The Breakdown - The Next Big Crypto Battle

Episode Date: May 9, 2023

..it's not BRC20. (At least not yet). Nope, it's the SEC's custody rule which is yet another attempt at a de-facto crypto ban through legal wrangling. The crypto industry, however, is not having it.  Enjoying this content? SUBSCRIBE to the Podcast: https://pod.link/1438693620 Watch on YouTube: https://www.youtube.com/nathanielwhittemorecrypto Subscribeto 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 “The Breakdown” is written, produced and hosted by Nathaniel Whittemore aka NLW. Research is by Scott Hill. Editing is by Rob Mitchell and Kyle Barbour-Hoffman. Our theme music is “Countdown” by Neon Beach.

This is much more subtle and suggests, I believe, a lot of intentionality about using the limited powers that the SEC has to cause maximum damage for the crypto industry. Make no mistake that this rulemaking would function as a de facto ban on investment advisors handling crypto assets due to impossible to comply with restrictions. This is Operation Choke Point, but for advisors. Welcome back to The Breakdown with me, NLW. It's a daily podcast on Macro, Bitcoin, and the Business. big picture power shifts remaking our world. What's going on, guys? It is Tuesday, May 9th,

and today we are talking about crypto's next big battle. A quick note before we dive in. If you haven't yet, you should go check out the other breakdown network shows. There is, of course, Bitcoin Builders, which is a show all about the incredible entrepreneurial and creative energy coming into the Bitcoin space, which is at the moment, not without its controversy given the BRC 20 space and ordinals. And then there's also an AI version of the breakdown, which comes out every day as well. If you are liking those shows, I would super appreciate it if you would take the time to leave five stars or even a review, especially at the beginning showing that there are people who are listening and enjoying the shows makes a huge difference when people are deciding if they're going to try them or not.

But today, we are popping firmly back into the crypto space, and as I said, we're starting with what I see as one of the big crypto battles right now. It's something that might seem subtle, but I think could actually have a pretty dramatic impact. I am talking about a new proposed SEC crypto custody rule. And to get a sense of the significance, I'd point to this tweet from Tyrone Ross, who wrote, I really don't think folks understand how damaging this particular part of the new custody rule is for the space as a whole. No advisor in their right mind will attempt to comply with this. So what is going on? Well, a group of crypto players, including the Blockchain Association, Andrewson Horowitz and Coinbase have all filed letters calling for major revisions to the SEC's

proposed changes to custody rules. Jake Chivinsky of the Blockchain Association tweeted, In February, the SEC proposed a new investment advisor custody rule that would restrict capital formation and put U.S. investors at greater risk. Today, the blockchain association filed a comment letter explaining how the proposal both contradicts the SEC's mission and violates federal law. Miles Jennings, the General Counsel at Andresen Horowitz, wrote, On Friday, we filed a comment letter to the SEC's Safeguarding Custody rule. We did not mince words.

The proposal is another misguided and transparent attempt to wage war on crypto, and if passed, it will result in investor harm, market inefficiencies, and poor capital formation. Coinbase's chief legal officer Paul Grewell wrote, earlier this year, the SEC proposed major revisions to a rule requiring RIAs to hold client assets at qualified custodians. Today, we're adding our comments to the pile to explain where this proposal is misguided and how it can be improved. So this rulemaking was proposed in February, and it would require investment advisors to use qualified custodians for all assets, including crypto. This expands that requirement from just securities and shares of funds as it stands currently.

The SEC claimed that this change meant that, quote, investors working with advisors would receive the time-tested protections that they deserve for all their assets, including crypto assets. They also suggested that a requirement to segregate customer funds could allow custodians to protect customer assets during a bankruptcy. The problem identified at the time of the rule's proposal was that there is no current framework for crypto custodians to register as qualified custodians. The SEC declined to propose a qualification method for existing firms, which left the industry unclear whether established custodians in the industry would be recognized. The Blockchain Association's letter pointed out this issue, stating that, quote,

