The Breakdown - The SEC Backs Off Another Crypto Enforcement Action

Episode Date: July 16, 2024

The SEC has dropped it's three year investigation into the Stacks ecosystem. It's a good outcome -- but at an absurd cost that simply shows how moribund and counterproductive the SEC's regulation by enforcement strategy has been. 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 Monday, July 15th, and today we are talking about the SEC backing down. 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. pod. Hello friends. Welcome back to The Breakdown. This weekend was obviously a massive one in American political history, not just in the context of this campaign, but in general. At this juncture, my plan is to

continue to cover the presidential campaign and former President Donald Trump specifically, exclusively in the context of the Bitcoin and Crypto space. That leaves no shortage of discussion to be had. And indeed, even after this assassination attempt, President Trump has confirmed that he will be keeping his appearance at the Bitcoin Conference in Nashville. That will be one of his first appearances after being confirmed as the Republican nominee on Thursday night, and will be our first chance to see how the language and the discourse of Bitcoin is fitting into what promises to be a pretty new campaign story following the shooting. Reports from Trump himself are that the attempt on his life has fundamentally changed the nomination

acceptance speech that he was going to give on Thursday. In the way that this incredible and terrible event has heightened the political stakes in just about every dimension, so too has it heightened everything that will happen around the Bitcoin Conference. It seems likely to me that throughout the week and leading up to that event, there will be more context for discussion of Bitcoin in both the Trump campaign and in the presidential election more broadly. For now, though, we are going to wish President Trump a very speedy recovery, be very grateful that the outcome of this horrific event wasn't different from what it was, and turn our particular attention today to an extremely notable event in crypto politics from the end of last week, which was the SEC dropping its

investigation into stacks. Hero Systems, formerly known as Blockstack, had been the subject of an SEC investigation for the last three years. Hero was, of course, the developer of Bitcoin Layer 2 stacks and raised $70 million from token sales between 2017 and 2019. This is the third SEC investigation that has been formally closed over the past month. Other investigations related to Consensus and Ethereum 2.0, as well as Paxos and the BUS stablecoin. We can start to connect the dots here and presume that the SEC is responding to their legal theories meeting resistance in the Binance case. A recent decision in that lawsuit found that BUSD is not a security under any circumstance and that secondary market sales of tokens are not

covered by securities law. The investigation into stacks potentially carries even more weight, as the company made a serious attempt to comply with securities regulations. A portion of STX tokens were sold under Regulation A-plus, which allows small quantities of securities to be sold to the public without registration. Additional supply was sold under Reg D and Reg S exemptions, which allow sales to accredited and international investors, respectively. In other words, Blockstack treated the tokens as if they were securities and filed the appropriate documents along the way. The SEC investigation seems to be related to a protocol redesign in January 2021, when Stacks transitioned to a proof-of-transfer consensus mechanism. Hero filed documents,

which claimed that it was no longer providing essential managerial services to the Stax blockchain and that it was no longer necessary to treat STX tokens as securities and provide public disclosures. They were effectively claiming that the blockchain had become sufficiently decentralized to no longer be covered by securities regulations. The SEC seemed to have disagreed with Hero disclosing that they had received an inquiry from the Division of Enforcement in September 2021. While we don't have all that much information yet, this news does seem to demonstrate some viable pathway from ICO to sufficient decentralization while sticking to regulations. Stax was one of the few ICOs to take this route before token projects

just decided to avoid the U.S. jurisdiction entirely. The SEC doesn't provide extensive comments after an investigation is closed, so we don't know for sure exactly how they made their decision. Still, this seems to validate the idea that regulatory compliance is possible. The other side of that point, however, is that regulatory compliance was anything but smooth for Stacks. They filed all the right paperwork and the token still came under investigation. Munib, the co-creator of Stacks, said, we're pleased that the SEC dropped the investigation after this time and effort. This is the best outcome a company in our industry could ask for, but the U.S. can do better. We need a regulatory system that meets builders of innovative open protocols where they are.

We'll continue working with policymakers and developers to help make this happen. The closing of the Stacks investigation gives us hope for a bright future for decentralized technologies for Bitcoin and the next generation internet. Tommy Sondi, the founder of Delphi Ventures, commented on how unnecessary all of the legal work ended up being, tweeting, zooming out in aggregate, I always wonder how much more innovative we would have. Projects spent their SEC defense time and money on innovation instead. It's a shame, glad the tides are turning. Julie Fredericksson put an even finer point on this sentiment. She wrote, The energy time and money that regulated and compliant crypto companies have had wasted by the SEC as criminal.

