Top Stories of the Week - 1.13

In the newsletter this week, we cover AWS’ partnership with avalanche, SBF’s new substack blog, and a negative joint statement from banking regulators. Subscribe here and receive Galaxy's Weekly Top Stories, and more, directly to your inbox.

Fed, OCC, FDIC Raise Concerns about Crypto

The Federal Reserve, Federal Deposit Insurance Corporation (FDIC), and Office of the Comptroller of the Currency (OCC) issued a joint statement highlighting the risks associated with the digital-asset sector. U.S banking regulators further expressed the importance of mitigating crypto related risks from bleeding into the U.S banking system. The joint statement comes almost two months after the FTX fallout and touches on the failures witnessed with this event. The statement presented a list of key risks in crypto that banking organizations should be aware of including: unclear regulation, blowups, inaccurate or lack of proper disclosures, fraud risk, stablecoin run risk, intra-crypto contagion via interconnectedness, risk management practices lacking robustness or maturity, and general “heightened” risks associated with open permissionless ledgers. The agencies clearly laid out the risks in crypto that cannot be controlled by regulators at the moment and stress on eliminating the potential for these risks to migrate to the banking system.

More importantly, the banking regulators also expressed their viewpoints on the current dynamics between depositories and crypto-related businesses. The regulators stated that “Based on the agencies’ current understanding and experience to date, the agencies believe that issuing or holding as principal crypto-assets that are issued, stored, or transferred on an open, public, and/or decentralized network, or similar system is highly likely to be inconsistent with safe and sound banking practices.” The language the banking regulators used in the joint statement insinuates that they’re assessing if banks can safely conduct crypto-related activities, while maintaining compliance with anti-money laundering, consumer protection laws, and general principles of safety and soundness.

Our take

The joint statement issued by the regulatory agencies is the most explicit and clear language we have seen regarding their viewpoints on crypto-related activities. The language remains consistent with statements in the past from Martin Gruenberg, Chairman of the FDIC, Michael Hsu, Acting Comptroller of the Currency, and Michael Barr, vice chairman of the Federal Reserve, who all historically have negative viewpoints on crypto.  

The conclusion reached by the agencies appears to apply to activities previously defined as "permissible" by the OCC. Although the crypto related activities addressed by previous OCC interpretive letters may still be legally permissible for banks, the agencies last week made it clear that these activities are "highly likely to be inconsistent with safe and sound banking practices." Notably, the use of “safe and sound” is an expression used to define the risk tolerance held from a banking perspective and provides no guidance on specific activities that pose significant risk. To this point, the agencies should have been clearer on what activities are still permissible. 

The regulatory agencies further stated they have “significant soundness and safety concerns with business models that are concentrated in crypto-asset-related activities or have concentrated exposures to the crypto-asset sector.” This statement is noteworthy to mention considering that the message is obviously alluding to business models employed by Silvergate and Signature, both of which derive significant portions of their business from the cryptoasset industry. It is likely that these banks will encounter significant pressure from bank regulators. While it’s likely the statement had been in the works for some time, it’s clear that the FTX blowup, and its impact on Silvergate, provided additional motivation. 

Another notable inclusion is that the agencies said “that issuing or holding as principal crypto-assets that are issued, stored, or transferred on an open, public, and/or decentralized network, or similar system is highly likely to be inconsistent with safe and sound banking practices.” The inability to hold digital assets principally will make it more difficult for national banks to operate in the space at all, such as by providing custody services. While there are technological and business process designs that can mitigate this, typically a custodian would hold some crypto to pay network transaction fees, either to facilitate customer withdrawals or simply to shuffle their custody addresses. The inclusion of “issuing” in the statement also appears to dissuade or prohibit certain tokenization use cases if they occur on “open, public, and/or decentralized networks,” which, while problematic, would perhaps allow for certain token issuances if they are performed and carried on permissioned and closed networks.