requirements for qualified custodians in particular would discourage digital asset native custodians from continuing to provide custodial services, which would reduce rather than increase protections for advisory clients. They noted that because the major exchanges have integrated custodians, if these investment advisors were prohibited from using these custodians, then they would also be barred from using the major exchanges. This is a move which would likely push advisors out into use of over-the-counter trading or much less well-established non-custodial exchanges. To the point about segregation of customer funds,

the blockchain association noted that this may not be sufficient to establish protection under bankruptcy, being only one factor considered by the court. Their letters suggested that the SEC rulemaking had failed to, quote, adequately account for distinctive digital asset features and would leave investors' assets more at risk. Essentially, they said that firms operating in the industry were in the best position to provide the most technologically sound protection for customer assets, and that by mandating particular custodial arrangements, the SEC could be denying investors' access to best practice custody. Marissa Tashman-Culpal Policy Council at the Blockchain Association wrote a long threat about this.

Excerpting, she wrote, The proposed rule fails to consider the unique technology, features, and functionality of digital assets. Digital assets offer revolutionary upgrades to the traditional financial system by enabling trust without the reliance upon an intermediary. No wonder why advisors want to provide digital assets. asset-related services to their investor clients. Investing in digital assets through an investment advisor who is registered with the SEC should be something that the SEC promotes rather than snuffs out. The proposed rule deviates from the SEC's obligation under the Advisors Act to take an asset-neutral

approach. This deviation is at odds with the limits of the SEC's statutory authority and their mission to protect investors. Rather than allowing for flexibility between an advisor and client to shape the scope of their relationship, the proposed rule discourages custodians and advisors from offering digital asset-related services. Given that custody is already a low-margin business, the cost to comply with the requirements imposed by the proposed rule may reduce the number of qualified custodians available to advisors. Ultimately, this will harm investors.

She also got specific about the problems. She writes, The requirements of the proposed rule stifle an advisor's ability to provide these services. At issue, possession and control requirement, indemnification requirement, written assurances requirement, segregation requirement, and expansion to apply to, quote-unquote, all assets.

First, the possession and control requirement disallows an advisor to self-custody assets, which would impede an advisor's ability to carry out their fiduciary duty to ensure their client's assets are custodied in the safest manner possible. Under the possession and control requirement, it is also unclear whether technology such as MPC technology would be allowed to be used by advisors or qualified custodians despite the increased safety and security this technology allows. participating in non-custodial activities such as staking may also not be permitted, given these activities are not administered by a central intermediary. It would also be impossible to trade assets

when the exchange itself is not a qualified custodian. These curtailments would unlawfully omit an entire class of investments from an advisor's service to clients. The proposed rule should allow for these activities. Now, when the rulemaking proposal came out in February, multiple SEC commissioners dissented. Commissioner Hester Purse wrote a long and thoughtful, disagreeing. with the proposal, starting her piece, safeguarding client assets is at the heart of investor protection. Accordingly, I had anticipated supporting a proposal to amend the custody rule, which, after 14 eventful years, deserves another update. Significant aspects of the proposed approach in its implementation timeline, however, raised such great concerns about the rules, workability,

and breadth that I cannot support today's proposal. Commissioner Perce makes much the same argument that these crypto industry participants have, that this would actually reduce the number of qualified crypto custodians. She writes, the proposal would expand the reach of the custody requirements to crypto assets while likely shrinking the ranks of qualified crypto custodians. By insisting on an asset neutral approach to custody, we could leave investors in crypto assets more vulnerable to theft and fraud, not less. She also references some specific parts of the proposal that include the idea that crypto assets are securities and says, I disagree with the main premise that most crypto assets are securities, and the sub-premise that crypto assets sold in a securities offering are

necessarily themselves securities. Such sweeping statements in a rule proposal seem designed for immediate effect, a function proposing releases should not play. These statements encourage investment advisors to back away immediately from advising their clients with respect to crypto. More generally, the sweeping just about every crypto asset as a security statements also seem to be part of a broader strategy of wishing complete jurisdiction over crypto into existence. Another commissioner, Commissioner Mark Ueda, added his own dissenting thoughts. He said the quiet part out loud, going even farther than Commissioner Perce, suggesting that the seemingly impossible to comply with rule, quote, appears to mask a policy decision to block

