Top Stories of the Week - 6/16

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Slew of Legal & Regulatory News Shakeup Crypto

This week, particularly Tuesday, saw a flurry of major crypto-regulatory headlines. At this point, there are multiple concurrent, sometimes divergent, threads of legal, regulatory, and policy developments colliding simultaneously. Despite the massive news day on Tuesday, cryptoassets were mostly flat.

To recap, on Tuesday:

• Federal District Court Judge Amy Berman Jackson, a 2012 Obama appointee who presided over the trials of both Trump-world figures Paul Manafort and Roger Stone, declined to order a temporary restraining order that would wholly freeze BinanceUS’s assets and business. Instead, the Judge ordered the two sides – Binance and the SEC – to come to agreement on a path forward that would allow BinanceUS to keep operating during the court proceedings but also protect and segregate BinanceUS’s assets from Binance International & CZ.

• The House Financial Services Committee held a full committee hearing titled “The Future of Digital Assets: Providing Clarity for the Digital Asset Ecosystem” featuring witnesses Jeremy Allaire (CEO, Circle), Coy Garrison (Partner, Steptoe Johnson – former counsel to SEC Commissioner Hester Peirce), Emin Gun Sirer (Founder & CEO, Ava Labs), Thomas Sexton III (President & CEO, National Futures Association), and Aaron Kaplan (Founder & Co-CEO, Prometheum). Much of the hearing was focused on discussing the recently published draft market structure bill from Reps. McHenry and Thompson, with most witnesses praising the effort and calling for legislative action. A notable exception was Mr. Kaplan from Prometheum, a broker-dealer recently granted a special purpose license from the SEC to handle crypto asset securities, who argued that no additional legislation or regulatory authority was required (essentially parroting SEC Chair Gary Gensler’s position). On this topic, we recommend watching Rep. Flood’s line of questioning to Mr. Kaplan.

• The SEC replied to Coinbase and the 3rd Circuit Court of Appeals in Coinbase’s Writ of Mandamus request. Coinbase asked the 3rd Circuit Court to force the SEC to respond to its 2022 petition for rulemaking and last week the court ordered the SEC to reply and either deny the petition, say that it hadn’t yet decided to deny the petition, and suggest how much time it would need to make a decision. On Tuesday, the SEC replied and called Coinbase’s request “extraordinary” and said the Commission “has not decided what action to take on that petition in whole or in part—which is entirely reasonable given the breadth of the rulemaking petition and the fact that it was filed just months ago.” The SEC says its staff anticipates “being able to make a recommendation to the Commission regarding Coinbase’s rulemaking petition within the next 120 days.” Coinbase Chief Legal Officer Paul Grewal called the SEC’s statement that they haven’t made a decision on any new crypto rules a “fallacy.”

• Documents related to a 2018 speech by former SEC Head of Corporate Finance Bill Hinman were released in the SEC’s litigation against Ripple Labs. In the 2018 speech, Hinman advanced the notion that the assets that are “sufficiently decentralized” should not be classified as securities, specifically referencing Ethereum and arguing that it was no longer a security (by 2018), despite its initial offering likely have been an unregistered securities offering. The documents showed that Hinman’s speech had been reviewed by the division of Trading & Markets, the SEC’s general counsel, and had at least been shared ahead of time with then-Chair Jay Clayton. While not strictly dispositive the way a formal guidance from the SEC would be, the documents nonetheless dispel the notion that Hinman was acting solely on his own accord. Indeed, high level colleagues and counsel at the SEC reviewed and appear to have agreed with his analysis. Read more analysis of Hinman docs.

• The comment period for the SEC’s proposed amendments to the definition of “exchange” in the Securities Exchange Act closed on Tuesday. The final day, June 13, saw a flurry of comments pour in, including from Galaxy (written by Alex Thorn), Polygon Labs, Consensys, Virtu Financial, Blockchain Association, Hedera Hashgraph, Circle, Crypto Council for Innovation, SIFMA, Coinbase, Bloomberg, Multicoin Capital & True Ventures, a group of members of the US House of Representatives, Fidelity Capital Markets, and Bain Capital Crypto. Not all these comments, or all the comments in general, relate to the proposed change’s impact on crypto. Fidelity Capital Markets, for example, argues that the change is simply overly broad and vague, and the reason for the change is unclear. As written and as explained in the SEC’s responses to prior comments, the proposed change would result in wide swaths of DeFi protocols being required to register with the SEC as national securities exchanges, even those whose smart contracts are non-upgradeable and have no admin keys. Galaxy’s comment is narrowly focused on the last point specifically – that it is impractical to require non-upgradeable smart contracts to register as national securities exchanges, as they functionally will not be capable of complying, and so the SEC’s position will create an unenforceable prohibition.

