The Breakdown - The CFTC Sues Binance, but Is It Regulatory Turf War?

Episode Date: March 29, 2023

The Commodity Futures Trading Commission (CFTC) filed a lawsuit against Binance on Monday, alleging seven different charges related to derivatives exchange registration. In this episode, NLW explores the charges and to what extent they reflect not only a case against Binance but an ongoing regulatory turf war between the CFTC and the Securities and Exchange Commission.  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   “The Breakdown” is written, produced and narrated by Nathaniel Whittemore aka NLW, with editing by Michele Musso 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 “Foothill Blvd” by Sam Barsh. Image credit: Antonio Masiello/Getty Images, modified by CoinDesk.  Join the discussion at discord.gg/VrKRrfKCz8.  

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It's a daily podcast on macro, Bitcoin, and the big picture power shifts remaking our world. The breakdown is produced and distributed by CoinDes. What's going on, guys? It is Tuesday, March 28th, and today we're talking about the CFTC's lawsuit against finance. Before we dive into that, 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, it was another day in crypto time that would be a week in any other industry. So there are three things that I'm thinking about right now. The first is the CFTC

case against finance. News of that dropped right after I finished recording yesterday's show. I did a rapid reaction video on the YouTube, but I want to dig into that in much more detail here. The second is news this morning that SBF has had yet another charge added to his tab, and this time it's bribing a Chinese official. The third thing is a little bit more nebulous, but is the background noise of the looming restrict act in the U.S. Today is going to focus primarily on Binance, but I'll try at the end to wrap up why these other two feel like they fit together, at least orthoginally. All right, so as I mentioned, yesterday the CFTC dropped a lawsuit against Binance, and what we're going to do is go over the background in context, what the charges actually were and were not, what the proposed penalties are, and why it might not have been entirely about Binance per se.

So, first, the background, like basically every other crypto exchange, Binance has been in constant conversations with U.S. regulators for some time. Especially for the past few months, however, there has been pretty rampant speculation around what the nature of those conversations might be. In December of last year, just about a month after FTX collapsed, Reuters ran an exclusive saying that the Department of Justice was split around whether to bring criminal charges against Binance. According to the piece, the DOJ's investigations of the company began in 2018. They were focused on Binance's compliance with AML rules and sanctions, and specifically

they were looking into unlicensed money transmission, money laundering conspiracy, and criminal sanctions violations. Reuters reporting suggested that some of the federal prosecutors involved believed that there was enough evidence to file criminal charges against the firm and founder CZ, but others didn't think so. What's more, Reuters also suggested that there were active discussions around potential plea deals. So this was December, obviously coming a month after FTX, had everyone's gums flapping. Then in February, the Wall Street Journal published a piece where Binance chief strategy officer Patrick Hillman told the paper that Binance was expecting to pay monetary penalties to settle ongoing investigations. Hillman basically said that while the

company had strong compliance for the past few years, early in its life there had been gaps that they expected to have regulators want to redress. The company is, quote, working with regulators to figure out what are the remediation we have to go through now to make amends for that. End quote. Hillman said that the outcome would, quote, likely be a fine, could be more, we just don't know. That's for regulators to decide. And while Hillman said he couldn't estimate the size of the fines, or when it might be resolved, he said that the exchange was, quote, highly confident and feeling really good about where those discussions are going. Now, this was frankly, a pretty weird piece to have a story around. It was a very in-between sort of story, right?

There wasn't anything resolved. It was just one member of a negotiating party saying that things were going well. Regulators, as you might guess, tend not to like it when one of the parties they're negotiating with gives the press information, which led some to speculate that Binance saw it as necessary at the time to counteract these other narratives in the press that might be suggesting that criminal charges were forthcoming. Anyway, all of that brings us up to yesterday. The CFTC dropped their lawsuit in the morning, and by all accounts, Binance didn't know it was coming. So let's talk about the charges first. The CFTC is alleging seven counts of breaching the rules around offering derivatives products in the U.S. The allegations paint a picture of continued

and purposeful evasion of derivatives rules during Binance's growth period from a new startup to the largest crypto exchange in the world. Up until late 2020, the CFTC claims that Binance conducted their business with the deliberate intention of allowing U.S. customers to access the offshore exchange through a series of rudimentary loopholes and lax compliance process. So again, the thing to note here is that the focus is really on this early period of the company's life between 2017 and 2020. In a press statement, CFTC chairman Rosten Benham said, quote, for years, Binance knew they were violating CFTC rules, working actively to both keep the money flowing and avoid compliance. It should be a warning to anyone in the digital asset

world that the CFTC will not tolerate willful avoidance of U.S. law. The CFTC's Enforcement Division chief counsel, Gretchen Lowe, added, quote, defendants' alleged willful evasion of U.S. law is at the core of the commission's complaint against Binance. The defendant's own emails and chats reflect that Binance's compliance efforts have been a sham, and Binance deliberately chose over and over to place profits over following the law. Now, this idea that many of these charges are based on proprietary company communications, i.e. emails and chats is something that we'll get into a little bit more later. Overall, the sprawling 74-page lawsuit covers a huge range of violations that sum up really though, in two key ideas. The first that Binance was offering derivatives trading to U.S.

