The Breakdown - SEC Is Reprimanded by Government Accountability Office (And It Could Lead to Lawsuits)

Episode Date: November 1, 2023

Today on The Breakdown, NLW discusses the end of SBF's testimony, some ETF updates, and the SEC being called out by the GAO. Today's Sponsor: Kraken Kraken: See what crypto can be - https://kraken.com/TheBreakdown 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 Wednesday, November 1st, and today we're talking about the SEC being reprimanded by another government body. 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. All right, friends, well, as I mentioned earlier this week, I am heading off later today, actually, for around five days, so the breakdown will be taking basically its first break ever. And so what I'm going to try to do today is get through as many of the big stories that are

floating around as possible. The most important one I think in many ways is this reprimand of the SEC by the government accountability office. But before we get to that, let's wrap up our coverage of SBF's testimony. Sam's cross-examination finished up on Tuesday with U.S. Assistant Attorney Danielle Sassoon getting specific about what Sam knew as FTX came crashing down. The questioning for the day began with an inquiry into Sam's cozy relationship with regulators and government officials in the Bahamas.

Sam continually deny knowledge of the details. This included him initially claiming to not remember inviting the Prime Minister of the Bahamas to a private dinner with Bill Clinton and Tony Blair during an FDX conference. This struck most observers as a very bizarre thing to claim to forget, And as Carly Riley from Overpriced JPEGs put it, that was a classic Sam moment that just embodies the way he answers everything, where you're pulling teeth. Even for things that are benign,

you can just admit that you invited the Prime Minister to dinner. Now, eventually Sam admitted that there had been, quote, something like a dinner with them, and Sam quibbling over whether or not there had been food. Sam was asked whether he offered to pay off the Bahamas national debt of around $11.6 billion, which he also couldn't remember. The upshot of this line of questioning was that Sam admitted that after FTX collapsed, he had offered to allow Bahamian residents to withdraw their funds in preference to other customers.

Sam's defense had addressed this point at length earlier in their case, presenting a witness who testified that Bahamian regulators had compelled some of Sam's actions after the bankruptcy. Moving on, Sassoon asked Sam what he knew about customer funds being spent by Alameda via their subsidiary North Dimension. She pinned Sam down to acknowledge clearly that, by either September or October of 2022, he was aware that customer funds had been used for venture investments and expenses. He carefully avoided using the wording that customer funds had been spent.

Sam claimed that he thought this had been permissible, but he didn't think it had been happening prior to September. He admitted that this use of customer funds for investments was not disclosed. Sassoon confirmed with Sam that he had been CEO of Alameda when North Dimension had been set up for the purposes of receiving customer deposits. Sam claimed he didn't recall giving directions to Alameda employees to hold that money for the benefit of FTX customers, nor segregate the deposits from other Alameda funds. Springing her trap, Sassouin confirmed that at the same time that he knew that

no protections were in place, Sam had made representations before Congress about the safeguarding of customers' assets. Now, establishing Sam's frame of mind when he claims to have discovered that there was an $8 billion hole in Alameda's balance sheet, Sassoon asked, you didn't call in your deputies and employees and say, who spent $8 billion? Sam said that he had only asked Carolyn Ellison, then CEO of Alameda, how it had happened. He also confirmed that no one was fired for spending $8 billion of customer funds. Moving back to June of 2022, Sassoon asked Sam about what he did after he discovered the bug in the accounting system, which he claims had caused Alameda's liabilities, to be overstated by $8 billion in the Fiat-At account. Sam testified that he was told by FtX engineering

executives Gary Wong and Nishad Singh that, quote, they were busy and I should stop asking questions. Sassoon confirmed that his, quote, supervisors told you to stop asking questions. Sam had testified that he briefly believed that Alameda could be on the verge of bankruptcy and that he had canceled a flight to Washington to deal with the problem. Sam was asked whether he remembered Adam Yadidia telling him after the bug was fixed that Alameda, still owed $8 billion. After Sam evaded answering the question numerous times, the judge snapped, demanding that Sam put an answer on the record.