Knowing that the joint statement from the regulators has reached the entirety of the depository sector in the US, our view is that state-chartered banks and foreign banking organizations operating in the U.S may be affected to a lesser degree--though that is unknown today. Despite the focus being pinned on banks that are regulated at a federal level, the joint statement itself could further stunt institutional adoption in the U.S. As the Fed, FDIC, and OCC continue to roll out more clarity on their statements, regulatory pressure could become more expansive. In the near term, it will be important to monitor how regulators handle corporate accounts used by crypto firms. But the negative tone alone could either signal or motivate the creation of further, restrictive banking regulations in the future. -GP

AWS<>Ava Labs

AWS partners with Ava Labs to accelerate crypto adoption. The goal of the partnership is to support builders on Avalanche with the technological and business resources needed to accelerate the network's adoption. Ava Labs already leverages AWS for its cloud solutions, such as Amazon Elastic Compute Cloud (Amazon EC2), to enable sub-second transaction settlement on Avalanche. As part of the partnership, AWS will be available as a hosting provider to many validators on Avalanche. Ava Labs will become a member of the AWS Partner Network (APN), which connects over 100k partners around the world, and will also join the AWS Activate, a free program where Amazon will offer builders on Avalanche with AWS credits, resources, tools, and expert advice.

Ava Labs also plans to add its own managed service to the AWS marketplace so individuals and institutions to easily launch a validator node in just one click and launch their own custom chain on Avalanche as a subnet—a blockchain built on top of Avalanche's primary network. Subnets are Ava Lab's "blockchain-as-a-service" product that provides builders with full customizability over the blockchain (read our Avalanche report for further details about the tech stack and subnets). The partnership also enables blockchain solutions for enterprises and governments by providing node operators with tools like AWS GovCloud for FedRAMP compliance use cases. “Number one on my list of how AWS helps us is by allowing customers to launch validator nodes out of whatever legal jurisdiction makes sense for them,” said Ava Labs' founder and CEO Emin Gün Sirer in an AWS Startup Spotlight post.

Our take

This Ava Labs<>AWS partnership announcement follows last month’s Alibaba partnership announcement. The AWS partnership extends some of the expected benefits to Ava Labs (e.g., AWS Activate credits, startup spotlight, entry into the APN network) so that both entities can support builders with the tooling/resources needed in their go-to-market strategies to grow the Avalanche network. It isn't Amazon's first entry into blockchain, but it is significant because it represents AWS' first foundational partnership with a blockchain, and it provides Ava Labs with core technological and business synergies to address key pain points of builders looking to enter web3 via subnets, particularly the one-click validator feature in AWS Marketplace.

With subnets, builders have full customizability over the set of rules on the blockchain including validator set. They can specify how much computing power, throughput, privacy, or security they require so they can hyper-optimize for any application or product, whether it be for government, enterprise, social, gaming, etc. This AWS partnership seems to be targeted more towards enterprises and governments as highlighted by the AWS compliance solutions. There are currently only two subnets for gaming applications (Swimmer & DeFi Kingdoms), though there are hundreds of subnets in testnet with many expected to launch in coming months.

According to the Ava Labs team, one of the main pain points for some developer groups specific to the subnet model is having to bootstrap their own validator set – it’s clearly beneficial for enterprises and governments that need full privileged control over the network for compliance requirements (e.g., Deloitte to help FEMA make more efficient disaster recovery disbursements and KKR to tokenize one of its largest funds), but it can be more of a burden for smaller applications that are unfamiliar with the notion of crypto-specific security. But with AWS’s one-click validator feature in marketplace, the coordination and technical requirements to bootstrap validators becomes more frictionless for any project to launch a subnet.

We recognize some concerns with Big Tech’s foray into blockchain and the centralization risks with cloud hosting providers, but censorship-resistance for some other apps isn’t as big a concern as it is for money use cases (i.e., bitcoin) ’ – many apps even prefer having a familiar provider like AWS (e.g., most of the non-crypto enterprises or government entities) especially during a time when trust across the crypto industry has broken down. Government and TradFi’s adoption of blockchain seems inevitable as this point but, ideally, working with AWS-Avalanche would help drive them in the right direction to be more aligned with the ethos of the industry. For builders looking to avoid that model, they certainly have the choice of going with a cheaper, less centralized options than AWS. Again, the main objective is for Avalanche to offer the widest array of options for people to deploy their own subnet and to support builders with whatever technical and business resources needed to deliver the best product to end users and accelerate crypto adoption.