customers, and second, that once Binance decided to begin denying access to U.S. customers via KYC processes, they knowingly allowed and encouraged U.S. customers to circumvent those controls. The complaint, for example, alleges that Binance offered materials across their website containing guides to use a VPN to make it appear that customers were not logging in from the U.S. Some large customers, known as VIPs, were allegedly asked to submit a second set of KYC documents to obfuscate the fact that they were U.S. residents. There were even examples listed where VIPs would be pointed towards using a VPN with a wink and a nudge. The lawsuit quotes internal Binance documents as instructing customer service personnel to, quote,

inform the user that the reason why he slash she can't use Binance.com is because his slash her IP address is detected as a USIP. If user doesn't get the hint, indicate that IP is the sole reason why he slash she can't use.com. Samuel Lim, who was Binance's first chief compliance officer serving from April 2018 to January 2020, explain the policy further in notes alongside. We cannot teach users how to circumvent the controls, he wrote. If they figure it out on their own, it's fine. Now, the lack of compliance section is punctuated by references to organized crime and terrorist financing. The CFTC alleges that in February 2019, Lim received information regarding Hamas transactions. Lim explained to colleagues

that terrorists usually send small sums as, quote, large sums constitute money laundering. The colleague responded that you can, quote, barely buy an AK-47 with 600 bucks. There were also allegations that Binance allowed customers related to dark web markets to use the exchange and had informed customers to be more careful rather than off-boarding them. In February 2020, Lim acknowledged the obviousness of the issue, saying, like, come on, they're here for crime. Binance's money laundering reporting officer responded, we see the bad, but we close two eyes. While Binance claims extensively to have tightened up its compliance, the CFTC noted that, quote, as of at least May 2022, Binance had not filed a single suspicious activity report in the U.S.,

despite having filed such reports in other jurisdictions. Now, it's worth hanging here for just a moment as it makes a key point. These are not, although they look very bad, criminal complaints. They are civil complaints about compliance. The example of Hamas is being used to reinforce how lax controls were, not to accuse Binance of willfully aiding and abetting terrorists per se. Still, this hasn't stopped some within the crypto community from taking issue with this. Metamask's Taylor Monaghan says,

are we going to talk about the fact that Binance seems totally fine, helping actual thieves and actual violent extremists, and actual authoritarian regimes launder money through their centralized platform? Or just that they stupidly put it in writing? Now, lots of people jump to defend Binance at this. And she responded again, FYI, guys, the biggest threat to the future of this industry is not the bumbling idiots at every U.S. bureaucracy. It's the fact that criminals scams, steal, and harm, and people in this industry, and this industry not only tolerate it, but ardently defend their right to do so. Continuing on through the charges, and this set really bummed some people out in the space,

the CFTC claims that Binance operated multiple trading entities to make markets on the exchange, which of course is not necessarily a problem if proper anti-manipulation and anti-fraud controls are in place. Marketmakers are a key part of liquidity on any trading platform, and certainly in the case when there's highly illiquid assets like some small coins are. However, the CFTC alleges that no such controls were in place, giving the appearance that Binance was trading against their customers, and attempting to keep the existence of these internal market makers a secret. The lawsuit refers to two main entities.

Merit Peak, which acted as an over-the-counter market maker to deal directly with large block trades, and Sigma Chain that was involved in market-making the live order book, ensuring that the exchange was highly liquid. The CFTC also alleges that more than 300 in-house accounts indirectly controlled by CZ were used to trade on the exchange. And like I said, these were accusations that a lot of people took notice of. While there was always scrutiny and questions around whether Alameda Research was using FtX data to trade against FtX customers, many had hoped that Binance would be different.