Sam said he didn't remember being told on that day, but that he was eventually told. Sassoon circled back to testimony Sam had given on Monday, where he claimed that certain Alameda payments could be characterized as margin trades, specifically repaying loans to external lenders. Sam acknowledged that billions of dollars worth of venture investments in mining firm Genesis digital assets, K-5 partners, and Anthropic AI were not margin trades on FtX. Sam confirmed that he had directed most of these large dollar investments made by Alameda. Sassoon used this information to discuss the state of the Alameda balance sheet in July

after lenders had begun recalling their loans. She noted that the balance sheet included all of these illiquid investments as long-term assets. The prosecution pulled up a tweet which said that Alameda had, quote, "...returned most of our loans by now. Sam was forced to admit that it did not correctly state most of our third-party loans. Winding up her cross-examination, Sassoon sought to establish that Sam had conspired with Caroline, Gary, and Nashad to commit wire fraud and money laundering. She played a segment of the audio recording of Caroline's final all-hands meeting at Alameda

one more time for the jury. In that clip, Caroline was pressed by an employee to answer who knew about the use of customer funds. The employee said, I'm sure this wasn't just a Yolo thing, right? Caroline responded, I guess I talked about it with Sam Nishad and Gary. After numerous objections, Sassoon finally landed on a question about the conspiracy that she was allowed to ask. She questioned whether Caroline, Gary, and Nishad were the ones involved in the decisions to spend FTX customer money by Alameda. Sam said no initially, but acknowledged that each of the co-conspirators had pled guilty and cooperated with the government. To close out, Sassoon presented a document written by Sam in late December 2022 after he had been arrested and released on bail. The document

was a list of things Sam was mulling over as he stued in his parents' home. It included a substantial section on Nishad, who had not yet been charged by the DOJ. Sam noted that the complaints filed against Caroline and Gary had referred to three co-conspirators leaving Nishad out of the picture. wrote, information about a customer's account to the public or to other customers. The answer seemed to avoid the main issue of whether FTX had a duty to disclose its financial peril to customers. Sam was able to give his long and complete explanation of how repaying lenders could be

considered a margin trade. His explanation was that, quote, if that customer wanted to return a loan it had taken from someone else, and if they were permitted to borrow from FTCS in the first place, there's nothing prohibiting them for withdrawing to the negative in a particular asset from FTCS and then repaying that lender with those or other funds. Sam also addressed his poor recollection of events. He said that he had conducted over 50 interviews in the wake of the FTX collapse and couldn't recall every single statement he made to a journalist during that period. Still, maybe the most telling statement from Sam came when he was asked why he had testified that he had not spent the $8 billion in customer funds. He responded, at least in my knowledge,

I don't think it would be the case that there was a clear, simple point or decision at which a particular person or people decided to spend particular dollars. Money is fungible anyway. There are a lot of things that I don't think I would have ever been able to define in trying to answer that question if I had investigated it. Good Lord, the word salad. We'll come back to that point in just a moment. Anyways, with Sam's testimony over, the defense rested their case. The prosecution declined to present a rebuttal case, so the evidence in the trial was over. Lawyers held a charging conference with the judge to finalize the substance of jury instructions. The party settled how the law surrounding the seven charges of fraud and money laundering will be explained to the jury before they

begin their deliberations. In a promising sign for the prosecution, the judge ruled that he would instruct the jury to find Sam guilty of defrauding customers if they believe that he had misrepresented FTCS rather than strictly if he had misappropriated funds. The defense had asked for the jury to be instructed that British law governs the FTC's terms of service. The judge quickly cut down that argument, noting that I apply the law of New York. Today, both parties are expected to deliver their closing arguments, followed by jury instructions from the judge. The jury could have the case in their hands for deliberation as soon as tomorrow morning. And of course, if Sam is found guilty, he likely won't be sentenced for several months once a hearing can be scheduled.