Stax was the project that, quote, came in and registered, and their reward was a three-year investigation? Is this really how we want to treat emerging industries? Still, by and large, people are enthusiastic. Coinbase Chief Legal Officer Paul Grewell writes, Let's hope that what is plainly a retreat signals the SEC is ready to start acting in good faith and actually working with the industry it claims to engage, rather than just handing out Wells' notices like candy. Now, there is another crypto-legal case that I wanted to comment on as well. The criminal case against Tornado Cash developer Roman Seminoff saw its first major hearing on Friday. Lawyers dueled for three hours over whether the case should be dismissed without going

to trial. The central premise of the case is that Tornado Cash developers knew and were complicit in bad actors using the service to launder money. The highest profile use was by hackers from Democratic People's Republic of Korea, which used the service heavily in 2022. The defense made the point that Sevenov had no control over the protocol after May 2020. They said, they're not connected to those transactions. I don't think we're anywhere close to willfully providing service to the DPRK. And indeed, a lack of willing engagement with the DPRK, together with the non-custodial nature of tornado cash, are the two major sticking points in the case. The defense emphasized, quote, this is the only money laundering case ever where the defendant didn't have control over the funds, period.

though, claim that any legitimate business that becomes aware of criminal activity is required to take steps to stop it. Judge Catherine Polk-Felia seemed skeptical of this point, asking prosecutors, that's a lot. I'm not sure what you expected Mr. Storm and his colleagues to do. Should they have shut down Tornado Cash? How do you saddle him with liability? She queried whether the tipping point would be when a platform should shut down over a illicit use, asking, if Tornado Cash has 1,000 customers and one is a bad actor, are they criminally liable? Prosecutors insisted that knowing of a single transaction would be enough. Falia also asked whether the case would be different if Seminoff had not profited from his

involvement with Ternado Cash. Prosecutors claim there would still be a case, adding, we could imagine a philanthropic money launderer. Still, they pointed to profits and marketing aimed at criminal use cases as helping to, quote, prove intent to participate in a conspiracy. Hello, friends, before we get back to the rest of the show, I want to implore you to join me at Permissionless. Permissionless is the conference for Cryptonat, by crypto natives, and the reason it's so important this year is that despite regulators' best attempts to push industry founders, devs, and executives out of the U.S., the United States

remains the beating heart of crypto. Today, the tide is turning. Policymakers have pivoted from fighting crypto to embracing it. Literally now we are in a major political party's platform, which will lead ultimately to the creation of new financial products, new applications, and ultimately new adoption. Permissionless is the conference for those using and building on-chain products. It's home to the power users, the devs, and the builders, and perhaps more importantly, I will be there. The location is Salt Lake City, the dates are October 9th to the 11th, and tickets are just $499.

If you want to get 10% off, use code Breakdown 10. Go to the Blockworks website, blockworks.com. There will be links to register for the conference, and again, you can use Code Breakdown 10 to get 10% off. The DOJ seems to be accepting that a willingness to collaborate with DPRK hackers is central to the charges. No evidence has been presented of communications with the hackers. meaning the entire case rests on whether offering an unstoppable service to the entire world implies

willing collaboration in how it ends up being used. Integrating these arguments, Falia drew the comparison with messaging platform WhatsApp. She noted that because the service is encrypted, WhatsApp, quote, must know of its popularity with criminals. However, she put to prosecutors, I don't see you charging WhatsApp. They responded that due to the encryption, WhatsApp is not able to separate illicit use from legal but private communications. Falia countered by stating that the Attorney General could simply write to WhatsApp and inform them of the illicit use. By the DOJ's stated logic, this would force the service to be shut down. Prosecutors eventually landed on the point that communication via

WhatsApp is protected by the First Amendment, but it is, quote, certainly constitutional for the government to place limitations on financial institutions. The defense noted that although this may be true, the DOJ is taking on a regulatory role by trying to put these limitations in place via criminal prosecution. The hearing also covered the timeline for the trial. In previous filings, the defense had stated, additional time is needed because this case involved, complex and novel legal and factual issues. The government has also produced voluminous discovery in this case on a rolling basis, millions of pages of documents, many of which are in Russian and require translation. There was also a lengthy argument about whether the defense was entitled to

communications with Dutch law enforcement, who were prosecuting fellow tornado cash developer Alexi Perzzev. Perzzev was sentenced to five years in prison for money laundering earlier this year. Last week, he was denied bail while working on his appeal. Finally, the defense called into question the legality of seizing crypto from hardware wallets discovered during a search. Prosecutors are attempting to seize any and all crypto owned by storm, even though he has large holdings unrelated to tornado cash. The defense argued that a generalized search warrant does not extend to hardware wallets as the crypto is stored on the blockchain rather than in the wallets. They made the point that prosecutors are in the habit of describing hardware wallets as, quote, containing tokens,