access to crypto as an asset class. It deviates from the commission's longstanding position of neutrality on the merits of investments. A16Z also pointed out the same issue of bad faith regulations coming from the SEC in their letter. In the rare instance, they wrote, where the Commission specifically considers the crypto markets, it is only to propose an overbroad and unworkable restriction, a blanket ban on RIA's trading crypto assets on platforms. Paul Grewell, the chief legal officer at Coinbase said, like other recent SEC actions, this proposal unnecessarily singles out crypto and makes inappropriate assumptions about custodial practices based on securities markets. Now, public comments on the proposed rulemaking are now closed, so the matter will be brought up for a vote

by the commissioners in due course. On the one hand, this is more subtle than the new. normal problems we have with the SEC. We're used to Gary Gensler coming right out and being angry at us or making videos or targeting companies with enforcement actions. This is much more subtle and suggests, I believe, a lot of intentionality about using the limited powers that the SEC has to cause maximum damage for the crypto industry. Make no mistake that this rulemaking would function as a de facto ban on investment advisors handling crypto assets due to impossible to comply with restrictions. This is Operation Chokepoint, but for advisors. It seems pretty clear that the SEC doesn't believe they have the authority to actually put forward

an overt crypto ban, so instead they're focusing on these sort of de facto bans that are much harder to challenge in courts. The playbook is clear. Take a proposal that appears reasonable at first. Of course you want people to deal with qualified custodians, right? But then wrap inside an extremely restrictive policy that can almost fly under the radar. Indeed, in this case, once you dig into the details, you find that literally zero existing firms can qualify, and that the insurance costs would make it prohibitive for anyone to even attempt it. And thus, a fairly common-sense investor protection measure becomes a de facto ban on an entire category of investments. I will, of course, keep you guys posted as this evolves. A few more before we get out of here, crypto exchange bitrex

filed for Chapter 11 bankruptcy on Monday after announcing in March that it would be winding down U.S. operations. Two weeks ago, the SEC sued Bitrix for operating an unregistered securities exchange, with the lawsuit alleging that a number of tokens, including Algorand and Dash, were unregistered securities. Bitrex announced at the time that they would thoroughly defend the lawsuit, but this bankruptcy calls into questions the firm's ability to do so. In their bankruptcy filing, Bitrex estimated that it had over 100,000 creditors with outstanding claims between $500 million and $1 billion. The liquidation plan, which was put forward with the bankruptcy proposed, quote, 100% like-kind cryptocurrency distribution, implying that the firm had sufficient assets on hand

to clear existing liabilities. Evan Hengel, the company's co-chief restructuring officer, said BitTrek's quote, faced an untenable regulatory and economic environment given the lack of regulatory clarity in the U.S., which created a substantial negative economic impact on the digital asset industry, and resulted in overlapping regulatory burdens and soaring regulatory costs. Bitricks co-founder and CEO, Richie Lye, tweeted, Yes, we filed Chapter 11. Yes, we still have 100% of customer funds. Yes, there will be a claims process through the bankruptcy courts. this was the cleanest way to bury the baby, RIPP. The firm also said that the bankruptcy will not

affect BitTREX Global, which continues to service customers outside of the U.S. as normal. Now, for many in the crypto industry, it was pretty clear where to lay the blame. Crypto lawyer Mike Selegg says BitTrek's filing for Chapter 11 bankruptcy less than a month after the SEC filed a complaint against it is no coincidence. SEC investigations are extremely expensive to defend, and the agency knows this. Without winning a single legal argument, the SEC can win by draining the bank. Coin Bureau tweeted now that Bitrek's US has filed for bankruptcy in the U.S., which retail investors has the SEC, quote-unquote, protected. It's just going to reduce optionality for U.S. citizens

