of things that I wanted to say about this. One, I think it's interesting in the standpoint of there is going to be an ongoing conversation about what the impact of the having will be on Bitcoin's price, on Bitcoin mining, and seeing

more of this activity kick up and spin up in the lead-up to that is interesting. Now, these companies are pretty resolute that they're not looking at crypto prices in the context of, you know, months at a time. They're looking at years at a time. However, you still are seeing this energy and attention and focus come back to this section of the industry in a major way. So that's interesting. A second, I think, is a narrative that I'm seeing spin up around U.S. base mining. And, you know, one of the big questions with Bitcoin mining, obviously, is the energy consumption. If you look at Nick Carter's original Bitcoin Fudd dice, energy consumption was one of the key or one of the first sides of that dive. It's a standard thing that has been thrown around forever.

One of the narratives that I see starting to emerge this year, which was theoretical last year, or people were arguing about it theoretically last year, is this idea of Bitcoin capturing energy that might otherwise be lost. I think that's something to watch for this year. If you're interested in hearing more about that, I touch on it with my end-of-year podcast with Marty Bent. The reason that I wanted to focus on this today is just almost to flag for you a narrative watch around Bitcoin mining in the lead-up to the happening and specifically Bitcoin mining in the U.S. But with that, let's move on to our third and final topic for the day. So earlier this morning, an op-ed popped up on the Financial Times website. It was called

digital currencies will not displace the dominant dollar. Proposals of a synthetic hegemonic alternative face steep obstacles. It was written by Gita Gopanath, who is the chief economist for the IMF. And before you say, well, of course, I roll the IMF thinks that the dollar is going to beat out digital currencies, the reason that it's interesting to note, I think, is in the larger context of the conversation that is going to be, I think, center stage in major economic circles, not just crypto this year, about digital currencies, digital alternatives to traditional fiats, corporate alternative traditional fiats. And in a lot of ways, this article was less a critique of Bitcoin per se. I mean, this is like much of this level of discourse, not even really addressing

the potentiality of something that is a independent decentralized network-based model like Bitcoin to challenge centralized models. But it's more about the response that the governments have had to Libra. And in particular, it looks at a proposal from Mark Carney, who's a Bank of England governor, around a synthetic hegemonic currency. So each year in Jackson Hole, the Kansas City Fed hosts a meeting of big thinkers, you know, basically Davos, but for just money. And at that, the Bank of England Governor Mark Carney said that they should maybe question whether the dollar was really serving the world as a global reserve currency, and instead they should look to a synthetic hegemonic currency. Digital basket of reserve currencies effectively, but made by central

banks. So in some ways, Mark Carney looked over at what Lieber was doing and said, hey, that basket of reserve currency's model is really interesting, but it shouldn't be you, Facebook doing it. It should be us, the central banks of the world, creating this synthetic hegemonic currency. There were a lot of things that were interesting about this. The first of which was just, I think, in terms of the fact that all of a sudden there was an openness at the very highest level. levels to talk about the role of the dollar in the world, which I think is new, at least in mainstream circles. The fact that a Bank of England governor was proposing this alternative to the U.S. dollar has to be worrying to the U.S.'s role. The other interesting part about it was just

that in some ways, Carney was riffing on Libra's central design conceit around this basket of currencies. And other folks like Raoul Paul have pointed out how to them that was, in fact, the most interesting feature was the replacement of a single currency with a basket of currencies. The point of this article is basically that when it comes to global reserve status, the most important part of a currency isn't the features, but the institutions. And so she says, advances in payment technologies do not address fundamental issues of what it takes to be a global reserve currency. Consider the euro, which has been the leading contender to replace the dollar over the past 20 years. Its impact on the dollar's dominant

has been modest at best owing to financial fragmentation, inadequate fiscal risk sharing, and slow progress on the euro area's governance framework. Uncertainty about the long-term stability of the Eurozone does not help. It is difficult to imagine how technology would address these issues. The dollar status is bolstered by the institution's rule of law and credible investor protection that the U.S. is seen as providing. Simply raising the supply of an alternative currency will not be enough to surmount these considerations. Chinese efforts to internationalize the Remenby have met only limited success to spite his policy push and liquidity support through bilateral swaps with more than 30 central banks.

So the point is that, again, for her, it's not about the features of a technology. It's about the underlying institutions. And more specifically, it's about the trust and faith and the social stability in some ways. And I think that one of the really interesting comments, so I tweeted this out this morning, and John Riley wrote, it's a fair assessment, but misses the fact that the biggest innovations coming from Bitcoin aren't technical at all. And I think that that's a really fascinating point that is maybe missed in these discussions of what are the new features or how does it reduce cross-border payments or what's the, you know,

transactions per second or whatever, which is the question of the social momentum behind a currency and what it takes to actually get people bought in. So I wanted to present this op-ed more as just one more bit of evidence in a conversation that I think is going to be one of the most important, certainly this year, but obviously in terms of implications in a much bigger way throughout the coming decade and even longer. We are facing questions that we have never faced in a real way at all levels of policy, government, business around the future of money and the future of currency. And this world that Bitcoin and Satoshi have unleashed is now reaching the very, very highest echelons. And that's pretty fascinating. Check out the op-ed. I'll link to it when I share this

article. I'm interested to see what you think. But for now, guys, thanks for hanging out. Thanks for listening. And I will catch you tomorrow.