The Breakdown - The Integration of Crypto and TradFi

Episode Date: December 14, 2023

As the Bitcoin Spot ETF gets closer and closer, NLW covers a number of stories relating to the growing integration of crypto into the mainstream financial system. 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, December 13th, and today we are talking about the integration of crypto into the mainstream financial system. Before we dive 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. Well, friends, like I said, the theme of the day is integration, and we have a bunch of different angles that we are coming at that from, starting with a little update from ETF land. Now, the biggest thing that has shifted over the last, call it month or so, is that more and more,

it appears that the SEC is interacting positively and proactively with an eye to actually addressing their issues rather than just finding excuses to deny the raft of spot Bitcoin ETF application. To that ends, the SEC have held a series of meetings with asset managers over the past month to iron out key details in those spot Bitcoin ETF applications. The theme of earlier engagement with the regulator was ensuring full disclosure of risks, with firms responding by fleshing out their filings with a comprehensive index of Bitcoin FUD. Over the past few weeks, however, SEC meetings have turned to the pragmatic issues which come with launching the first spot crypto product in the U.S.

Grayscale, Franklin Templeton, BlackRock, and Fidelity have all met with SEC staff over the past week. While we don't know everything that was discussed at these meetings, presentation slides from the most recent BlackRock Infidelity sessions were made public. They describe in great detail the proposed creation and redemption mechanism for the ETFs. Walking SEC staff through, step by step, how these asset managers propose to gather Bitcoin from the spot market to back these novel crypto products. Behind every ETF is a network of intermediaries which gathers assets and then submits them to the ETF issuer in exchange for shares. The same process runs in reverse, when shares are redeemed for the underlying assets. This process is critical to allow market

makers to arbitrage the price of ETF shares to ensure they remain pegged to the value of the underlying assets. The way this process operates for financial assets like stocks and bonds is well established, with entire divisions of large financial institutions dedicated to the process. The current batch of Bitcoin ETFs, however, will be the first time crypto tokens are used as the underlying asset for an ETF in the U.S., so a novel creation and redemption process involving crypto firms needed to be proposed. Many of the asset managers initially proposed an in-kind mechanism, where shares would be created and redeemed using physical Bitcoin delivered to the funds custodian. The alternative, which some of the ETF applications proposed, would be a cash mechanism,

where cash would be exchanged for the ETF shares, and the spot Bitcoin transactions would be performed in-house. A big part of the difference in these mechanisms is who carries the risk. ETF creation and redemption is only available for limited hours, while the Bitcoin price can move dramatically while other markets are closed. This means that delays between initiating a creation or a redemption and the arbitrage process being cleared can create risk for intermediaries throughout the process. This risk can of course be hedged, but any delay is less than ideal. BlackRock's currently proposed model would clear within one day and assigns price risk to market makers, ensuring that it doesn't impair intermediaries within the process. Currently, though,

it looks like SEC staff will require a lot of convincing that in-kind creation and redemption will be safe and functional. In other words, we don't know whether this mechanism will be approved. All of the ETFs which include in-kind mechanisms have structured their proposal as a hybrid model, which also includes cash mechanisms. Having a cash mechanism available for the largest products could be critical. Remember, currently banking regulations make it difficult, if not impossible, for investment banks to hold crypto on their balance sheets. By allowing cash creation and redemption, some of the largest market makers would be able to participate in arbitraging the Bitcoin ETFs without requiring regulatory changes to allow them to touch physical Bitcoin. There are numerous smaller market makers

experienced in crypto arbitrage, but to get the largest players like Goldman Sachs and JPMorgan on board, a cash mechanism would need to be part of the structure. And of course, these massive institutions are important, as they have balance sheets and order of magnitude larger than participants like Jane Street and Jump Trading. CF Benchmark CEO Sui Chung said, If the SEC accepts this revised dual model of create and redeem with cash and physical, That means the liquidity that supports the ETF shares when they trade would be increased because obviously you have more potential firms as part of the process. And although trading firms like Jane Street, etc. are large and are experts, they fundamentally don't have the trillion-dollar-plus

balance sheets that large American banks have. End quote. Now, according to their slide deck presented to the SEC, BlackRock claimed this hybrid model would offer, quote, superior resistance to market manipulation. They also noted that it would increase, quote, simplicity and harmonization within the broader crypto ecosystem. BlackRock's latest meeting on Monday was their third time attending the SEC over the past three weeks. They brought six BlackRock employees along with three NASDAQ staff to discuss the mechanism in detail. Bloomberg Senior ETF analyst Eric Belcunis writes, damn, the SEC is busier than Santa's elves. BlackRock's third meeting with them yesterday is the most notable in my opinion, as everyone is waiting to see if they can convince the SEC