which isn't technically correct. Summing up, the defense said, our position is that they can't search the wallets. They're using a passcode to seize your assets, which is beyond the scope of a premises search. Similar to her work on the SEC versus Coinbase lawsuit, what really stood out was Judge Fahlia's command of the key legal, technical, and social issues inherent in crypto cases like this. At one stage, she pointed out that Tornado Cash developers had limited options due to the service being operated via an immutable smart contract. Prosecutors insisted that the developers had the power to block withdrawals and so should have done so. Reflecting on the financial privacy goal of Tornado Cash, Falia said, you might look at this and say it's a very noble message. I might look at it and say it's a

haven for criminals, and we'd both be right. Valia did not indicate on how she would decide on issues, but said she would deliver her ruling promptly. She accepted the need to delay the start of the trial from September until December. Falia explicitly framed the delay as necessary to give her more time to consider the legal issues raised by the defense. Writers Peter Van Valkenberg, the director of research at Coin Center, positive developments in Roman Storm's tornado cash defense. Motion to delay trial date was granted, and Judge Valia is asking the right questions and appears to recognize danger in establishing a mere negligence standard for money laundering as the Dutch did to Alexi. If we treat the tornado cash

software as speech, which we should, then this kind of subjective moral ambiguity is exactly why our First Amendment jurisprudence abhors content and viewpoint discrimination. If judges, prosecutors, and bureaucrats start dictating to citizens which scientific and technical innovations can be shared and which are banned as immoral, then you stop being an open liberal society. So some pretty interesting developments on the crypto legal front, certainly promising, if not fully positive just yet. Now, a couple follow-up stories to things from last week. To close us out, last Thursday saw Congress vote on whether to overturn a presidential veto and repeal SAB-121. The controversial SEC accounting guidance forces crypto-custodians to hold customer assets on their own balance sheet. It also

acted as a de facto ban on commercial banks providing custody due to the way it interacts with capital requirements. The House fell far short of the two-thirds majority required to overturn a veto. Only 21 Democrats voted alongside Republicans, with some suggesting that an overturned veto would have been terrible optics for the embattled president. More interesting than the vote, however, was the SEC's response. The vote had already been postponed from Thursday, with rumblings that the SEC was working behind the scenes on modifications and exemptions. According to Bloomberg tax, SEC staff had begun to deliver tailored guidance dealing with individual custodians. It appears that certain firms will be exempted from the guidance as long as they can satisfy

SEC staff that customer assets are protected from bankruptcy. The SEC seems to be framing this as a success for their policy, with Bloomberg tax writing, the regulator believes that the guidance worked and companies have adjusted to address the threats that hacking and business failures have posed to investors. We don't know exactly who has received the exemptions at this stage, but it sounds as though they were handed out liberally. One SEC source told the block,

anyone who demonstrates the ability to answer the questions raised by the SAB and has the technology and practices and procedures in place can come in and receive this no-objection guidance from our accounting staff. That is available to any entity that would want to be providing crypto asset safeguarding services. Earlier in the week, Democrat lawmaker Maxine Waters had said that a special interest group representing large custody banks had engaged on the issues. Cryptop policy expert Zach Wong weighed in on this method of bespoke exemptions in a long thread, writing, the right way to regulate is to conduct open and transparent rulemaking with fulsome good faith analysis.

This SEC has chosen a different path and prefers to work with allies to give one-off approvals behind closed doors. His larger objection, however, is that the SEC simply has no place dabbling in regulating banks, adding, that is the domain of the bank regulator. who set and evaluate capital ratios, supervised business practices, and prescribe best practices. What the SEC is now doing, according to the chair's own leak, is prudential regulation of banks. It is appropriate for the SEC and should be deeply offensive to its sister regulators like the Fed, the FDIC, and the OCC. But this is so typical of this SEC, especially when it comes to crypto. This is yet another example of the unrestrained, ineffective, and arrogant attitude of this SEC.

Lastly today, Bitcoin prices back up, coming in into two-week high above 63,000, And one of the things that people are pointing to is the end of German government selling. Over the past month, the Germans have managed to liquidate around $50,000 worth of Bitcoin worth more than $3 billion. The bulk of the selling happened last week is the pace really ramped up. Around 40,000 Bitcoin were sold off during the final five days. On Friday afternoon, the German government finally ran out of coins, removing a large and very public overhang from the market. We still don't have a good idea of why the Germans felt the need to liquidate so quickly. But this bout of selling was a massive stress test for the market.

It seems there was enough liquidity to absorb more than $2 billion in selling pressure last week without significantly impacting price. So friends, that is where we will wrap today. I'm sure it is going to be a very interesting week. Can't wait to get into all of it with you and of course appreciate you listening as always. Until next time, be safe and take care of each other. Peace.