Weekly Stories - 5/17
This week in the newsletter we write about crypto’s big win on SAB 121, increasing institutional ownership of bitcoin as illustrated by the ETFs’ 13-F filings, and a DOJ action against MEV-bot exploiters that raises interesting questions about crypto and law.
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Senate Rebukes SEC with SAB 121 Overturn
Senate passes bill to block SAB 121 using Congressional Review Act, with 11 Democrats (and 1 Democratic-leaning Independent) joining Republicans. The US Senate voted to overturn the SEC’s controversial balance-sheet accounting rule known as SAB 121 in a 60-38 vote that saw Senators Schumer (D-NY), Gillibrand (D-NY), Hickenlooper (D-CO), Peters (D-MI), Tester (D-MT), Rosen (D-NV), Kelly (D-AZ), Casey (D-PA), Booker (D-NJ), Lujan (D-NM), and Wyden (D-OR) voting with Republicans. Kyrsten Sinema (I-AZ) is an independent who caucuses with the Democrats, also voted for the legislation.
The “privileged resolution” needed only a simply majority to pass the Senate (51 votes) and passed that threshold handily. The bill, which passed the U.S. House last week with 21 Democrats joining Republicans, will now go to President Biden’s desk for signature or veto. Attention now moves to the White House, which last week threatened to veto the bill should it pass. While a sizeable contingent of Democrats joined Republicans to pass, 60 votes is below the 67 needed to override a Presidential veto, should it happen.
For context, SAB 121 is a staff accounting bulletin the SEC published in March 2022 and which requires publicly-traded crypto custodians to carry client assets on their balance sheets. Due to separate bank capital requirement rules, which require matching balance sheet assets with cash, the rule effectively blocked all banks from holding crypto for clients. For a more detailed explanation, read our newsletter from last week.
OUR TAKE:
Momentum to overturn SAB 121 gained steam last week with 21 Democrats joining House Republicans to pass the bill and send it to the Senate. The White House has made clear that they oppose the bill, and Sen. Elizabeth Warren (D-MA) took to the floor ahead of the vote to argue against passage of the bill. As we wrote last week, it was surprising to see the White House wade into the fray with a veto threat on what is ultimately a relatively niche item like crypto accounting, but we believe the White House was driven more by circling the wagons around current SEC leadership than taking a particular directional view on the policy matter itself.
To that point, the vote became a bit of a referendum on crypto for members – a litmus test on whether Democrats are willing to buck the leadership of the White House and Sen. Warren (D-MA), who argued strenuously before the vote that her colleagues should oppose it. With crypto becoming increasingly relevant in the 2024 election, Democrats who voted yes here – in the House and the Senate – are signaling to constituents that they are not as anti-crypto as people think, and that they are willing to push back on the SEC.
Although the White House is likely to veto, and it’s not clear that the Senate could get to the 67 votes that would be needed to override a veto, the bipartisan nature of the rebuke to the SEC’s “rule” was a striking display of crypto policy on the highest political stage. There are a dozen members of the Senate Democratic caucus who at a minimum want to signal that they are not categorically opposed to crypto, or even that they disapprove of the current SEC’s approach to the industry. -Alex Thorn
Bitcoin ETFs see Early Institutional Demand
13F filings reveal new bitcoin ETF holders among institutional asset managers. Following Wednesday's deadline to file Q1 13F reports with the SEC, over 900 US investment firms revealed holdings in Bitcoin ETFs as of 3/31/24. The list of buyers includes prominent names across banks (e.g., JP Morgan, Morgan Stanley, Wells Fargo), hedge funds (e.g., Millennium, Point72, Citadel), and even pension funds (e.g., the State of Wisconsin Investment Board). According to Bloomberg ETF Analyst Eric Balchunas, 13F-filing institutions collectively owned ~$11bn at Q1-end - among institution types, investment advisors led other institutional types with 60% of the total while hedge funds were the next largest segment with 25%. The combined $11bn held by institutions accounted for ~20% of total bitcoin ETF ownership, suggesting the majority of these products are held by retail or smaller asset managers (<$100m in AUM).
Millennium was the biggest ETF holder with nearly $2bn worth of shares across four separate Bitcoin ETFs. Balchunas noted that IBIT's 414 holders was a "mind-boggling" number, adding that "normally you don't see this long a list of holder types till years after launch and mega liquidity - which IBIT already has." While the influx of institutional money and the list of institutional holders may have been stronger than most have expected, reasons for bitcoin ETF ownership among 13F filers may not be entirely bullish - for example, hedge funds may have purchased the ETFs as part of the GBTC arb trade or as part of a basis trade to offset a short position in derivatives and profit off differences in prices between spot and futures markets. In either case, the record amount of money flowing into these ETFs illustrates the demand for bitcoin ETF products.