Fat Man Terra, who is one of the most prominent lunacritics, said, Very Dark Day for Crypto. You can call it naivety, but I've long considered CZ to be an upstanding and trustworthy ambassador of the space. Learning that Binance had secret in-house trading accounts and access to proprietary client data is disheartening and jarring. Now, CZ, for his part, felt strongly enough about this point to pen a response. In his blog post following the lawsuit, CZ wrote,

Binance.com does not trade for profit or manipulate the market under any circumstances. Binance trades in a number of situations. Our revenues are in crypto. We do need to convert them from time to time to cover expenses in fiat or other cryptocurrencies. We have affiliates that provide liquidity for less liquid pairs. These affiliates are monitored specifically not to have large profits. Personally, I have two accounts on Binance. Personally, I have two accounts at Binance. One for Binance card, one for my crypto holdings. I eat our own dog food and store my crypto on Binance.com. I also need to convert crypto from time to time to pay for my personal expenses or for the card. Binance.com has a 90-day no trading rule for employees, meaning you are not allowed

to sell a coin within 90 days of your most recent buyer vice versa. This is to prevent any employee from actively trading. We also prohibit our employees from trading in futures. Further, we have strict policies for anyone with access to private information, such as details of listings, launch pad, etc. They are not allowed to buy or sell those coins. I observe these policies myself strictly. So that's what CZ said, but still not everyone is reassured. Cryptotrater Wolf writes, So Binance is being sued by the CFTC for basically having a secret in-house trading desk with 300 accounts. This states that Binance is basically trading against all of their users with their quant desk using private transactional data. It seems they also sold it to Merit Peak and Sigma

Chain. TLDR, Binance has an insider trading desk with data to all of your stops and have been trading against you for years. All of the centralized exchanges are basically the same. You give up your custody and data to be traded against. There's so many people in this thread who are like, who cares? Every TradFi exchange does that. Duh, we all know they do this, and we all know that every centralized exchange at crypto does it too. But blockchain fixes this. Instead of just giving up, why don't you learn about Defy? Decentralized exchanges put everyone on the same playing field. Honestly, if you don't want better for yourself or the industry, why are you even involved with cryptocurrency?

Blockchain technology was created to build trustless systems and upgrade the current, broken, corrupt, overpowered financial systems. Now again, at this point, it might be relevant to talk about what's not included in these charges in more detail, which is accusations of criminality. That stands in stark contrast, for example, to allegations against SBF and Alameda, where customer funds were basically used as a source of infinite credit. Bloomberg's Matt Levine actually did a pretty great summary taking a step back from all of it. He writes, a decent rule of thumb is that all cryptocurrency exchanges are doing crimes, and if you're lucky, your exchange is doing only process crimes. Today, the US CFTC sued Binance for letting Americans trade crypto derivatives. There are no

accusations that Binance is stealing customer money or even taking big risks with it, which makes finance look better than some other crypto exchanges I could name. Now, what Matt hones in on this piece is that pretty central to the CFTC's complaint isn't even really accusations about Binance letting individual retail users in the U.S. trade derivatives without getting a license. Instead, it seems to be really focused on particular large trading firms. Indeed, by far the most substantive allegation and the one that appears to have been the main focus of the CFTC is that Binance knowingly allowed U.S.-based trading firms to onboard with the exchange via offshore subsidiaries to avoid being classified as U.S. customers. In 2020, a Chicago-based trading firm

was a top-five client and made up 12% of the exchange's volume. When the firm was picked up in Binance's IP location checks, CZ allegedly directed an employee to, quote, give them a heads up to ensure they don't connect from a U.S. IP. Don't leave anything in writing. They have non-U.S. entities. Let's also make sure we don't hit the biggest market makers with that email first. Email referred to the notification that U.S. customers would be off-boarded. Three trading firms are listed as case studies in the complaint, with each experiencing some form of switching to offshore KIC documents through an offshore entity. Now, the issue isn't so much that Binance allowed U.S. firms to trade through offshore entities, which is largely the prerogative

of the firms if they want to evade U.S. restrictions. The problem is that on the allegations, Binance appeared to be entirely aware of the situation, indeed sometimes giving a gentle nudge in the direction of how to avoid being detected as a U.S. firm, and other times being so explicit as to roll over account settings like position limits onto fresh accounts. Matt Levine sums up that while other recent crypto crackdown actions are nominally about investor protection or financial stability concerns, this one seems different and even more traditional in a way. Quote, the CFTC's complaint here gestures at traditional regulatory concerns like retail customer protection and cracking down on money laundering. But it is mostly about cutting off a big international

crypto exchange from big sophisticated proprietary market-making firms in the U.S. The financial world is interconnected and everything touches the U.S. at some point. And U.S. regulators have become experts at using that fact to get jurisdiction over the whole financial world. And now they're coming for Binance. Join CoinDesk's Consensus 20203, the most important conversation in crypto and Web 3, happening April 26 through 28th in Austin, Texas. Consensus is the industry's only event bringing together all sides of crypto, web and the Metaverse.