Our take

The rest of the week was relatively quieter in terms of regulatory headlines. The Fed’s ‘hawkish pause’ dominated news on Wednesday, and Thursday was quiet overall. But Tuesday was a whirlwind – I spent the entire day eyeing court dockets, getting updates from colleagues literally inside the House Financial Services Hearing (Tyler Williams) and the Binance’s TRO Hearing (Brandon Bailey), and reading court exhibits as fast as possible. In the end, Tuesday ended up being mostly a neutral day in crypto markets, with Wednesday night finally seeing a dam begin to break, with Ether falling below $1700 and Bitcoin falling below $25k.

It’s hard not to comment more fully on Promethean, the so-called special purpose broker/dealer approved by the SEC to trade crypto asset securities. This isn’t that big a deal, but it’s fair to say the emergence of this entity, and appearance in the House, really left a lot of the crypto research and legal communities scratching heads. There’s a lot that doesn’t make sense about the firm: it claims on its website that it has employees in 20 countries, and lists its office as the 25th floor of a major office building on Wall St., but also says 80% of its employees are remote; it actually conducted a 2017 Reg A qualified ICO and apparently raised $50m to build their own blockchain (“Prometheum Network”) with their own token (“Embers”), but that doesn’t ever appear to have happened; they believe that no additional regulatory guidance or legislation is required to bring clarity to the cryptoasset markets, but they told Rep. Flood in the House Financial Services that they don’t allow trading of Bitcoin or Ether; the company is co-CEO’d by two brothers and their father is the Chairman; and on and on.

For now, we wait for trials and rulings in other cases, such as SEC v. Ripple (motion practice still ongoing), Grayscale vs. SEC (over the SEC’s denial of Grayscale’s ETF conversion), and Fir Tree vs. Grayscale (in which Fir Tree is seeking books & records info). And we wait to see if there is progress on the new draft market structure bill (which we wrote about last week) – House Financial Services Committee Chair Rep. Patrick McHenry said on Tuesday that he wants to move the bill out of committee and put to the floor of the House once Congress returns from July 4th recess. The market structure bill and the SEC’s positions on enforcement and rulemaking are in direct conflict – so we may see some fireworks if Congress can get some momentum.

-Alex Thorn

Scaling Ordinals on Bitcoin

A new update to the Ordinals tech stack introduces an efficient way to scale Ordinals on Bitcoin. As it stands, Ordinals are self-contained and lack the ability to interact with other Ordinals on-chain, mainly due to their incapacity to recognize other inscription data. Despite that, the incorporation of recursive inscriptions enables Ordinals the ability to reference the inscription data of other Ordinals. This is made possible by a new syntax that allows Ordinals to access other inscription metadata. Consequently, the inscription data size for individual Ordinals is no longer restricted to 4MB (Bitcoin's blocksize limit) as inscription data can now be distributed across multiple inscriptions. This allows creators to craft collections where one Ordinal is the summation of multiple inscriptions, including any inscriptions created in the future, thereby facilitating the evolution of Ordinals over time. This empowers developers to inscribe more data-intensive products, such as games, on Bitcoin.

Recursive inscriptions provide a more efficient method of storing arbitrary data on-chain without congesting the mempool. This will inevitably lead to a reduction in the volatility of Bitcoin transaction fees from increased inscription activity in the long run. While the potential uses for recursions are still being explored, some inscribers have already proposed the idea of using Bitcoin as a decentralized file storage, similar to IPFS, through launching publicly accessible computer code for developers on-chain.

Our take

The activity surrounding Ordinals continues to grow robustly, with integration achieved across key exchanges and marketplaces including OKX, Binance, and Magic Eden. The total number of inscriptions carrying image data now exceeds 950k, resulting in approximately $207mn in trading volume. It's inevitable that the integration of Ordinals among more prominent NFT marketplaces will further spur inscription activity, propelling it beyond current levels. As the Ordinals ecosystem expands, it's crucial to find a way to scale inscription data at the base layer to accommodate widespread adoption. Without this, Ordinals will have to depend on the evolution of Bitcoin L2 protocols that facilitate off-chain Ordinal markets. However, transferring Ordinals off-chain contradicts one of the core values held by many Ordinals collectors; the ownership of digital artifacts on Bitcoin's main chain. It's already evident that there is value owning immutable digital goods on the most trusted and secure blockchain.

Long-term value for recursive inscriptions could potentially be sustained through the creation of accessible public goods designed for the emerging creative economy within Bitcoin’s ecosystem. Such public goods include complimentary packages for creators to produce on-chain generative art, emulators for running a wide variety of programs, and free decentralized games. Evidence of this development is already apparent within the first week, as the On-Chain Monkey project plans to launch a free package that allows any user to create on-chain generative 3D art.

