Top Stories of the Week - 2/17

In the newsletter this week, we write about paxos’ forced shutdown of the BUSD stablecoin, the SEC’s proposed change to the Advisers Act’s current “custody rule,” and the launch of a native token by NFT marketplace Blur. Subscribe here and receive Galaxy's Weekly Top Stories, and more, directly to your inbox.

The 3rd largest stablecoin ordered to wind down

Paxos ends its relationship with Binance for BUSD. On Monday morning, Paxos announced it would be ending its relationship with Binance for BUSD as ordered by the NYDFS, which justified the order by saying there were "several unresolved issues related to Paxos’ oversight of its relationship with Binance in regard to Paxos-issued BUSD.” Paxos noted that new issuance of BUSD will be ceased by 2/21, though Paxos will continue to support BUSD redemption requests from onboarded customers through at least February 2024.

For background, BUSD is the 3rd largest stablecoin with a supply of $16bn prior to the NYDFS news. BUSD is marketed by Binance but it is issued/redeemed and its collateral is managed by Paxos, a NYDFS regulated trust company that also issues its own stablecoin, Pax Dollar (USDP). Per its approval from NYDFS, Paxos was only authorized to issue its stablecoins on the Ethereum network. Any BUSD that exists outside of Ethereum (i.e., BUSD on BNB Chain, Avalanche, or Polygon) is wrapped and bridged by Binance as Binance-peg BUSD. BUSD & USDP are both managed by Paxos and subject to the same reserve requirements; however, pegged-BUSD (the primary form that BUSD is used) is managed by Binance and comes with a different setup that may not provide users with the same level of safety/security as provided by Paxos with BUSD.

At 4pm on Monday, Paxos issued another press release revealing the company had indeed received an SEC Wells notice on 2/3 that stated the agency was “considering recommending an action alleging that BUSD is a security and that Paxos should have registered the offering of BUSD under the federal securities laws” - an allegation to which Paxos specifically objects: "Paxos categorically disagrees with the SEC staff because BUSD is not a security under the federal securities laws. This SEC Wells notice pertains only to BUSD. To be clear, there are unequivocally no other allegations against Paxos.” Paxos continued, saying they “will engage with the SEC staff on this issue and are prepared to vigorously litigate if necessary."

Shortly after that announcement, Bloomberg later reported that USDC issuer Circle had tipped the NYDFS in 2022 about the past mismanagement of BUSD (Binance had acknowledged its past flaws in its maintenance of Binance-peg BUSD reserves that resulted in the asset being undercollateralized by more than $1bn on several occasions).

On Tuesday, some headlines reported Circle had also received a Wells Notice from the SEC, but those claims were refuted by Circle directly. Circle later published a tweet thread detailing its views on why stablecoins are not securities, though it noted that it does not know what specific aspects of BUSD may be of interest related to the SEC's.

Our Take

This appears to be a coordinated regulatory effort between the NYDFS and SEC. Since Wells notices from the SEC only serve as a notification of possible future action, the order for Paxos to cease its relationship with Binance with BUSD came specifically from the NYDFS. In the US—at a federal level—stablecoins like Tether have been regulated as commodities by the CFTC, but with this new Wells notice to Paxos, the SEC is arguing for enforcement authority over stablecoins. The SEC would have to have to make a convincing argument whether BUSD and similar stablecoins are "securities" under the Howey Test or Reves Test. Currently, there are several legislative bills aiming to clarify how digital assets like stablecoins are classified and which agency will have oversight. As regulatory guidance is still in process of being formalized, existing issuers have been linking up with regulated TradFi entities (e.g., Circle custodies reserves with BNY Mellon and partners with Blackrock to manage some of its reserves; Tether recently tapped Cantor Fitzgerald to oversee some of its bond portfolio), which may provide some coverage from regulatory risk.

The most important question at this time is what exactly is being targeted and what the scope of these regulatory actions are. An ideal case would be if the regulatory target was confined to just Binance (it’s more difficult for regulators to go after Binance directly since it's an offshore entity, so a more addressable option would be to target affiliate and partnered companies like Paxos). A more troubling scenario would be if the regulatory actions create precedence to attack other onshore stablecoin issuers like Circle. An attack on stablecoins more broadly would have an outsized impact on the rest of the crypto - they are arguably the most important asset class in crypto – they serve as the on/off-ramps for crypto, are the preferred DEX trading asset, and underpin most of DeFi. Since the NYDFS and SEC specifically called out Paxos for its BUSD product and not Pax Dollar, it’s possible that the enforcement is more about particulars involving BUSD than a broad attack on stablecoins generally. This indicates that these agencies are particularly targeting Binance rather than stablecoins in general—at least at this time (and also aligns with the recent action leading to Binance’s suspension of US dollar bank transfers). Regardless of the argument whether BUSD is a security, no one disagrees that the marketing of the product should be accurate and include sufficient risk disclosures for anyone touching it. It’s easy to see why a regulator could view as problematic the fact that there are tons of “versions” of BUSD wrapped on other chains but which do not have the express blessing of its issuer or the regulator who oversees it.