I want to turn it over again to Carly Riley, the host of Overpriced JPEGs, to give the sum up. First, on the prosecutor Daniel Sassoon, she wrote, Sassoon is just a beast. This woman's command of the facts of the case is just amazing. It's genuinely a joy to watch. It is in such contrast to the defense who, by comparison, come across as bumbling and confused. Now, on Sam's performance, she wrote, I do think that his tone was better today than it was yesterday. He really started to become like a petulant child on the stand yesterday, and you got a little bit less of that petulancy today. I think that served him well because he seemed a little bit more likable at least. But ultimately,

she summed up, the prosecution's story is fairly simple. And Sam's story is not simple. Even as somebody who is really trying to keep track of everything, it's hard for me to really understand what Sam is saying he knew when. It really just belies belief. And in what I think is the most telling statement and reflects what I was saying yesterday, in my argument that Sam ultimately just never viewed any asset or any company that he was associated with as anything other than one big pool for him to do whatever he wanted with. Carly said, Sam made a comment today that money is fungible anyway. In some ways, that is the heart of his story, and not necessarily the one he's trying to portray in court, but I think the real heart of the story, that Sam believed that money is fungible. Of course money is fungible, and yet

$1 put in a bank account by a customer of FTX is not the same as $1 earned by FTX in profit. Those two dollars needed to be treated very differently, and they weren't. At the end of the day, a lot of people have been very hurt by his inability to prioritize not treating all of that money like it was the same. The drama man. Today's episode is brought to you by Cracken. For far too long, the whole financial system has been standing still, too slow, only on for certain hours, overly designed for some types of people, but not for others. Crypto, at its best, represents progress. It asks the question, what if? It invites people in instead of leaving them out. It's on 24-7, 365, and moves at the speed of real life.

Not everyone believes it. We've got our fair share of detractors, but that's the way it always is when you're building something new. Cracken is a crypto company that has been through the highs and lows of the industry, facing forwards towards progress throughout. And now they're inviting us to see what crypto can be. Learn more at crackin.com slash the breakdown. Disclaimer, not investment advice.

Crypto trading involves risk of loss. Cryptocurrency services are provided to U.S. and U.S. territory customers by Payward Ventures Inc., PVI, DBA, Krakken. But with that, let's put Sam aside and move to a different story. After years of playing fast and loose with administrative procedure, the SEC has been reprimanded for ignoring due process. The Government Accountability Office, or GAO, has issued a finding that the SEC should have given Congress a chance to review the notorious Staff Accounting Bulletin 121 before it was published. SAB-121 was an accounting clarification issued by the SEC in April of 2022. In essence, it said that firms were required to place custody crypto assets on their own balance sheet rather than in segregated customer accounts. Since its publication, numerous firms and commentators have noted this guidance would

dramatically decrease customer protection as crypto assets could not be made remote from bankruptcy. This guidance particularly affected banks as holding crypto assets on their own balance sheet came with prohibitive capital requirements. The SEC has fielded endless complaints from crypto-friendly and crypto-curious banks that this guidance would make it impossible for them to operate crypto-custody services. Now, importantly, the GAO was not concerned with the soundness of the policy implications, only whether the SEC followed the correct procedure. They found that it had not.

Many crypto lawyers had noted that the SEC had published this guidance as a staff bulletin, rather than going through the formal rulemaking process. They said this had allowed the agency to avoid public comment. SEC Commissioner Hester Purse had even written a scathing dissenting dissent of the time, stating that the SEC should, quote, embrace a more deliberate approach to changing rules, one that involves consulting with affected parties. She said that it represented the SEC's, quote, scattershot and inefficient approach to crypto. Now, of course, SEC Chair Gary Gensler had defended the agency's actions. He claimed that the guidance was merely a clarification of existing

