Top Stories of the Week - 8/11

This week we write about the launch of PayPal’s stablecoin (PYUSD), new notices from the Federal Reserve relating to banks’ interactions with crypto, and the Y00ts NFT project moving from Polygon to Ethereum. Subscribe here and receive Galaxy's Weekly Top Stories, and more, directly to your inbox.

PayPal Launches Dollar-Backed Stablecoin PYUSD

On Monday (Aug. 7), PayPal announced the launch of a new U.S. dollar-denominated stablecoin, PayPal USD (PYUSD). PYUSD is an ERC-20 token built on Ethereum and issued by Paxos Trust Company, the same company that issues the Pax Dollar (USDP). Paxos custodies the dollar reserves, held in U.S. Treasuries and similar cash equivalents, backing PYUSD and USDP. PayPal will roll out their new stablecoin to customers over the coming weeks so that purchases of PYUSD will be able to access the following features:

• Transfer PayPal USD between PayPal and compatible external wallets

• Send person-to-person payments using PYUSD

• Fund purchases with PayPal USD by selecting it at checkout

• Convert any of PayPal's supported cryptocurrencies to and from PayPal USD

“The shift toward digital currencies requires a stable instrument that is both digitally native and easily connected to fiat currency like the U.S. dollar," said Dan Schulman, president and CEO, PayPal in a press release. "Our commitment to responsible innovation and compliance, and our track record delivering new experiences to our customers, provides the foundation necessary to contribute to the growth of digital payments through PayPal USD." U.S. Congressman and Chair of the House Financial Service Committee Patrick McHenry (R-NC) said in a statement about the launch of PYUSD that it was “a clear signal” affirming the promise and potential of stablecoins to transform payments if issued and innovated under a clear regulatory framework. Beginning in September, Paxos will publish monthly reserve reports for PYUSD to increase the transparency around the stablecoin and issue public third-party attestations of PYUSD reserve assets.

Our take

The launch of PYUSD could be a boon for the adoption of stablecoins because of the high-profile and wide reach of its issuer, PayPal, that may advance efforts to create robust regulatory frameworks around stablecoins in the U.S. There are several areas of active and ongoing debate between lawmakers on how cryptocurrencies should be regulated in the U.S. that will impact PYUSD, and other major stablecoins created by U.S. companies, including:

Stablecoin issuance: On Thursday, July 27, the U.S. House Financial Services Committee passed bipartisan stablecoin legislation, but without the support of Ranking Member Maxine Waters (D-CA). A dispute over who can issue stablecoins – banks only or also state-chartered nonbanks – was reportedly one of the major sticking points that prevented broader bipartisan support. In this instance, PayPal & Paxos would be nonbank issuers that would be allowed under the current legislation advancing through the House, but not allowed under language favored by Democratic party leaders.

Banking activities: The Federal Reserve published two notices on Tuesday, August 8 focused on supervision of member banks involved with cryptocurrencies. This, in addition to the closure of three different crypto-friendly banks in the U.S this year, has sparked concerns over the existence of a potential coordinated regulatory effort to unbank crypto-native companies, which puts into question the future of custody for cash collateral balances backing stablecoins like PYUSD.

Asset categorization: Should stablecoins seek to offer interest on deposits, regulators will need to contend with how to characterize these instruments with the SEC likely viewing some of these types of instruments as securities

AML and KYC requirements: New bills targeting AML and KYC concerns about the use of cryptocurrencies and blockchain technology raise questions about the extent to which transfers of stablecoins will need to be facilitated by issuers between only whitelisted users on primary markets, and even potentially on secondary markets such as decentralized exchanges (DEXs).

Users of PYUSD should be wary of regulatory actions potentially impacting their use of the stablecoin, especially as it gains adoption in the U.S. Transfers of PYUSD like other major stablecoins issued by a centralized provider is wholly controlled by the issuer, meaning PayPal/Paxos could freeze PYUSD funds from user accounts regardless of whether the balance is held directly on PayPal or in a user owned Ethereum address. These risks are the same ones that apply to users of any stablecoin issued by centralized, regulated entities, such as USDT and USDC. The growing adoption of centralized stablecoins, especially among users of decentralized finance (DeFi) applications, will also likely expedite the bifurcation of DeFi between permissioned and permissionless financial services and products.

- Christine Kim

Federal Reserve Issues New Guidance on Banks’ Crypto Activities

On Tuesday (Aug. 8), the Federal Reserve published two separate notices, each focused on supervision of member banks involved with cryptoassets. The first notice expands on Jan. 27 guidance from the Fed (which announced that national bank requirements would extend state banks as it relates to crypto activities, per their Jan. 3 guidance) and explains the specific process that state-chartered Fed members will need to complete to be approved to issue, hold, or trade in stablecoins. The second notice is an initial announcement of the creation of a wholly new supervisory regime covering “novel activities,” which includes cryptoasset activities but crucially also formalizes the Fed’s interest in scrutinizing banks that support mainstream fintechs.

The first notice clarifies that state member banks wishing to engage in crypto-related activities permitted to national banks with OCC-approval (such as issuing, holding, or transacting in stablecoins) will be subject to a specific supervisory regime. This was already known and made clear in the Jan. 27 notice, but this update provides more specific guidance as to the nature of the supervisory process. Notably, banks are prohibited from doing anything with stablecoins until they receive a formal "nonobjection" from the Fed supervisory process. The topics the Fed will cover in its supervision are:

• operational risks (such as oversight over governance of the network, validation, timing and finality, irreversibility of transactions, etc.)

• cybersecurity risks (such as protocol risk, smart contract risk, etc.)