to invest in crypto. Those that really want it will be forced to use offshore exchanges, the exact companies, the SEC, has no jurisdiction to regulate. Now, there was also a lot of discussion around the idea that this might represent some type of new precedent. Simon Dixon wrote, interesting new approach, operate outside the U.S. and file Chapter 11 for the U.S. entity. They just want regulators to tell them how to compliantly return funds that may be securities in the U.S. it seems. They seem to be using Chapter 11 to figure that out. Heimdahl RWA wrote something similar. They said, quick thoughts on the BitTrex bankruptcy and why we think it's more of a regulatory exit than a pure bankruptcy play. BitTrecks, like many

crypto exchanges onshore in the U.S., has both an onshore and offshore entity, the lion's share of the business happening offshore. The offshore entities of not just BitTex, but other venues, are likely providing a larger surface area for regulatory enforcement in an environment where you are likely guilty and need to be proven innocent. In fact, Bitrex had already agreed to pay U.S. Treasury 29 million last October for violating sanctions. But then the SEC charged Bitrex a few weeks ago with operating an unregistered National Securities Exchange, clearer and broker. Inevitably, continuation of fines and actions would have led to a slippery slope invitation for other enforcement agencies to join the party. So the options for Bitrex, Inc. were likely limited.

There was the option to voluntarily shut down, which doesn't always untether you from all liabilities. But uniquely, there was also the option to file for bankruptcy, because whatever would be reorged in the future must comply with the blessings of the powers that be. So with this stroke of genius, by going into bankruptcy, not only did BitTex get to prime its focus on its offshore ops, which likely bring in the money, but it will also allow BitTex Inc, whenever and however it should reemerge, a legitimate and unencumbered past. As such, we don't believe that creditors or depositors will be taking deep haircuts, absent lawyer fees because lawyers always win, because this bankruptcy is more of a regulatory

exit than a business exit. More importantly and scarily, we think this will crystallize precedent of how to exit U.S. markets for crypto companies. The lack of a proactive regulatory framework that is unable to remove red tape for innovation has fully opened the spigot on the brain drain. So in short, people are seeing Bittrex's bankruptcy as a new model for companies to leave the U.S. Finally, speaking of international exchange things, as part of their world, tour, Coinbase executives have visited the United Arab Emirates this week to meet with local regulators and lawmakers. In a blog post on Sunday, Coinbase said, There is no doubt that UAE has the potential to be a strategic hub for Coinbase, amplifying our

efforts across the world. It further serves as a particularly strategic bridge between Asia and Europe, two of our existing focus international regions to date. End quote. Now, in addition to checking out how the UAE's regulatory scheme is going, CEO Brian Armstrong will present the keynote address at the inaugural Dubai Fintech Summit. Armstrong said the region, quote, deserves a lot of credit for being forward-thinking on crypto. He wrote, First dedicated crypto regulator in the world,

a clear rulebook published, business-friendly plus strong customer protections, really enjoying my visit so far. Now, of course, this visit comes shortly after the launch of Coinbase's offshore institutional exchange domiciled in the Bahamas. Coinbase has been in an antagonistic struggle with U.S. regulators for more than a year,

leading some to speculate they could be looking for the exits. In their blog post, Coinbase wrote, It is no secret that Coinbase is also working with Abu Dhabi global market regulators to further expand the licensing and availability for Coinbase International Exchange. We've also been engaging with Dubai's Virtual Asset Regulatory Authority, a dedicated regulator for virtual assets, as they put forward a comprehensive retail framework, built on the principles of economic sustainability and cross-border financial security.

This expands our global footprint, helping us get closer to bringing 1 billion users to crypto. In short, the region is standing out as a leader in the network. development of a Web3 ecosystem, making it an attractive location to consider investing in. The vacuum created by other notable jurisdictions means that international counterparts, such as the UAE, are racing to fill the regulatory gap. Despite this international push, Armstrong tried to assure shareholders during last week's quarterly earnings call that the firm is dedicated to remaining in the U.S. He said, let me be clear, we're 100% committed to the U.S. I founded this company

in the United States because I saw that rule of law prevails here. That's really important, and I'm actually really optimistic on the U.S. getting this right. We shall see, Brian. We shall see. Anyways, guys, that is the story from where I'm sitting. I appreciate you listening. As always, keep paying attention. There is a lot going on. Until tomorrow, be safe and take care of each other. Peace.