OUR TAKE:
Less than three months since first launching on January 11, bitcoin ETFs attracted substantial inflows, helping to drive BTC price from $40k at 2024-start to over $70k in March. While institutions only account for ~20% of total bitcoin ETF ownership so far, the broad types of institutional holders are profound. In particular, the State of Wisconsin Investment Board stands out - it is the 10th largest US pension fund with $156bn in AUM, and it is also the first and only state pension to allocate to Bitcoin ETFs as of Q1-end. Public pensions collectively manage ~$6 trillion in AUM and typically follow conservative strategies with long time horizons, so the early adoption by SWIB is encouraging for future pension allocations to bitcoin.
In contrast to pensions, other institution types have shorter investment timelines, such as hedge funds. Hedge fund allocations to bitcoin ETFs are less indicative of structural conviction in Bitcoin compared to pension allocations. Millenium's ownership of four different types of bitcoin ETFs and significant ebbs and flows between GBTC and other ETF products in the initial weeks of trading suggest hedge funds are engaging in some of the trading strategies mentioned above.
Still, these 13F filings for Q1 are extremely supportive of Bitcoin demand going forward. All of this institutional demand for bitcoin ETFs has occurred even as the most funds/platforms are still working on due diligence and onboarding. The largest wealth platforms have yet to allow their brokers to recommend bitcoin ETFs, though Morgan Stanley is reportedly exploring enabling its brokers to solicit customer purchases. We wrote in our report Sizing the Market for a Bitcoin ETF that the access ramp for bitcoin ETFs across wealth platforms - including broker-dealers, banks, and RIAs - would likely span several years. In our view, the unlock of sales-driven inflows from institutional platform access will be a significant catalyst for bitcoin adoption in the near-to-medium term. - Charles Yu
U.S. Department of Justice Accuses Two Brothers of “Attacking Ethereum”
On Wednesday, May 15, the U.S. Department of Justice (DOJ) unsealed an indictment charging Anton Peraire-Bueno, 24, of Boston, and James Pepaire-Bueno, 28, of New York, with conspiracy to commit wire fraud, wire fraud, and conspiracy to commit money laundering. The press release for the indictment states that the two brothers attacked Ethereum and stole $25m in cryptocurrency from the network. “As we allege, the defendants’ scheme calls the very integrity of the blockchain into question. The brothers, who studied computer science and math at one of the most prestigious universities in the world, allegedly used their specialized skills and education to tamper with and manipulate the protocols relied upon by millions of Ethereum users across the globe. ... no matter how sophisticated the fraud or how new the techniques used to accomplish it, the career prosecutors of this office will be relentless in pursuing people who attack the integrity of all financial systems,” said U.S. Attorney Damian Williams for the Southern District of New York in a press release.
The charges against the Peraire-Bueno brothers are based on an incident from April 3, 2023, when the two brothers back ran transactions executed by MEV bots. MEV bots are algorithms designed and operated by highly specialized actors on Ethereum called searchers that identify lucrative trading strategies on user transactions by reordering transactions and inserting their own within a block. To execute MEV strategies, searchers rely on block proposers, also called validators, that will include their transaction bundles within a block for a cut of the MEV profits. Usually, validators are not privy to the contents of a block, only the cut of the searcher’s profit they can earn from proposing the block on-chain.
However, on April 3, the Peraire-Bueno brothers identified a loophole in MEV-Boost relay software, a key technology that facilitates MEV and searcher activities on Ethereum, that would enable them to view block contents before the block is proposed on-chain. First, the brothers baited 5 MEV bots with their own transactions into making specific trades on high leverage. Then, the brothers took advantage of the MEV-Boost relay loophole to see which MEV bots took the bait. Finally, they proposed a new block inserting their own transactions that would back run the MEV bots’ initial front running transactions. The exploit essentially took advantage of sandwiching attacks on user transactions and made the brothers $25m. For the full breakdown of the incident on April 3, refer to this prior Galaxy Research Brief.
A few hours after the incident, the Flashbots team promptly released a patch for MEV-Boost to close the loophole. It’s worth noting that, a few weeks after this incident, the Peraire-Bueno brothers notified the Flashbots team of another vulnerability in MEV-Boost that was not used in production which was also promptly patched by the Flashbots team upon notice.