Paxos has, for years, tried to compete with Circle's USDC as the primary on-shore regulated stablecoin by touting its conservatism and transparency around reserves (e.g., moving towards 100% cash & cash equivalent backing, securing certain licenses/charters, providing more frequent and thorough reporting). Transparency and reserve quality are the primary ways that centrally-issued fiat-backed stablecoin issuers compete, but operational processes (ease of create/redeem, for example) and integrations (such as with exchanges or DeFi protocols) are also relevant. But starting in September 2022, competition between Paxos and Circle heated up after Binance implemented a new auto-conversion policy of USDC to BUSD, an anti-competitive but understandable strategic play.

In any case, Paxos and Binance suffer a huge blow from the ordered unwinding of BUSD, which has already seen significant redemptions, with circulating supply drop from $16.2bn to $13.8bn as of writing (-15%). However, this opens up opportunity for alternative products to take BUSD's place on Binance/BNB Chain (including non-dollar stablecoins as noted by CZ in his Twitter Space AMA earlier this week). Similar to last week’s news about the SEC fining Kraken for its staking product, the regulatory actions against Paxos/Binance have driven increased interest in decentralized solutions. Supply of crypto-backed stablecoins (e.g., DAI, FRAX, LUSD, sUSD, RAI) have expanded and the prices of associated governance tokens have rallied since the BUSD news broke.

SEC Proposes Change to Custody Rule

SEC votes to approve proposed expansion and clarification of the “custody rule,” with SEC Chair Gary Gensler claiming that crypto firms’ custody practices potentially violate incumbent safe guard compliance requirements. The SEC commission voted 4-1 to approve a proposal that expands the list of assets that require “qualified custodians” to include any asset held by an investment advisor on behalf of clients. This expansion makes it clear that cryptoassets held by advisors on behalf of clients must be custodied at a qualified custodian. In announcing the proposal, SEC Chairman Gary Gensler provided limited clarity on the definition of a qualified custodian, leaving crypto investors questioning if they comply with the new Custody Rule proposal.

The crypto industry watched a live webcast of the Wednesday meeting of the Commission, read a supplied fact sheet, and poured through the 400+ page proposal document to assess the impact. The primary question was whether or not state-chartered trust companies, such as those operated by Coinbase, BitGo, Fidelity Digital Assets, and other custodians, would still be considered “qualified custodians.” Paul Grewal, Coinbase’s Chief Legal officer, tweeted that Coinbase is confident that they will remain recognized as a qualified custodian. Georgia Quinn, Anchorage’s general counsel, also expressed confidence that, from being the first and only operational OCC-chartered digital asset bank, Anchorage is “Unequivocally a ‘qualified custodian.’” BitGo tweeted that it “remains a qualified custodian under the new SEC proposal.”

Despite the confidence displayed here from crypto institutions, Republican SEC commissioner Mark Uyeda, noted his concern regarding the use of crypto trading platforms, which are not recognized as qualified custodians. Additionally, Gensler backed up Uyeda’s concern by stating, “What I'm highlighting is that today investment advisers ought to be aware that the provisions by these crypto exchanges don't meet the qualified custodian provisions of the 2009 rule.”

Hester Peirce, the only SEC commissioner to vote against the new Custody Rule proposal, released a formal statement raising concerns. Peirce argued to the other SEC commissioners that limiting the amount of qualified crypto custodians “could leave investors in crypto assets more vulnerable to theft or fraud, not less.”

The proposed rule also adds new requirements for advisors, including the need to individually sign agreements with custodians, and that those custodians must have annual audits. The rule also perhaps removes the exemption for privately-offered securities, such as SAFEs or other venture-type deals, which had not been required to be stored at qualified custodians, but now will be, a change that will impact some hedge funds and venture firms.

Our Take

The industry’s big fear heading into this meeting was that the SEC might either say that state-chartered trusts cannot be qualified custodians broadly, which would harm most of the institutional cryptoasset custody industry (which largely operates through state trust companies, many of them based in New York). This did not come to pass, but there are some notable issues that the proposal nonetheless creates.

While most institutional firms were already using these qualified custodians, the expanded requirement will make it difficult for advisors to trade on behalf of clients. Crypto market infrastructure is largely built around exchanges, but unlike in traditional markets, users must literally deposit their assets into the exchange to trade. Exchanges themselves are not qualified custodians, although several of them may also have a trust company that is used for qualified custody and/or cold storage. But while trading on an exchange, the assets are not typically held inside the qualified custodian. In January, Binance announced a program that would allow its institutional clients to “trade from within their cold storage wallet.” To our knowledge, Binance International does not operate a US-based qualified custodian, but we expect those exchanges who do (such as Coinbase and Gemini) to begin offering a similar service to allow their institutional clients to trade OTC from within their qualified custodian.