Immerse 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 paths. Visit consensus.coindex.com or check the link in the show notes. But this brings us to another big point of this conversation. Is this entirely about Binance or is it also about the CFTC positioning itself? One of the hugely notable things about the lawsuit was that it states, extremely clearly a set of assets that the CFTC considers to be commodities, including most

notably ETH. Remember, the New York Attorney General just made an argument that ETH is a security in its lawsuit against Ku-coin, and so many are seeing the CFTC arguing that it's a commodity as a silver lining or a bright side. Still others noted that it doesn't really create precedent, it just articulates the lines of the turf war. Coinbase chief legal officer Paul Gruwell says, a security can apparently also be a commodity except when it's not, and it depends on which regulator you ask and when. If you're confused, you're not alone. Is this really the best American law has to offer? Lawyer Haley-Lennon writes, there is a lot to be said about today's news, but the battle between the SEC and the CFTC about whether tokens are securities or commodities is going to get interesting.

Another crypto lawyer, Jason Gottlieb, quote, tweeted that and said, They're Heisenberg's tokens. While they're in the box, unobserved, they exist in a superimposed state, everything all at once. securities, commodities, money. Once taken out of the box by a regulator, they're whatever that regulator regulates. Still, there is a lot of sentiment in crypto land that the timing of this suit was driven by the SEC's ratcheting up enforcement actions, and the CFTC not wanting to be seen as the junior partner as it tries to position itself in the regulatory pecking order when it comes to crypto and digital assets. In other words, assume Congress over the next few years gets its crap together and figures out regulations for the digital asset space.

One of the things to be determined is going to be which agencies have authority over what. Authority, of course, brings with it a budget, as well as prestige for the leaders of those organizations who have broader political ambition, almost without exception. So if you're the CFTC right now and you see Gary Gensler going on his rampage and sending Wells notices to Coinbase and things, even while some in Congress are saying, hey, where TF were you on FTX? You might get a little concern that, one, similar heat would be coming for you, and that, two, you were going to get left behind in the enforcement wars and look weak when Congress was

considering who should be given the keys to the building. So what do you do? Well, you go after the biggest fish out there and you go after them hard. And Binance is by far the biggest fish. Now this assessment of the situation would certainly track with what we saw. The charges weren't criminal, yes, but it was certainly not an accident that the CFTC dropped every damning thing they could about connections with terrorists, etc. What's more, the proposed remediation scream tough on crime. In many ways, this would be a death sentence for Binance along the lines of the agreement that FTX execs who were facing criminal charges struck with regulators. The CFTC is asking for a total ban on Binance being involved

with derivatives and spot crypto market activity in the U.S., as well as a ban on seeking registration in the future. They're also requesting, quote, full restitution by making whole each and every customer or investor whose funds were received or utilized by them, which could literally mean reimbursing every single U.S. trader. They're also looking for full disgorgement of profits, its salaries, so basically every cent that Binance made. And what's more, because the suit is focused at CZ2 in addition to Binance, it makes him personally on the hook for these disgorgement orders. Now, all of this basically leaves Binance to go back to the negotiating table, although it's certainly going to feel a lot more bad faith than it might have been before. And for what

it's worth, one day new ma, as I mentioned, one of the things that crypto Twitter found most curious was how the CFTC got so many private chat transcriptions. People jump to some wild suggestions. For example, was it Sam trying to get lenient's by giving information on an even bigger fish? Now, an explanation that might make more sense, of course, would be that Binance had actually been in these good faith negotiations that they said they had been and had turned over the information themselves. That would certainly account for its completeness. Well, while I can't validate this for sure, a source in a position to know told me that this was indeed the case, that this information, these chat and email transcripts, came from Binance

directly as part of their efforts to comply with regulators and find an amicable settlement. So make of that what you will. All right, well, at this point, we are way too deep to get into the new Sam accusations and the Restrict Act thing. But the preview of it is a real examination of the U.S.'s super popular anti-China stance. Basically, you had Sam stirring up anti-China feelings among U.S. regulators when it comes to Binance because CZ was born in China and started the company there before, of course, racing to get out when China banned exchanges in 2017. But the then at the same time, you have Sam allegedly paying Chinese officials a $40 million bribe to unlock Alameda trading accounts. And I think it matters to examine the politics underlying

all that, because we're also right now being confronted with legislation in the Restrict Act that, while nominally focused on a TikTok ban, would actually give the U.S. government the power to ban anything that they didn't like on the internet in the name of national security. It's popular right now because screw China is just about the most bipartisan position you can have in America, but it's probably something we should examine in more detail. So I'll be looking forward to doing that in the days to come, but for now, I appreciate you listening. I hope you have a better sense of what's going on with Binance and the CFTC.

Until tomorrow, be safe and take care of each other. Peace.