accounting standards and had been crafted with the aid of, quote, significant dialogue with accounting professionals. The GAO said this was nonsense and found that the guidance had met the definition of a rule under the Administrative Procedure Act. They said the rule would need to be submitted to Congress for a review, although there is no details on how that will work or whether public comment will be received. Now, lawmakers Cynthia Lummis and Patrick Henry had asked the GAO to open an investigation into this matter in March. In response to the GAO findings, McHenry said, Congress must step in to block this harmful rule. Lummus said in a statement, Staff accounting bulletin 121 should have been an official rule issued by the SEC through the normal

process of federal rulemaking. This bulletin has massive implications, and the SEC should have received feedback on it from the federal banking regulators in the public before implementing this legally binding directive. Nathan McCauley, the CEO of Anchorage Digital Bank, said in a statement, today the GAO recognized SAB-121 for what it is, regulation under the guise of staff guidance. He said the bulletin, quote, makes it economically impossible for SEC reporting banks, some of the most trusted financial institutions worldwide, to custody digital assets at scale. the crypto legal crew was extremely vocal about how big a deal this was. Jake Chivinsky, the former chief policy officer at Blockchain Association, said,

this is huge. The GAO reviewed SAB-121, an illogical anti-crypto accounting bulletin issued by the SEC last March, and found that it's a rule under the CRA and the APA. The SEC didn't comply with either. This is a clear statement from a federal agency that the SEC broke the law. SAB-121 basically required crypto custodians to double-count digital asset liabilities on their balance sheets. It has done extraordinary damage to the crypto industry and cost untold millions in legal and consulting fees over the last 18 months. It was illegal from the start. The SEC should immediately withdraw SAB-121. If it does not, the GAO's analysis makes a slam dunk out of a lawsuit against the SEC, alleging a violation of the APA's notice and comment requirement.

Now, speaking of people being reprimanded or at least corrected, last week, a huge amount of attention was soaked up by a misleading Wall Street Journal article, which pushed the narrative that Hamas had made substantial use of crypto networks for terrorism financing. Elliptic, one of the sources in the article, had pushed back on claims that Palestinian terrorist groups had raised $93 million using crypto. They said the real figure was likely a small fraction of that amount. On Friday, after a week-long pressure campaign, the Wall Street Journal issued a correction, kind of. They now quoted the figure as up to $12 million and noted that, quote, Elliptic said it isn't clear if all the transactions it identified directly involved

P-IJ because some of the wallets belong to crypto brokers that may have also served non-PiJ clients. Critics noted that the headline and lead paragraph remained, both of which directly blamed crypto financing for enabling the attacks on Israel. Last week also saw a panel of experts give testimony in front of the Senate Banking Committee on illicit finance. Democrat senators leaned heavily into the crypto angle, but were rebuffed by the experts, who had noted elliptics correction and claimed that crypto plays a minor role compared to other payment methods. Dr. Shlomit Wagman of Kennedy University said, crypto is currently a very small part of the puzzle. The major funding channels are, were,

were, and remain state funding. Iran and others, those are the major players. She urged lawmakers to focus on traditional financial rails, fake nonprofits, and shell companies, and not, quote, lose sight of the big picture. To cap it all off, Deputy Treasury Secretary Wali Adayamo, delivered a speech on Friday covering the issue of terrorism financing. He warned the crypto industry strongly, stating that, quote, our expectation is that financial institutions and digital asset companies and others in the virtual currency ecosystem will take steps to prevent terrorists from being able to access resources. If they do not act to prevent illicit financial flows, the United States and our partners will. He said that the U.S. will use, quote, every tool available to go after crypto platforms

which facilitate the movement of funds for terrorist organizations. Now, buried beneath the headline making quotes, Adiyamo noted a small but important concession to the reality of the situation, saying, the use of crypto is not the vast majority of the way these groups are funded. We're going to prevent it from becoming the way they are funded in the future. Now, in contrast to the WSJ, Senator Elizabeth Warren has, of course, refused to issue a retraction of her letter, which gained over 100 signatures from fellow lawmakers and was sourced solely from the journal's article. Instead, she had doubled down, stating that, it's not about one report. It's about the whole structure of crypto that attracts some of the worst people around the world

