The Breakdown - How to Fight Back Against Rogue Regulators

Starting point is 00:00:04 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 Sunday, February 19th, and that means it's time for Long Read Sunday. 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 Biddle.

Starting point is 00:00:37 It.ly slash breakdown pod. All right, friends, well, today we are really picking up on the theme of 2023 so far, which is, as it turns out, not just fallout from FTX, but specifically the emergence of a dramatic regulatory battle around crypto in the United States. I think many of us felt that this was inevitable coming off of the events of last year, but it is playing out in very specific ways, which I think demand specific responses. We're going to read one essay and a couple of threads today, and we start with a piece by Michael Casey from Coin Desk called Regulating Crypto by Enforcement and Stealth will set the U.S. back.

Starting point is 00:01:15 Michael writes, Call me naive, but I've always resisted the conspiracy theory that the anti-cryptostance adopted by certain U.S. regulators is meant to strangle this industry and protect the financial establishment it seeks to disrupt. I've preferred to see it as a wrong-headed but well-intended effort to protect consumers. Recent events have me wondering if something more sinister isn't afoot, and that maybe I am naive. First, all indications are that the Securities and Exchange Commission will outright prohibit companies from providing staking services to retail

Starting point is 00:01:43 customers in the U.S., products that give investors an opportunity to share in the token rewards that proof-of-stake blockchains deliver to validators. Following a hint from Coinbase CEO Brian Armstrong that such a ban was coming, news broke that in response to an SEC lawsuit, Coinbase competitor Cracken is indefinitely abandoning the staking service it offered to U.S. customers and paying a $30 million fine. Second, per observations from Castle Island Ventures General Partner Nick Carter and Blockchain Association Chief Policy Officer Jake Trevinsky, and evident in other signs such as Binance's problems with U.S. dollar bank transactions,

Starting point is 00:02:16 it seems regulators are pushing U.S. banks to stop servicing crypto companies. These latest moves will make it even harder for average U.S. citizens to participate in this industry, limiting it to large institutional investors, while various innovative startups look to disrupt those same rent-seeking intermediaries will struggle to access liquidity. It's hard to understand how these actions serve to protect consumers or further other policy objectives such as expanding financial inclusion. It feels as if government agents are deliberately trying to force this industry into the hands of Wall Street Fat Cats. But here's the thing. Making it hard for Americans to invest in and build crypto projects

Starting point is 00:02:50 won't stop people outside of the U.S. from doing so. Hardline actions here will just push activity overseas. And while the U.S. might continue to generate business in institutional crypto, it will miss out on the true innovations occurring at grassroots levels. Staking ban, question mark? To be fair, SEC Chair Gary Gensler has been warning for some time that staking services could constitute unregistered securities, which would mean that exchanges such as Coinbase could be barred from listing them. The argument hinges on the income-like earning that validators of proof-of-stake blockchains earn

Starting point is 00:03:20 in the form of new tokens and transaction fees when they lock up pre-existing tokens, putting them at stake in a mechanism intended to keep them honest. It could be argued that the promise of fresh token income meets one part of the all-important Howie test, which posits that for an investment instrument to be a security, the investor needs to have an expectation of return. And from the complaint against Cracken, it appears that the exchange's role as an intermediary managing the pool of stake token investment means that, in the SEC's eyes, it tripped up another Howey prerequisite, that the expected returns are, quote, derived from the efforts of others. Fine, in a letter of the law sense,

Starting point is 00:03:51 the SEC's backlash against staking may have some standing. But why do this now, and in such a brutal way shutting down a well-functioning program in the U.S. without offering the company to get its program into an SEC compliance structure. In a statement explaining her loan descent on this action, SEC Commissioner Hester Purse argued that the core problem is the overall inaction around creating a workable regulatory framework for crypto assets. She writes, whether one agrees with the commission's crack-in analysis or not, the more fundamental question is whether SEC registration would have been possible. In the current climate, crypto-related offerings are not making it through the SEC's registration pipeline. An offering like the staking service at issue here raises

Starting point is 00:04:27 a host of complicated questions, including whether the staking program as a whole would be registered, or whether each token staking program would be separately registered, and what the important disclosures would be and what the accounting implications would be for Cracken. End quote. The timing here may be related to Ethereum's development. It is less than six months since the second largest blockchain successfully migrated from proof of work to proof of stake, and what became known as the merge, and comes just before the blockchain launches its Shanghai upgrade, which will allow holders of locked ether tokens to unlock them. The action also comes just one month after the CFTC declared ether to be a commodity,