OUR TAKE:
The DOJ alleges the Peraire-Bueno brothers committed wire fraud by exploiting a vulnerability in MEV-Boost relay software to steal money from MEV bots. In making these allegations, the DOJ asserts that the Ethereum protocol is a legitimate financial system used by millions of people across the world with rules and codes of conduct protected to some degree by the full authority of U.S. law. Evidence to suggest that a user is intentionally trying to defraud other users, even an extremely specific and niche group of users, by exploiting vulnerabilities in open-source code, even open-source code that is not directly related to the Ethereum protocol, is criminal evidence. Based on the internet search history of the Peraire-Bueno brothers which includes searches for “how to wash crypto” and “cefi exchanges with no kyc”, as well as their unwillingness to return funds back to the MEV bots that had stolen from, it is difficult to argue that they did not know or were not intentionally trying to commit fraud against MEV bots on Ethereum by exploiting a temporary loophole in MEV-Boost relay software. Because of their actions during the exploit and in disclosing another bug in the open-source software a few weeks after, Flashbots was able to identify major problems in their code and release fixes to uphold the integrity of their software.
It is important to note that the DOJ makes no distinction between the integrity of Ethereum, which was not in jeopardy in the incident on April 3, and the integrity of MEV-Boost relay software. In this complaint, the two are one and the same in the eyes of the DOJ. Even users that are in the business of profiting from exploiting other users (i.e. MEV bots designed to sandwich regular users’ trades) are suggested by the complaint to be merely “victim traders,” suggesting that prosecutors view regular MEV activity as simply a form of high frequency trading.
What is not acceptable in the eyes of the DOJ is hacking with malicious intent, that is black hat hacking, and in this case with the intent to defraud other users. This is not the first case the DOJ has brought against an individual for defrauding users on-chain. Last month, the DOJ convicted Avraham Eisenberg for engaging in fraudulent schemes on decentralized exchange Mango Markets by artificially manipulating the price of certain perpetual futures contracts. The DOJ has also convicted individuals and tried to shut down crypto products for charges related to money laundering, as seen by their cases against Tornado Cash founders and Samourai Wallet founders. The DOJ is clearly keeping a close watch on the activities that happen on-chain and bringing charges based on the profiles and intents of users interacting with public blockchains. On one hand, it’s positive that the DOJ is taking public blockchains and the value created on them seriously but on the other hand, the DOJ is not in the business of upholding the values of decentralization, permissionless innovation, and censorship-resistance on these blockchains. When they take action against certain types of activities and behaviors on-chain, the DOJ is doing so based on their subjective claims about how a public blockchain should work and who should be allowed to use it. So, such actions are also a cause for concern as these cases point to the possibility of more types of on-chain activities that may be permissible according to code but criminalized according to U.S. law. - Christine Kim
Charts of the Week
The total amount of assets deposited in EigenLayer and Karak, the largest Ethereum-based restaking protocols, is approaching $16 billion. The chart below shows the combined amount of assets restaked by type. Natively staked ETH makes up the greatest portion of restaked assets between these protocols, capturing 64% of the total. LSTs hold the second largest share at 33%, followed by Pendle Finance tokens, liquid restaking tokens (LRTs), stablecoins, and bitcoin (wBTC).
EigenLayer makes up $15.06 billion of the $15.7 billion in restaked value (96% share). As of today EigenLayer only accepts natively staked ETH through EigenPods and ETH liquid staking tokens (LSTs). The value between these two asset types is split 66% / 34% in favor of natively staked ETH. The chart below shows the total value deposited into EigenLayer by asset. Note, EigenPod signifies natively staked ETH, and the remaining assets are LSTs.
Karak holds $662 million in deposits across all chains it is deployed on, which includes Ethereum, Arbitrum, Karak Network, and Mantle. The protocol accepts deposits of various types of assets, including ETH (WETH), LSTs, LRTs, stablecoins, and Pendle Finance tokens. Pendle Finance tokens and LRTs make up 60% of the value deposited into Karak, with only 7% being ETH.
Other News
State of Wisconsin Investment Board reveals $163 million in spot bitcoin ETFs
Vitalik Buterin drafts EIP-7706, proposing new calldata gas type for Ethereum
Morgan Stanley discloses US spot bitcoin ETF holdings worth over $270 million in filing
CME Group plans to launch bitcoin spot trading
Japan’s Metaplanet adopts bitcoin as reserve asset amid yen slump
Pudgy Penguins announces one million plush units sold in less than a year
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