to allow in-kind creations in the first run of approvals. Crypto rumor mill Andrew AP Abacus writes, update, more conversations today in and around legal teams SEC and spot Bitcoin ETF applications. Without equivocation, there is an unrelenting belief that all approvals happen in January. This has been the belief since late November, SEC divisional staff work being dominated by this process and meetings. Now, overall, you might be sitting here thinking to yourself, that is a really small technical detail. And you're not wrong about this. I wanted to share it, one, because I think it's useful to actually understand a little bit more about the process of these instruments. two, because it does show where and how this is something that's more novel than just approving

another garden variety ETF that requires an actual back and forth in consideration. And three, because it's kind of reflective of the place that we are. So many of our conversations are around politicians making big, grandiose statements, which may or may not be backed by fact, which don't really have any meaningful impact on the world, other than to capture some headlines, whereas this minutia, these seemingly tiny little details, are where progress is actually being made. It also seems, to the extent that we take the SEC's engagement in all of this as a positive sign, that the SEC is apportioning significant resources to keeping these things moving,

which again is just further evidence in the column that this is now a when, not an if. 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.

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Cryptocurrency services are provided to U.S. and U.S. territory customers by Payward Ventures Inc. PVI, DBA, CRACN. Our next integration story is that ratings agency S&P Global have launched their first ever stablecoin stability assessment. The project scores across a range of factors with the aim of providing, quote, market stakeholders with transparency into the stability of various stablecoins and specific insight into their depegging risks. S&P analyzed governance, legal and regulatory framework, redeemability and liquidity, technology

and third-party dependencies, as well as track record. The first batch of stablecoins assessed included market leaders tether, USDC, and die, as well as five smaller tokens. Tether and die fared poorly, with S&P criticizing tether for its lack of transparency and die for its governance and reserve quality. USDC achieved the highest rating, but failed to reach the top rank. The main knock on Circle's token was, quote, insufficient information on asset protection, specifically the question of how assets would be protected in the event of a bankruptcy.

To be clear, S&P wasn't suggesting that reserve assets would be impaired in the event of a bankruptcy, but simply that they didn't have enough information to judge this issue. This potentially points to the problem being a lack of regulatory clarity rather than an issue with Circle's financial structure. Now, Gemini's GUSD and Paxos' USDP also achieved high ratings on par with Circle. Of the smaller stable coins, FRAX and TrueUSD achieved the lowest possible score. FRAX was dinged for their under collateralization and a lack of clarity on future asset composition, and True USD's problem, according to S&P, was that they, quote, have no information on the nature of the assets in the reserve or the creditworthiness of

institutions holding these assets. Which kind of seems like a nice way of saying that the stablecoin rumored to be linked to Justin's son is a black box. Founder of Zero Knowledge Consulting and Stablecoin expert Austin Campbell had some major issues with how S&P had designed their Stablecoin rating system. He argued in a Twitter thread that they were assigning too much weight to irrelevant issues and instead should focus on two things, asset stability and structure. Essentially, he argued that the metric should be simplified.

Campbell noted that the only things which really matter for stablecoins are quality of reserves and whether the tokens are redeemable during a crisis. So this should be made exceptionally clear in the scoring process. He pointed out that overly complicated scoring mechanisms were part of the reason that S&P had rated mortgage-backed securities as safe right up until they detonated in 2008. Still, despite a long list of suggested improvements, Campbell acknowledged that, quote, I do think S&P is moving in the right direction by proposing a clear framework and trying to rate these things. I think there are a lot of structural elements that need to be improved,

and we continue not to horizontally transfer lessons from other domains or vice versa. Imagine how banks would rate in this framework, but it's a start, and hopefully we can improve from here until we get to a point that is long-term meaningful. Now, although Tether was rated poorly by S&P, the financial industry partners involved in their day-to-day operations are apparently much less concerned. In an interview with CNBC yesterday, the CEO of Cantor Fitzgerald, Howard Lutnik, said that he was a fan of UST. He said, I'm a big fan of this stable coin called Tether. I hold their treasuries, so I keep their treasuries and they have a lot of treasuries. They're over $90 billion now, so I'm a big fan of Tether. Now, until recently, the custodian of Tether's portfolio

of treasuries was a closely guarded secret. It was disclosed by Wall Street Journal reporting in February that the New York-based firm was holding some of Tether reserves on shore. This appears to be the first public acknowledgement from management at Cantor and came as quite a shock to some. Bloomberg's Jamie Safart tweeted, feels like this should be a bigger deal? Or was I just completely out of the loop? Was it already publicly known that Cantor Fitzgerald holds at least a significant chunk of Tether's treasuries? Travis Kling noted the major implication of this public disclosure tweeting, this is not new info, but it is a reminder that Tether is in business because the U.S. government is cool with that. Tether is completely beholden to U.S. regulators. If the U.S. government ever changes its mind

for some reason, Tether would be gone the next day. Letnig even acknowledge this point later in the interview. After claiming that Bitcoin is one of the only assets which is not seizable by the U.S. government, he said, there's no one to call. If you have Tether and the Justice Department calls Tether, they freeze it because there's someone to call. There's no one to call on Bitcoin. So, Bitcoin is a weird thing, but it's only Bitcoin. With Ethereum, you can call Joe Lubin. You can call the guy and say, Hey Joe! Now, Czech-Mady put all of this in a broader context as he's so good at doing. He tweeted, Tether is the CBDC. Travis, referring to Travis Kling, is dead on. If the U.S. government can shut down Russia's reserves, hard to argue they are incapable of closing down tethers.