Along the same lines, the restriction raises delivery-vs-payment (DVP) issues which may see dealers have to devise procedures to deliver to RIA counterparties first, lest they be deemed to be “custodying” RIA assets outside of a qualified custodian, albeit briefly during a settlement process. This could complicate some business processes and workflows for industry dealers, but it is certainly not insurmountable.

In her statement on the proposal, Commissioner Hester Peirce raised a valid point (that this expansion of the custody rule will further limit the number of digital asset custodians), but the bottom line is that this proposal, which also applies to real estate assets and commodities, does not appear to be the negative bombshell the industry had feared. Although it will require some adaptation from industry players ranging from advisors to clients, the proposal is also open to a 60-day comment period that requires registered investment advisers to use the custody process on all client assets (including commodities), not only securities and funds, as is done now.

Blur One-Two Punches OpenSea with Token Airdrop and Revised Royalty Stance

Blur steps on the gas. This past Tuesday (Feb. 15), Blur finally conducted its highly-anticipated airdrop of $BLUR tokens. While the token had a short-lived pump to $5, it quickly fell down to ~$0.60 before settling into ~$1 range (where it currently trades). Tokens were allocated to users based on how much they had interacted with the exchange. According to Decrypt, heavy users of Blur engaged in wash trading and other tactics to increase their expected allocation, with top traders on Blur receiving millions of dollars of $BLUR token in the airdrop. $BLUR has a totally supply of 3B tokens with 360M tokens claimable by users as of Tuesday. Its circulating market cap is currently in the range of $360M, implying a full-diluted market cap of ~$3B.

Interestingly, Blur founder, @PacmanBlur, also penned a blog post outlining Blur’s new stance on creator royalties the day after the airdrop (Feb. 16), an issue we have covered multipletimes in this newsletter and in this Galaxy Research report. According to Pacman, it is not currently possible for creators to earn royalties on both Blur and OpenSea at the same time. His proposed solution to this problem is for creators to block trades on OpenSea for either new or existing collections. In the blog post, Pacman also provided creators a link to Blur’s Discord where they can learn exactly how to implement an OpenSea block at the smart contract level.

The motivation behind this new stance appears to be driven by OpenSea’s refusal to unblock Blur after they implemented Seaport (which we wrote about two weeks ago in this newsletter). Blur claims that their new approach to royalty enforcement will “solve the issue for good”, and they invite OpenSea to “collaborate with them” for a long-term fix to the royalties problem.

Our Take

There are two key things to watch with respect to Blur. The most obvious is how much market share Blur can retain now that their $BLUR token is liquid. In the short term, we don’t expect a serious drop-off in trading volume due to the fact that Season 2 of their token incentive program will run for at least another 30 days. The other factor to consider is that the $BLUR token is one of a few avenues for traders to gain liquid exposure to NFT marketplaces (other than $LOOKS and $X2Y2), and there could be some persistent demand for the $BLUR token that might mitigate the obvious sell pressure. That said, only about 12% of tokens of the 3B are unlocked right now, so continued unlocks of $BLUR will be an important trend to monitor long-term.

The more interesting point is this ongoing battle between OpenSea and Blur. The fact that most top traders on Blur effectively wash traded to farm the airdrop indicates that Blur’s volume may not have been organic compared to OpenSea’s. This is also evidenced by the fact that Blur’s number of active traders pales in comparison to OpenSea’s despite Blur boasting more nominal trading volume. Regardless of wash trading activity, Blur has managed to differentiate its product from other NFT marketplaces by catering intensely to high-volume NFT traders with an emphasis on speed of execution compared to NFT trading aggregators.

Blur hasn’t fully killed royalties with their most recent royalty pivot, but the net effect of their revised policy is reducing the royalty percentage to a bare minimum of 0.5% (regardless of creator preferences). Only if a creator chooses to block OpenSea will Blur then enforce the full royalty percentage set by the creator. Clearly, Blur is using their leverage to pressure OpenSea to collaborate with them instead of acting hostile with their block of Blur. Time will tell if Blur’s strategy will pan work, but they’ve been the most successful OpenSea competitor to-date both in terms of metrics and product.

Other News

• Flashbots unveils a new protocol for MEV revenue sharing between users and searchers.

• Wyoming lawmakers pass a bill to prohibit the forced disclosure of private crypto keys by state authorities.

• GQ Magazine announces first NFT collection linked to real world rewards.

• Polygon announces planned beta launch of their zkEVM on March 27.

• Citadel Securities discloses 5.5% stake in crypto bank Silvergate.

• US Senator Elizabeth Warren pledges to reintroduce a bill to tighten AML rules for crypto firms.

• Stanford scholars co-signed Sam Bankman-Fried’s $250 million bail deal

• eBay NFT platform KnownOrigin launches creator smart contract

• NBA Top Shot will let users buy NFTs via Apple, Android mobile apps

• Binance expects to pay fines to settle US investigations

• First Ordinals web wallet released

• From the Desk of Galaxy Digital Research