The AWS-Avalanche partnership adds to the success list of Ava Labs, which recently shipped foundational tooling and infrastructure improvements including the Rust SDK to build custom VMs on Avalanche, Avalanche Warp Messaging (AVM) for native subnet-to-subnet messaging. Patrick O’Grady, head of engineering at Ava Labs, noted in a Twitter Spaces that promising opportunities on Avalanche include the development of elastic subnets that offer dual-token incentives to validators, zk-subnets, and also shared security subnets where subnets can build on top of existing subnets to inherit their security. For the last one to take off, we will first need to see more subnets launching and further development – all of which seems more achievable with the right tooling starting to fall into place. -CY

Sam Bankman-Fried Blogs from His Parents’ Basement

Out on $250mm bond, SBF pens a screed with his version of events. Sam Bankman-Freid (SBF), the one-time founder of FTX and Alameda Research, has turned writer, launching his own Substack. In his first post, titled “FTX Pre-Mortem Overview,”Sam argues that FTX International was brought down by Alameda Research’s insolvency following an 80% drawdown of its assets over 2022. Importantly, SBF argues that insolvency would not have occurred were it not for a months long defamation campaign from rival Binance plus a “targeted crash precipitated by the CEO of Binance.”

SBF makes a number of claims in his defense. According to his data, models, and memory (none of which are verifiable), Alameda and FTX both made billions in profit over 2021, with the former’s balance sheet ballooning to roughly $100bn. Alameda’s NAV than dwindled over the first half last year, as “rising interest rates curtailed global financial liquidity.” It wasn’t until the summer of 2022 that the former market-maker turned prop shop finally hedged assets with “BTC, ETH, and QQQ.” Still (again, this is according to SBF), Alameda at October’s end was solvent.

But after a “fateful tweet” by Binance CEO Changpeng Zhao on November 6th, 2022 which targeted Alameda-owned assets specifically, the trading shop went belly up, dragging its sister exchange into bankruptcy because of an underwater margin position. Importantly, in SBF’s mind, no customer funds were stolen, insolvency was brought on by an unethical rival, and “strong-arming and threatening” from lawyers were the only things keeping FTX from accessing outside liquidity and making customers solvent again.

Our take

SBF’s 2,347-word post should be the end of Sam’s public comments, but based on his unusual penchant for public discourse, we aren’t holding our breath. If it has an inkling of accuracy, if he was wrongly targeted and pushed to file Chapter 11 bankruptcy despite funding being just around the corner, then it will surface in the courts. Regardless of the veracity of his timeline, data, or story, it appears impossible to believe that FTX and Alameda did not wrongly comingle client assets, give Alameda undue liquidation exemptions, and handle risk extremely poorly, among other things. SBF neither addresses these issues nor the fraud that top lieutenants have already pled guilty to.

It’s unlikely we get straight answers from SBF, who pled not guilty to eight criminal counts brought against him by the DOJ last week. But he seems keen as ever to keep writing, finishing his first piece with a note: “I have a lot more to say-about why Alameda failed to hedge, what happened with FTX US, what led to the Chapter 11 process … But at least this is a start.” Pray tell us, Sam. -WJS

Other News

• SEC sues crypto exchange Gemini and crypto lender Genesis for selling unregistered securities

• U.S. House Republicans plan to set up a new subcommittee focused exclusively on the crypto industry

• Former FTX CEO, Sam Bankman-Fried, denies stealing FTX funds in a new online post

• Crypto lender Nexo is being investigated by Bulgarian authorities on suspicion of money laundering

• The People’s Bank of China includes the country’s digital currency, e-CNY, in cash circulation data for the first time

• Cosmos-based DeFi protocol Quasar raises $5.4m at a $70m valuation

• The Legislative Assembly of El Salvador approves law for the issuance of cryptocurrencies other than BTC, including the issuance of a bitcoin-backed bond

• Cryptocurrency exchange Crypto.com to delist USDT in Canada in compliance with provincial regulators