Starting point is 00:04:59 i.e. not a security, which suggests there may be a little turf war here. Determining the policy treatment of Ethereum is a key marker in the race to establish a regulatory standard for blockchains. More importantly, what is the greater purpose here? Security's laws exist to protect small investors, specifically unaccredited investors of lower income and wealth, who are deemed to be less sophisticated and more vulnerable to abuse by the founder of an investment project than wealthy. your individuals and institutions. How is it that these retail investors in Ethereum are at risk now that they have a chance to earn yield on their tokens but supposedly weren't at risk when Ethereum

Starting point is 00:05:30 was a proof of work chain with zero yield? Whatever the motive, the SEC's move raises issues around the thorny matter of centralization risks in Ethereum's validation network. Immediately after the merge, concerns grew that a small pool of corporate-run staking pools were validating the bulk of Ethereum transactions and could collude to censor transactions. If hedge funds and venture capitalists are free to stake, but small investors are not, doesn't that risk rise? A solution, my colleague Daniel Kuhn writes, might lie in decentralized alternatives to Krakken's offerings such as Lido and Rocket Pool, but given that U.S. regulators have signaled a belief that decentralized protocols aren't outside their purview,

Starting point is 00:06:03 is there not a risk that the SEC would deem these projects illegal too, and go after their founders and developers in the vein of tornado cash, the Ethereum mixer that was sanctioned last year by the U.S. Treasury Department. For now, it would seem there's nothing stopping individual investors from staking the 32 ether needed to be a validator, but not everyone has that kind of money to put away, almost $50,000 at today's prices. And let's be honest, doing this on your own is too complicated for Joe Public. Eventually, small U.S. investors might be able to gain easier staking exposure through tightly regulated exchange traded funds, but the SEC has yet to approve a Bitcoin exchange traded fund, let alone an ether ETF. Another outcome is that retail investors' priorities might shift back

Starting point is 00:06:38 to proof of work chains such as Bitcoin. But it's baffling that the SEC would want to promote that, considering it's also devising guidelines for environmental social and governance standards, and Bitcoin's carbon footprint is now massively larger than Ethereum's on account of the latter move to proof of stake. In all of this, it seems we can expect to remain baffled because the SEC rarely offers comprehensive guidance on its crypto thinking. Gensler and his defenders might counter that he has consistently warned that most, if not all, tokens, are securities. But the industry's gripe goes beyond that. It's that, other than the occasional public invitations to, quote, come in and talk to us, there's been no real effort to collaboratively develop a regulatory

Starting point is 00:07:11 framework that accommodates the unique, decentralized features of this technology. Worse, industry leaders say, the SEC practices regulation through enforcement, with the crack and suit being case in point, which leaves everyone on their toes. The practice might be a good way for the SEC to show off its bureaucratic clout, but without a clear legal framework for how things move forward and reduce the risk of such enforcement actions, it fosters uncertainty and fear. And that's antithetical to innovation and entrepreneurship. New Operation Choke Point. Meanwhile, an even more stealthy regulation by enforcement approach is playing out in banking supervision. As Nick Carter explained in its blog post, the widespread reports that U.S. banks are being instructed not to service

Starting point is 00:07:48 crypto providers, comes with no official communication from any regulator. He compared it to Operation Choke Point, a stealth campaign during the Obama administration to restrict fund flows to fringe but entirely legal services such as gun stores, marijuana dispensaries, and porn providers. The new unannounced policy was likely a factor in signature banks moved to close the international arm of Binance's account, which led the world's biggest crypto exchange by volume to announce that it was temporarily suspending U.S. dollar transfers. I got wind of the crackdown last month, when the London-based head of an Eastern European bank told me that Swift, the U.S. headquartered international bank messaging service, was telling banks it would not permit large transfers

Starting point is 00:08:23 to providers of, quote, crypto services. The bankers comment got me thinking, what defines crypto? Therein lies another problem. Banks have some discretion in how they will carry out these instructions. Do we honestly believe they will stop dealing with BNY Mellon, the world's largest custodian bank, because it now custodies Bitcoin? Would Microsoft have its bank account shut off because it works on blockchain and metaverse projects? Legislative clarity. These events underscored the crying need for U.S. regulatory clarity around cryptocurrencies, specifically in the form of new legislation from Congress. The SEC's actions against staking tokens might be technically in line with the Howey-Test precedent and with the Commission's

Starting point is 00:08:57 guiding statute, but those Depression-era laws now seem woefully out of date. And as the blockchain associations Trevinsky noted, when there is a vacuum in legal clarity, regulators tend to default to the kind of stealth operations described above. Meanwhile, other jurisdictions, big ones such as the European Union and Japan, and smaller ones such as Bermuda, are moving forward with clear rules of the road for digital assets, cryptocurrencies, and blockchains. That's going to mean that innovation and trading activity that would otherwise have occurred in the U.S. will shift offshore. Obviously, regulators in Washington, D.C. are under pressure to take action against quote-unquote crypto right now, given the high-profile

Starting point is 00:09:30 blowups of last year. But doing so in this ad hoc, seemingly capricious, counterproductive fashion will ultimately backfire. All right, so we use that as set up just to kind of make the broader point that I think if you've been listening a lot, has been made pretty clearly that the SEC has crypto in its sites, and it's one part of a larger regulatory push against crypto in general. For the rest of this show, we're going to read some threads that focus on, one, what the implications for the U.S. really are, and two, how people who care about this industry can fight back. Let's start with a thread from Nick Carter. He writes, The analogy for crypto with regard to regulation isn't the Internet, it's capital markets.