to move value around in a way that they cannot do through the ordinary banking system. Nick Carter snapped back, when the one report, which you cited exclusively in your letter, issues a correction, I think you lose the right to say it's not about one report. If it wasn't about one report, you should have cited more than one report. Now, moving finally to a couple market updates. First on the ETF front, over the past week, asset managers have been preparing for the launch of their spot Bitcoin ETFs. We now have updated filings from Valkyrie and Vaneck. Van X filing suggested they plan to cede their fund directly with Bitcoin rather than in cash. Their plan followed BlackRock's indication that seeding could happen in October,

although this may have been merely wishful thinking. The Valkyry update disclosed that they expect to launch under the coveted ticker symbol BRRR. The ads will write themselves once the money printers are fired up once again. Invesco's fund joined BlackRock on the DTC website on Tuesday, listed under the much more boring ticker BTCO. The biggest news, however, came from a coin desk scoop on Tuesday. The article citing anonymous sources said that some of the largest market-making firms in the world are interested in signing on to provide liquidity for the BlackRock ETF. Jane Street, Virtue Finlaying, financial, jump trading, and Hudson River trading, were all said to have held talks with BlackRock to play a market-making role once the fund is launched. Marketmakers, of course, play a particularly crucial role for ETFs. Alongside arbitraging the order book to close spreads, market makers are

responsible for creating and redeeming ETF shares to ensure the price stays anchored to the underlying asset. James Butterfield, the head of research at coin shares, said, several market makers were pulling back and being quite cautious because there was some heavy cracking down on exchanges. But since the grayscale ruling, we've seen a very real change in stance from the SEC. Despite market enthusiasm, not everyone thinks the Bitcoin ETF approvals are a done deal. ETF commentator Dave Nadeg tweeted, I'm sure it will be much more boring than this,

but sometimes it does feel like this is all a setup for a giant Gensler's semi-cometic rugpole. Bloomberg ETF analyst James Safart responded, this thought has continually lingered in the back of my head for weeks, if not months. Would be absolutely epic on his part, though. However, Eric Balcunas, the senior Bloomberg ETF analyst, said that this move would be sadistic and trigger a wave of lawsuits. But he added that this possible outcome is also why he won't be raising his odds of a January launch above 90%. Gensler, himself known to be a gliv's self-styled comedian at times,

on Halloween wished a happy anniversary to Satoshi's Bitcoin white paper saying, any crypto companies that are tricking investors should start treating them to compliance with the securities laws. And yet, it is clear the direction the momentum is headed. One great indication of that, the Chicago Mercantile Exchange, or CME, has become the second largest Bitcoin Futures exchange after overtaking OKX and buybit in October. The CME now hosts 22% of Bitcoin futures open interest, only narrowly trailing Binance, which services roughly 25% of OI. For the CME to flip in finance and become the largest Bitcoin trading venue in the world, it would need to add just 400 million

in additional open interest, in other words, just a 12% increase. Certainly not impossible after the CME piled on a 30% jump in OI during October. Of course, it is no secret that Binance has been bleeding customers in losing market share since regulatory enforcement lawsuits were filed earlier this year. Its market share has dropped massively from over 50% since March. The rise of the CME has been pointed to as evidence of rising institutional interest in Bitcoin. The big question will be whether this renewed enthusiasm from traditional financial firms is just front-running a potential ETF launch, or a more long-lasting belief that Bitcoin is a legitimate asset to be traded by Wall Street players. Wrote Van Eck advisor Gaborbach. CME is about to flip Binance as the largest

exchange with respect to Bitcoin futures open interest. Institutions are here, and it's just getting started. Great way to wrap this episode. Like I said, I will be off for the next few days. That probably means we'll get an ETF approval during this time. So if that happens, you're welcome. In either case, I hope you have a great first weekend of November. I will see you on the flip side. Until then, be safe and take care of each other. Peace.