Most probable reality is the U.S. government just found an infinite bid for treasuries, exactly when they needed a bailout from an unsustainable fiscal situation. The developing world dollar rises as their fiat currencies collapse, where UST is objectively better than pesos, bolivars, and lira. Emerging markets essentially fund U.S. retirements, health care, military escapades, and government largesse. Ironically, this is a win-win scenario for both parties. Tether, truthers in shambles. Now, speaking of Russia, Binance's peer-to-peer trading platform has announced the end of support for the ruble as the exchange moves forward with exiting the Russian market. Rubel support will be sunset on January 31st, with customers asked to withdraw funds or transfer their

accounts to Comex, the new owner of Binance Russia. Binance divested of their Russian subsidiary in September after a string of scandals indicating that Binance was continuing to secretly deal with sanctioned Russian banks. Scrutiny surrounding the sale led Binance founder CZ to publicly clarify that he was not the owner of Comex and that the sale marked a genuine exit from Russia. At the time, Binance said that continuing operations in Russia was not compatible with their compliance strategy moving forward. Finalizing their exit from Russia is one of the first substantive moves taken by Binance and signing a settlement agreement with U.S. U.S. authorities back in November. The exchange agreed to ensure compliance with U.S. sanctions

among a range of other remedial measures. Now, back to bringing the traditional financial world into the crypto space and vice versa, Coinbase's asset management arm has launched a new service aimed at bringing traditional financial assets onto the blockchain. Called Project Diamond, the service will allow customers to trade digitally native debt instruments on the exchange's layer 2 network base. The platform has received in principle approval from regulators in Abu Dhabi and will begin operating within the region's regulatory sandbox, designed for testing novel blockchain projects. Now, unlike other real-world tokenized offerings, Project Diamond will feature fully on-chain debt instruments.

The first security has already been issued and distributed, a short-term note denominated in USCC, sent to local regulators as a demonstration. The platform will be available to registered institutional users outside of the U.S. This implies that the service will also leverage KYC features of base to create a permissioned ecosystem for trading the new category of financial assets. Sean Martinac, head of infrastructure development at Coinbase Asset Management, said, tokenization is an important first step, but the natural conclusion is a transition to digitally native assets. Instead of tokenizing off-chain assets, this digitally native debt instrument

was created and matured fully on-chain, with an automated lifecycle that takes full advantage of next-generation infrastructure. Coinbase explained their rationale for pushing the boundaries of on-chain assets, stating, today less than 0.25% of total global assets are represented on blockchain infrastructure, leaving massive efficiency gains uncaptured. Our goal is to close this gap by enabling institutional use of next-generation financial technology. Now, rounding out today one fun story, something that people have been watching for quite some time. Al-Salvador's Bitcoin bonds have taken another step closer to launch after obtaining regulatory approval. The El Salvador Digital Assets Commission has approved the bonds with an anticipated issue in state of quarter one of next year.

The National Bitcoin Office tweeted, this is just the beginning for new capital markets on Bitcoin in El Salvador. Now, the Bitcoin bonds, which have been affectionately dubbed Volcano Bonds, were first announced in November of 2021, but suffered a string of delays. Initially, they were intended to fund geothermal Bitcoin mining projects in El Salvador, but the scope has since expanded. The money raised from the bond issuance will now be used to pay down government debt and fund the construction of El Salvador's proposed Bitcoin City. The bonds will be issued with a 10-year maturity and offer a 6.5% annual interest payment to investors. The original plan was to raise $1 billion from the sale of the bonds and featured a mechanism to denominate principle in Bitcoin.

This week's reports overlooked that aspect of the bonds, so it's unclear whether that part of the plan remains in place. The bonds will be issued and traded on the Bitfinex Securities Platform, with Paulo Arduino, the CTO of Bitfinex Securities, saying, We support the government of El Salvador's commitment to the development of Bitcoin-based capital markets and are excited to be part of their economic transformation. El Salvador President I.e. Bucle tweeted, tweeted, when Volcano Bond, followed by several retweeting posts announcing the Q1 launch.

Now, relatedly, earlier this week, El Salvador announced an investment visa program, which will allow crypto nomads to reside in the country in exchange for a $1 million investment into Bitcoin or Tether. Immigration experts noted that the $1 million cost was around 10 times the cost of comparable visas offered by Caribbean nations. Still, all in all, I think Cryptomag sums up the vibe with the tweet, bonds are dead, unless they're volcano bonds. Then they're fire.

Anyways, guys, that is going to do it for today's episode. Big thank you one more time to the sponsor of today's show, Cracken. go to crackin.com and see what crypto can be. Until next time, be safe and take care of each other. Peace.