• liquidity risks (run risk on the token collateral leading to rapid deposit outflow)

• illicit finance risks (BSA, FinCEN compliance, etc.)

• consumer compliance risks (consumer protection statutes)

The second notice is more interesting and novel. The Fed is announcing a new supervisory program focused on (the fittingly named) "Novel Activities Supervision Program." The new supervisory program will oversee all member banks (state, national, etc.) that conduct any novel activities, which are listed as:

• Complex, technology-driven partnerships with non-banks to provide banking services (this seems to apply to any member bank that partners with a fintech to deliver banking services to end customers which access the banks infra in an automated way... read, Fintechs)

• Crypto-asset related activities (specific activities mentioned that would trigger scrutiny are crypto custody, crypto lending, crypto trading, or stablecoin issues/distribution)

• Projects that use DLT with the potential for significant impact on the financial system (essentially this refers to tokenization and stablecoins)

• Concentrated provision of banking services to crypto-asset-related entities and fintechs (this suggests additional scrutiny on banks whose deposit bases are highly correlated in the crypto-asset or fintech industries)

Our take

Neither notice prohibits or approves any type of activity. While the first one provides more clarity on the specific risks supervisors will consider when weighing approval activity, the second notice creates a new supervisory regime but does not offer as many specifics (we can expect the Fed to follow-up at some point with additional specifics on which risks in particular apply to each category).

It’s hard to know at this point whether these notices signal any shift in behavior from the Fed. On almost all the issues raised in the two notices, market participants have reported already facing the outlined scrutiny behind the scenes. From stablecoins to crypto custody to tokenization to concentrated crypto industry banking to simply API-based-banking services, the Fed has already been scrutinizing these activities in recent years. In that sense, these notices don’t materially alter the situation “on the ground” as it relates to these activities. As former Paxos PM for BUSD Austin Campbell wrote on Twitter, “the proof will be in the pudding.”

On the other hand, given that these notices do not materially alter the status quo but do formalize and provide “written” clarity on the Fed’s positions on these issues, the notices can be seen to be a marginal net positive. It is unlikely that these new supervisory regimes will result in an increase in crypto activity at banks in the near term, but the formalizing of these guidances does open a path for banks to press the Fed to allow them to do these activities. Whether or not any banks succeed depends on “how high the bar is set” by the Fed – it is possible the Fed sets the risk mitigation bar so high, on stablecoins for example, that no viable stablecoin model can emerge. (Specifically, an example might relate to banks assessment and mitigation of cybersecurity risks associated with the underlying blockchain protocol upon which they issue a stablecoin – a bank can only “mitigate” Ethereum protocol risk so much, and if it isn’t enough for the Fed, then it’s unlikely that a bank can issue a stablecoin that is viable in today’s market, which is dominated by Ethereum-based tokens.

- Alex Thorn

Y00ts to Move from Polygon to Ethereum

Y00ts, a leading Polygon NFT project, announced they will be migrating to Ethereum. Y00ts is the second PFP collection in the DeLabs collection and originally minted on Solana in Fall 2022. In December 2022 DeLabs announced it would be migrating Y00ts to Polygon. In migrating to Ethereum, Y00ts will join DeGods, the first collection minted by DeLabs in Fall 2021.

Y00ts originally received a $3 million non-equity grant from the Polygon Foundation to expand their team and assist in the original move from Solana to Polygon. Nearly 90% of Y00ts migrated and it has been the largest NFT project by market cap on Polygon since the migration. As part of the migration to Ethereum, all $3 million will be returned.

The announcement came at the same time that Y00ts parent collection, DeGods, announced the beginning of “Season III,” enabling DeGods holders to upgrade their art and spend points to “play & win prizes.” Y00ts will not be featured in DeGods Season III and exact timing for the Y00ts migration is yet to be announced.

Our take

Y00ts bridging to a new blockchain for the second time this year highlights the ongoing challenges facing NFT projects trying to grow their communities during the bear market. Since moving to Polygon, Y00ts has struggled to onboard new collectors and generate substantial interest in Polygon NFTs more broadly, a major objective of the initial move. This has been even more challenging given the broader drawdown in NFT volume, which dropped more than 70% year over year.

The Polygon NFT ecosystem has onboarded notable Web2 juggernauts like Nike, Reddit, Starbucks and the NFL, but this has not translated into substantial increases in daily volume. Y00ts generated only 3.5k ETH in volume during the last 90 days. In contrast, DeGods had 28.7k ETH within the same period on Ethereum. The success of Nike's swoosh initiative indicates that Polygon's NFT infrastructure is better positioned to serve as the backend for retail facing NFT projects rather than community based profile picture projects (pfp).

PFPs, which primarily rely on active and engaged communities to maintain their relevance, have repeatedly struggled to successfully migrate to other chains. In fact, one of the only successful examples to date has been DeGods migrating to Ethereum. Leading NFT marketplaces like OpenSea and Magic Eden now offer the ability to buy NFTs on multiple chains. However, it is clear that despite an easier purchasing process, collectors still place a premium on NFT collections based on Ethereum.

- Lucas Tcheyan, Gabe Parker

Other News

• HashKey obtains first license in Hong Kong to offer crypto retail trading

• Coinbase’s layer 2 network “Base” officially opens to the general public

• Microsoft partners with Aptos, will explore digital payments and tokenization.

• SEC will appeal XRP ruling in case against Ripple

• Russia to test Digital Ruble with banks, clients

• Maple Finance's tokenized Treasuries available to U.S. investors after securities exemption

• Matter Labs accuses Polygon of spreading "Untrue Claims" with code-copying allegations.