The Breakdown - The SEC's Vicious "Qualified Custodian" Trap

Episode Date: September 5, 2024

What the Galois Capital settlement with the SEC means for crypto. Spoiler alert: it's not good. 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, September 4th, and today we are talking about the latest SEC settlement. 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. Well, friends, the SEC continues to go scorched earth on the industry, this time bringing the hammer down on Galois Capital. The fund has agreed to a $225,000 settlement, which will be distributed to

harmed investors. The allegations are primarily that Galwa Capital failed to hold crypto assets with a qualified custodian. Corey Schuster, co-chief of the SEC's asset management unit, said, by failing to comply with custody rule provisions, Galois Capital exposed investors to risks that fund assets, including crypto assets could be lost, misused, or misappropriated. Additional allegations claimed that Gao Huo diverged from their redemption policy, allowing some investors to exit the fund on short notice. Gaowa agreed to settle without admitting to the allegations. For context, Galwa Capital was a mid-sized private quant fund based in Miami. They operated as an RIA or registered investment advisor. At their peak, they boasted 200 million in assets under management.

Their founder, Kevin Zhao, was best known for being outspoken ahead of the Luna collapse and made a significant return for investors betting on its downfall. In early 2023, the fund was shut down and returned money to investors. Reporting, and the firm themselves, revealed that they had half their assets trapped in the FTX bankruptcy, some $40 million worth. The SEC identified FTC specifically as one of the unqualified custodians that form the basis of the allegations. Zhu discussed the, quote, exhaustive and costly investigations that had gone on for more than two years in a Twitter thread. He explained, we used Fireblocks and non-qualified custodian as a best-in-class solution to secure our crypto assets. Although Fireblocks was not a qualified custodian, we believe that they

were the best solution for our needs, and in our opinion, the safest way to secure crypto for our investors at that time. We disclosed our use of fireblocks in our Form ADV filing with the SEC. The key thing here to put a really fine point on it is that there are no qualified custodians that meet the needs of actively trading quant funds. At the time, fireblocks offered a pass-through function that enabled funds to easily trade custody funds on exchanges. This obviously didn't end up being entirely safe, but the SEC are essentially taking the view that most crypto funds are not in compliance with the custody rules. Zhao continued, we also had a redemption policy for our investors that required at least five business days notice before month

end for redemption. However, we thought it would be a nice thing to do to allow investors out of the fund earlier if they didn't want to be there without having to wait the full five business days. As a result, no good deed goes unpunished. What more is there to say? The SEC's allegation here is that Galois misled investors by not advertising these priority redemptions. But then again, it's kind of understandable why someone would want to return capital to investors during that frantic period of late 2022. Still, the SEC clearly took issue with this behavior. The reason this enforcement action is a major issue is the lack of functional regulations around crypto custody. New rules were proposed in 2023 that would require RIAs to custody crypto and physical

valuables with qualified custodians. The rules have been widely panned as completely unworkable due to the lack of qualified custodians for crypto, and even more so for tangible goods like classic cars and whiskey. These rules haven't been finalized yet, but it appears the SEC is taking enforcement actions based on existing rules. This means the SEC are leaning on their own determination that most crypto assets are securities, despite a lack of legal precedent to support that view. Jacob Franek of Alliance Dow arrived at the same analysis, tweeting, let's review how egregious this is. The SEC requires RIAs to custody with qualified custodians, but says there are none, and it blocks new entrants from becoming qualified custodians,

and thus it can penalize any crypto RIA whenever it wants. Alexander Greve, the VP of Government Affairs at Paradigm added, by the SEC's own assertions, qualified custody doesn't exist in crypto, so not sure what anyone is supposed to do here. And of course, while a $225,000 fine is relatively modest, there would have been large legal expenses associated with handling a multi-year investigation. The concern isn't, of course, so much with Galois Capital, which had already wound down, but rather the chilling effect on other crypto funds. Security's lawyer, Brain Genius, commented on how far reaching this issue could be, tweeting, for the SEC, this chilling effect is the point of the Galwa Capital

sentiment. In a world of strict custody rule application in crypto, VC funds can't invest in a token round without guaranteed QC support at TGE. Liquid funds can't trade on an exchange unless it is a QC. Naturally, the question that arises is, why don't we just create more crypto-focused qualified custodians to fix this issue? Well, because the government is the gatekeeper to QC status. And now you understand how hard the SEC can screw the fund ecosystem using this rule. The other question is, why did the party settle?