Starting point is 00:10:09 It's not imagine if the U.S. ban the Internet, but rather, imagine if the U.S. never developed a securities market. As a wealthy common-law nation, with stable property rights and no recent revolutions or civil war, the U.S. is the greatest domicile for capital markets on the planet. 25% of global GDP, but a massive 46% of global public equity capitalization. Advantages from utter dominance in finance are incalculable. Near endless demand for treasuries, the U.S. government can finance deficits almost indefinitely. endless demand for U.S. corporate-issued debt and equity structurally lower cost of capital. Strategic value with U.S. dollar sanctions. Crypto will exist regardless of what the Biden regime

Starting point is 00:10:46 thinks and wants. Their choice, onshore, more accountable, risks transparent, regulators have a seat at the table, accretive to U.S. GDP, or offshore, unaccountable, shadow banked, outside of regulatory ambit, benefits UK, HK, UAE, etc. Thriving onshore stables like USD, USD, USD, offshore regulated safe transparent global extensions of the U.S. dollar, or empower U.S. DT and other offshore issued stables, untransparent, unaccountable, unclear if are creative to U.S. interests. So just imagine life without a market for public equity, government debt, fixed income. It's not pleasant. That's how the U.S. is currently positioning itself in the crypto space. Pushing innovation offshore isn't a meme. It's happening. I think Nick is dead on to make this distinction between

Starting point is 00:11:33 internet and capital markets analogies. I think it's a hugely important one, especially when it comes to the narrative side of this battle. And speaking of the battle, Ryan Sean Adams from Bankless wrote on Valentine's Day, OK, crypto, what's the best way to fight this rogue SEC? Balaji Shrinivasan, who, by the way, just started a new podcast that you should check out, responded saying, you need a state to fight a state. U.S. states like Wyoming, Tennessee, Mississippi, Montana are passing bills in support of Dow's and mining. Meanwhile, foreign states like El Salvador, Palau, UAE, are recruiting crypto founders. Sanctuary states for innovation, inside and outside. There are 50 U.S. states in 180-plus U.N. member countries in the world. Many of them will have a different take on

Starting point is 00:12:13 crypto than D.C. or Beijing. So, write model legislation, get it passed, and build sanctuary states for technological innovation. The SEC does not regulate the world. The other part? We need to build a better financial regulator than the SEC. Free, open-source, on-chain star ratings of crypto projects, eventually adopted by U.S. states and foreign states in lieu of the SEC, which didn't catch FTC. The basic idea is to start thinking of regulators as binary classifiers. We want low false positive and low false negative rates and constant quantitative assessment of the regulator themselves. Not just everything a scam or nothing a scam. Back to NLW here. I have a feeling we're going to be hearing more about these ideas from Bologi,

Starting point is 00:12:54 which is exciting to see. Join CoinDesk's Consensus 2023. The most important conversation in crypto and Web3, happening April 26th through 28th in Austin, Texas. Consensus is the industry's only event bringing together all sides of crypto, Web3, and the Metaverse yourself in all that blockchain technology has to offer creators, builders, founders, founders, brand leaders, entrepreneurs, and more. Use code breakdown to get 15% off your pass. Visit consensus.coindex.com or check the link in the show notes. I want to closed with a longer thread by Jake Trevinsky. He's the chief policy officer at the

Starting point is 00:13:42 Blockchain Association and has over the last few years become one of the calmest, most reasoned legal voices in the crypto space. He wrote a long thread about what's happened and what we do next. Jake writes, after a streak of hostile moves by U.S. regulators with rumors of more to come, fears of a crypto crackdown have never been higher. It may be tough, but we can chart a path through it. Let's discuss the state of crypto policy, what's happening, why, and what we do next. Before we start, some comfort for the concerned. The recent flurry of activity is jarring, but it's not a surprise, and it doesn't spell doom for crypto in the USA. Far from it, we have champions in key roles across government, and our industry is strong and ready to fight.