The capability for recursive inscriptions to make files and programs accessible, suggests that Bitcoin could serve as a fully decentralized file system. This idea aligns well with Bitcoin's inherent properties, given its immutable data, constant uptime, and now cost-effective file inscribing process. While IPFS currently leads as the most popular decentralized file storage system, it's not entirely decentralized and is heavily dependent on centralized pinning providers. The potential for Bitcoin to be utilized for file storage opens up significant opportunities including but not limited to on-chain games. Given Bitcoin's history of on-chain gaming, traced back to Satoshi Dice in 2012, gaming on Bitcoin offers a compelling use case for recursive inscriptions.

Today, we see free inscription games, such as Doom, but these offerings are compromised in terms of design quality due to blocksize limits. Recursive inscriptions are poised to dramatically improve the quality of on-chain games. This view does not imply that high quality games developed by top tier gaming studios will move to Bitcoin, however, Ordinal collectors will be able to use their assets in low-budget games.

While there's no absolute guarantee that recursive inscriptions will effectively scale Ordinals in the long term, the efforts towards this goal are promising. The road ahead, with development expected over the next few years, is not completely foreseeable. Yet, the swift introduction of recursive inscriptions demonstrates the agility and adaptability of Ordinals' developers, suggesting that the frameworks we see today could evolve significantly over time.

Overall, the various applications of recursive inscriptions present intriguing prospects to watch. With time as the true test, it will be fascinating to see which use case proves to be the most feasible.

- Gabe Parker

Uniswap Labs Released Draft Code for V4

Uniswap Labs announces details behind Uniswap V4 plans. Uniswap Labs shared the draft code for Uniswap v4 and invited the community to collaborate on the codebase. This version builds on the concentrated liquidity model pioneered in v3 and enables much more flexibility in designing swap mechanics during pool creation while lowering the gas costs. Uniswap v4 introduces hooks (hook contracts), which enable the calling of smart contracts before or after the swap, liquidity provision, initialization, or donation (a new feature that allows LPs to receive additional tips). As noted in the announcement post, hooks can unlock new functionalities, such as time-weighted order execution, limit orders, volatility-based dynamic fees, MEV internalization to LPs, and custom oracle implementations. Uniswap v4 enables developers to design their own hook contracts for the pools that they deploy allowing for innovation within Uniswap itself rather than in competition against it.

Other core features of Uniswap v4 include a singleton contract, flash accounting, ERC-1155 accounting within the protocol, and governance-immutable pools:

• Uniswap v4’s singleton contract unlocks significant gas savings when swapping across several pools by eliminating the need for transferring ERC-20 tokens between smart contracts of pools in a single swap.

• Flash accounting amounts to each operating updating a delta value that ensures that at the end of the call, neither the pool nor the user are owed funds. Building on the singleton contract, the new accounting methodology writes values to transient storage rather than writing values to memory, which is a more gas-itensive method.

• ERC-1155 accounting is an upgrade from ERC-721 accounting in v3 to allow for additional features within the protocol, such as keeping the tokens within the singleton contract rather than paying the token transfer fee to and from the pool contract in case of active position rebalancing.

Uniswap v4 also offers benefits to mitigate liquidity fragmentation across ETH and WETH markets, allowing for pools that feature native ETH in the protocol for the first time since v1. Finally, unlike in Uniswap v3, governance in Uniswap v4 would be unable to adjust permissible fee tiers and tick spacings - a step towards making Uniswap more immutable as it transitions from being just an application towards becoming an important infrastructure layer within DeFi that enables builders on the platform to offer new products such as options protocols, index products, and LP automation tools.

Our take

Uniswap v4 is a huge turning point for DeFi, where a platform that previously competed in the race of cool features is now attempting to solidify its position by allowing innovation to happen within itself. The team expects to see a lot of highly-technical whitepapers from ambitious developers for different hook designs. An example which the team hasn’t mentioned in the whitepaper would be providing payments to LPs that sacrifice returns and provide liquidity across the entire range, thereby making the cost of driving up the price in the pool significantly higher and thereby protecting the DeFi protocols that use the pool’s price feed in their applications. Across this feature and the immutability of pools to adjustments of key parameters via governance, Uniswap is distancing itself from being a business towards being blockchain infrastructure. This is in line with the results and discussions surrounding a recent extremely contentious proposal in Uniswap governance surrounding the fee switch that would allow the protocol to accrue revenue from a portion of swap fees that currently get distributed to LPs in full. Most notably, while the team abstained from commenting, some developers building using Uniswap LP tokens have put forth the view that Uniswap should be an immutable public good.

However, one potential area of concern regarding hook contracts relates to the security of user and LP funds. Given the ingenuity of exploits that have taken place in DeFi, especially the ones that have drained MEV bots, the concept of arbitrary hooks would be hard for MEV developers and trading aggregators like 1inch and 0x to grapple with. While the Uniswap Labs team released the Uniswap v4 code for review, it will likely go through several more iterations before launching to the public as auditors and testers review the security risks of hooks and other new product features behind v4.

- Charles Yu, Kirill Naumov