Most likely, Galois argued the tokens at issue are not securities and not subject to the custody rule. The SEC disagreed, and neither side felt confident enough in their position to take it to court. settling is also much cheaper. Indeed, this seems to be another case of the SEC picking off a weaker defendant that couldn't afford a fight. Large crypto funds operate in exactly the same manner, with the biggest difference being that they didn't have a very public impairment in 2022. Some commented this would have been an excellent case for the industry to crowdfunded defense for, but ultimately we don't know the details of anything that went on behind the scenes. Crypto lawyer Gabriel Shapiro was particularly

frustrated that the SEC is cracking down on funds that return money to investors quickly, tweeting, I am just gobsmacked that the SEC is finding them for this. This is not law or regulation. This is micromanagement by power mad bureaucrats. Data Finavation added, I mean truly, things that the SEC are way worse than we would have imagined even after how bad it's been for four years. Mike Dutas of Sixth Man Ventures summed it all up, tweeting, the SEC fined a crypto investment firm for holding tokens in fireblocks today. They required registered investment advisors to hold tokens in qualified custodians. The problem is that qualified custodians don't support most tokens. It's an impossible gotcha like most SEC cases. Enough is enough. The U.S. government is actively presenting U.S. institutional crypto investment

through seemingly arcane but incredibly consequential lawmaking by enforcement. Major U.S. crypto funds get guidance they can only hold tokens Coinbase custody supports, not fireblocks. So, with this enforcement action, the SEC has basically called into question the legality of pretty much every fund operating in the industry. There are some that exclusively use Coinbase or Anchorage, who claim to be qualified custodians, although the SEC has questioned that declaration as well, so even that isn't clear. This pair of custodians also don't support the huge range of early-stage tokens that most funds need access to. It's hard not to feel then like this is a soft ban on crypto funds executed through a back door. The SEC hasn't passed a rule or sought

public comment. They haven't even made clear exactly what the policy actually is. If the goal is to improve the standard of custodians, the SEC should figure out some rules and start handing out licenses. If the goal is simply to ban crypto funds, then that should be a clear policy, too, that can be challenged in court rather than inferred through a patchwork of unchallengeable settlement. None of this will come as a surprise to you, but this is clearly not any way to promote domestic capital formation and investor protection. 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 Cryptonatives by CryptoNatives,

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. Although the regulatory crackdown continues unabated, there are a few glimmers of hope coming from the SEC. Speaking at the Korea Blockchain Week on Tuesday, SEC Commissioner Mark Yuwaita suggested it's time to create a viable pathway for registering token sales in the U.S. His proposal was a modified version of S1 forms.

For stocks, the S-1 provides a range of disclosures about a corporate entity seeking to go public. Over the years, the SEC has modified S-1 filings for unusual asset types such as index-linked annuities. UADA said, why shouldn't we do the same thing with crypto? We have the flexibility to do that, and that was in part expressing my frustration that we have not done more to accommodate sponsors of these types of digital assets. He specifically said the SEC should not create a catch-22 situation, where the regulator asks asset issuers to register and provide disclosures that are impossible or irrelevant. The general tone of the discussion was that the SEC's current position is increasingly untenable.