Starting point is 00:14:27 To begin, some important scene setting, 2020 was the worst year in crypto history from a policy perspective by far. It may have been the worst year in D.C. for any industry in recent memory. The whole year was one thing crashing after another, ending with the collapse of FTX. FtX did massive damage to crypto's reputation. For many policymakers, San Bank-Pen-Fried was the name and face of crypto. His fraud burned many of them and cast doubt on the entire industry. Skeptics entered 2023 emboldened to act. We're just starting to see the fallout now. Regulators seem especially inclined towards action due to the makeup of Congress. In recent years, important government bodies like FSOC and the president's working group have said Congress,

Starting point is 00:15:06 not the agencies, must decide, crypto regulation. That hasn't happened, and now we have a divided Congress, which makes a deal on crypto legislation seem unlikely, given the ideological gap between House Republicans and Senate Democrats. In turn, the agencies are stretching their authority beyond recognition to, quote, get things done without Congress, whether the law allows it or not. With that scene setting as context for why some regulators are so active to start this year, let's cover what they're trying to do. The two most active groups worth watching right now? The banking regulators, the Fed, the FDIC and the OCC, the financial market regulators, the SEC, and

Starting point is 00:15:41 the CFTC. First, the banking regulators. Crypto supporters and skeptics both agree that last year's market turmoil didn't affect the traditional financial system. The banking regulators want to ensure it never can, no matter how harsh or extreme, the measures they decide to take. The banking regulators put out a joint statement on January 3rd, saying banks shouldn't conduct crypto-asset-related activities like issuing or holding crypto as a principle. The Fed made it official with a January 27th policy statement published as a final rule on February 7th. That's bad policy. Technology discrimination that limits consumer choice and restricts competition with zero public process. But there's no evidence to suggest that's chokepoint 2.0, a worst-case scenario in

Starting point is 00:16:21 which banks are forced to close accounts for all crypto companies. The banking regulators are focused on stopping banks from conducting crypto-related activities, stopping banks from giving dollar-based accounts to crypto-related customers is very different. Could this change? Maybe, but doubtful. Choke Point is far easier said than done. Second, the financial market regulators. The SEC has been crypto's chief antagonist for years. Its views consist of two points. Every asset with a market price is a security. Every commercial service is a securities transaction. I wish this were more of an exaggeration. The SEC's main tactic is regulation by enforcement, and it struck again last week by labeling crack in staking service of security. That's frustrating, but it doesn't change much for anyone else.

Starting point is 00:17:02 Settlements aren't the law, and every set of facts is unique. Others will fight. No matter how many enforcement actions the SEC and CFTC bring, they are bound by legal reality. Neither has the authority to comprehensively regulate crypto. Neither can obtain it through any amount of enforcement, and neither will ever have it without an act of Congress. So, what can we do to resist this current attack and advance good policy in the long term? I'll give you my top five priorities. First, we can participate in public process and make our voices heard. Regulators have to consider public comments before finalizing new rules, and well-enough written comments can delay, change, or kill a bad rulemaking proposal.

Starting point is 00:17:39 For example, last year we were all worried about the SEC's ATS rule, which still isn't final, maybe thanks to an aggressive comment campaign. Let's write a lot of sharp comments in 2023. Second, we can take the agencies to court if they fail to observe proper process, overstep their authority, or infringe constitutional rights. For example, will a court let the Fed adopt a quote-unquote final rule with no public process? Let's hold the agencies accountable to the law. Third, we can educate Congress.

Starting point is 00:18:06 Only Congress can answer major questions like how crypto should be regulated. We still have champions there, but a lot of folks are skeptical now. Let's make sure everyone on the Hill understands what crypto has to offer and what's at stake. Fourth, we can help Congress do its job. Part of that job is legislation. We can bring Congress good ideas for laws that actually work for crypto. Another part is oversight. We can explain what the agencies are doing and why it's wrong, so Congress can hold them to account. Fifth, we can litigate. Policy is made in all three

Starting point is 00:18:36 branches of government, and we've ignored the judiciary for too long. At the core of crypto is a fight for civil liberty, a fight that calls for impact litigation. Our best allies may be in the courts. Let's go find them. Back to NLW here. A great thread from Jake, I think all super on point. And I really just want to end by honing in on the this fifth point, this litigation point. This is something that I noticed all the way back to last year, that crypto companies were increasingly getting more comfortable with the idea that in the absence of comprehensive crypto legislation, we might need to actually bring things to court as a matter of course. I think based on what we're seeing at the beginning of this year,

Starting point is 00:19:14 that option is going to look more and more like one of the best, if not only, available to us in many situations. I think there's going to be many calls for alignment and coordination as we continue to fight in what appears to be a very difficult year. For now, I'll thank Jake, Bologi, Nick, Michael for their great pieces, you guys for listening, and until tomorrow, be safe and take care of each other. Peace.

The Breakdown - How to Fight Back Against Rogue Regulators

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