In particular, UADA thinks the SEC should clarify exactly what they mean by quote-unquote crypto asset securities, a term that shows up in every enforcement action but has no legal definition, and which was even taken a task recently by a judge. Uaida commented, I hope at some point whether it's Gensler or any of his successors will think about this. We've now had a fair amount of regulatory uncertainty on digital assets. Maybe we ought to move forward with some legislation or rulemaking. Now, a major concern looking in the background of this election is that even if Republicans win,

Chair Gensler might simply refuse to step aside. SEC commissioners are appointed by the Senate for a fixed term. Because the agency is considered independent, the administration has no ability to remove a commissioner without cause. This is typically never an issue. Agency heads traditionally resign when power is transferred to the opposing party. Trump has already proclaimed that he would fire Gary Gensler if he wins office, but it might not be that easy.

In a note published this week by T.D. Cowan, researcher Jared Seberg wrote, we believe this would get litigated and Gensler would likely win. This is because it is hard to see the point of having bipartisan commissions if presidents can fire the opposing party's members for any reason. Importantly, Gensler's term doesn't conclude until 2026. For the Democrats to hold a majority until then, the Senate would first need to reconfirm Caroline Crenshaw, who was nominated for an extension in July. Seberg wrote, we expect progressives to pressure Gensler to preserve Democratic policy wins by depriving the GOP of an SEC majority for at least 18 to 24 months. If this actually plays out, Seberg believes, quote,

Crypto policy might get stuck. Enforcement would likely ease, as the SEC chair can influence what cases get elevated to the board, yet it would be difficult to adopt regulatory changes or to accept settlements of existing legal fights if the Democrats have the majority. Former Republican SEC Commissioner Michael Puehawar doesn't think it's quite so clear. Even if Gensler holds on to his seat on the commission, a Trump White House could appoint a new chairman to lead the agency without a majority. Pinawar said, even in a minority commission, the chairman would have a lot of power to do things. He gave the example of appointing senior staff, particularly in the division of enforcement. This would allow a minority chair to influence decisions to appeal court rulings

and pursue investigations. However, Pinawar agreed that any controversial rulemaking would grind to a halt, adding, the new chairman coming in would be able to take a fresh look at every rule, including ones that affect the crypto industry and the ones that are out in the comment period and decide whether or not to move forward with certain rulemaking, but would need commissioners' votes. Overall, though, there's still a little skepticism in the industry that Gensler would make such a brazen move. Ashley Everslow, the General Counsel at Zero X Labs and former SEC lawyer said, direction of crypto regulation will be dictated by which party wins the White House. Whoever his president has the power to either direct activities of financial regulatory agencies

or appoint agency heads with known views and then allow them to lead the way. Lastly today, one of the most high-profile crypto candidates this year has won an important primary victory. Crypto lawyer John Deaton has secured the Republican nomination for Senate in Massachusetts in a landslide victory. He secured 64% of the vote according to overnight vote counting, easily defeating his two opponents. Deaton will move on to contest the seat currently held by the leader of the anti-crypto army Elizabeth Warren. A respected figure within the industry, Deaton has raised money from several big executives, including Chris Larson and Brad Garlinghouse of Ripple, Anthony Scaramucci, and Crackens Jesse Powell. He was also the recipient of $1 million

from the Commonwealth Unity Fund, a smaller crypto pack. Deaton notably hasn't received support from Fershake, the Goliath Crypto Pack that has dominated this year's corporate fundraising. Fairshake seems to be deploying their cash strategically, and carefully selecting close races where they can more effectively tip the balance. Unfortunately, at this point, Deaton's contest against Warren doesn't fit that description, with Warren currently holding a 23-point lead in the polls. Still, Deaton's entire backstory is about overcoming the odds, and he will no doubt fight hard to unseat Warren. Finance lawyer Scott Johnson noted that Deaton really turned out the vote and secured a wider margin of support than the 2020 Republican candidate. He commented, Deaton is not going to win in the

Massachusetts General, but there may be clues as to crypto voter turnout in these results. Noise level very high, he had much more funding, but this is probably what you want to see. If he did beat the odds to unseat Warren, Johnson added, seismic would even come close to describing that event. Anyways, friends, that is going to do it for today's breakdown. Appreciate you guys listening as always. And until next time, be safe and take care of each other. Peace.