Weekly Stories - 5/24

This week in the newsletter we write about the approval of Ethereum spot ETPs, the passage of the FIT21 Act in the US House, and China’s CBDC pilot in Hong Kong.

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One Spot Closer to Ethereum ETP

SEC approves key regulatory filings for spot Ether ETPs to begin trading in the US. On Thursday, the SEC approved "on an accelerated basis" 19b-4 proposals from three exchanges (i.e., Cboe, NYSE Arca and Nasdaq) that look to list spot ether ETPs, clearing a major hurdle for the products to begin trading. “After careful review, the commission finds that the proposals are consistent with the Exchange Act and rules and regulations thereunder applicable to a national securities exchange,” according to the notice posted on the SEC's website.

The approval follows Monday's abrupt and unexpected turnaround on the ETH ETP process where the regulator returned comments to the exchanges and prospective ETH ETP issuers, aiming to expedite the approval process. Prior to this week, the SEC has had limited engagement with prospective issuers, leading many to believe that the SEC was not yet ready to approve the ETPs – Bloomberg Intelligence ETF analysts Eric Balchunas and James Seyffart had predicted that the odds of approval this week was 25% before increasing the odds to 75% following Monday's positive developments.

Before the spot ether ETFs can begin trading, the SEC still must approve the S-1 filings by issuers, for which there is still no clear timeline. Seyffart believes that the S-1 approvals and ETF launches will take "days (at a minimum), likely at least weeks, and potentially months", while his colleague Eric Balchunas stated on Galaxy Brains that the process could happen as early as within the next two weeks.

The price of ether jumped from under $3100 to over $3700 on the improved ETP approval outlook on Monday, and reached a high of ~$3940 on Thursday after the SEC's approval was confirmed.

OUR TAKE:

The SEC’s approval of the 19b-4s marks a major milestone for the industry and a major policy shift by the securities regulator. Many had speculated that the sudden pivot was led by pressure coming top down from the Biden Administration following several tumultuous political weeks that saw major Democrats vote for pro-crypto legislation.

The development is also positive for several reasons: (i) it suggests that the SEC does not view ether as a security, which Chairman Gary Gensler had refused to state when questioned in the past, (ii) the correlation analysis between ether spot and futures prices submitted in the 19b-4s have passed the SEC's requirements, (iii) it builds on top of the growing political support we've seen lately in Congress (e.g., SAB 121 overturned last week and the passing of FIT21 Act).

However, final approval of S-1 forms filed by issuers is still not guaranteed and the timeline is still unknown. Key questions going forward are:

• How long will S-1 issues take to resolve? Most issuers already removed the option to stake from their applications.

• How will demand for an ether ETF look relative to a bitcoin ETF? Will potential investors be deterred from buying the ETF due to productivity loss vs. holding spot ether (i.e., inability to make gas payments to access DeFi and other applications) or due to the foregone staking yields?

• What will be the status of staked ETH from a regulatory standpoint (the SEC claims staked ETH products are securities in lawsuits against Coinbase, Consensys and others)? Will these ETF issuers eventually be approved to stake ether in the future?

• Could regulators soon approve ETPs for other crypto assets?

In any case, Thursday's approval for spot ether ETPs is a major breakthrough with positive implications for the rest of the industry. And as we’ve seen with bitcoin ETPs so far, 13F filings from last week are extremely supportive of bitcoin demand going forward – inflows and the list of institutional holders has been better than most have expected. Prominent RIAs, hedge funds, and even pensions have already bought in to the ETPs while banks and broker dealer platforms have yet to turn on access to the ETPs, which can be a huge unlock for institutional adoption of crypto going forward. - Charles Yu

House Passes Comprehensive Crypto Market Structure Bill

A whopping 71 Democrats joined House Republicans to pass the FIT21 Act. On Wednesday, the U.S. House of Representatives passed the Financial Innovation and Technology for the 21st Century Act (“FIT21”), a comprehensive regulatory overhaul that specifies when and under which conditions a cryptoasset token or exchange/broker would fall under the regulatory purview of the Securities & Exchange Commission (SEC) or the Commodity Futures Trading Commission (CFTC). The bill establishes clear lines between the SEC & CFTC, pushing more authority to the CFTC generally, so is a rebuke to the SEC’s current stance that almost all cryptoassets are “cryptoasset securities.”

The vote occurred around 6pm ET on Wednesday and passed with 279 votes in favor and 136 votes opposed, with the “ayes” including 71 Democrats, exactly one third of the caucus.

The bill also requires token creators to provide “accurate, relevant disclosures, including information relating to the digital asset project’s operation, ownership, and structure” and provides a legal pathway for token issuers to raise funding. On the business side, the bill requires companies that provide crypto services (i.e., exchanges, brokers, etc.) to segregate customer funds from their own, provide disclosures, and submit to regulatory examination.

The bill received the most bipartisan support of any crypto legislation in history, driven by high profile support from Democratic leaders like Rep. Nancy Pelosi (D-CA) as well as a shifting political climate that has seen crypto become a major political issue.

OUR TAKE:

There are important takeaways on this vote regarding both policy and politics. On policy, the bill is sweeping in both scope and magnitude, representing the most consequential crypto legislative package ever passed in Congress. The bill is complicated, many parts may have negative consequences to the industry, including creating a strangely bifurcated market that may harm liquidity or markets overall. But on balance, FIT21 is directionally what America needs to protect consumers, support innovation, maintain and enhance American competitiveness, and normalize the regulatory oversight of crypto markets.

The politics, though, are probably the bigger story. The magnitude of Democratic support for FIT21 was more than triple the House Democrat support for SAB 121 just two weeks ago. With the passage of SAB 121’s overturn in both the House and Senate despite an explicit veto threat from the White House, and with the Trump campaign now expressly raising a “crypto army,” crypto policy issues have become elevated to the national stage and it appears the Democrats no longer want to cede the issue to the Republicans. The White House’s veto threat 2 weeks ago on SAB 121 included hyperbolic language, suggesting that reversing that rule would create “financial instability,” but the White House’s statement of administration policy on FIT21 just two weeks later was full of conciliatory language and notably included no veto threat. The differences in these two statements of administration policy just two weeks apart is the clearest exhibition of an apparent shift in the White House’s political strategy on this issue.

Senate Majority Leader Sen. Chuck Schumer (D-NY) voted to overturn SAB 121. Former House Speaker Rep. Nancy Pelosi (D-CA) voted for FIT21. Rep. Maxine Waters (D-CA), ranking member o the House Financial Services Committee, and Rep. David Scott (D-GA), ranking member of the House Agriculture Committee, both spoke against FIT21, but explicitly said they would not whip votes against it. But, in just the last two weeks, small cracks have been expanded into a growing wedge between the Elizabeth Warren wing of the Democratic party and the White House, Senate leadership, and a third of the Democratic caucus in the House. This is a major political shift. Whether it results in true policy shifts from the current Democratic administration, or a future administration of either party, obviously remains to be seen. -Alex Thorn

China Expands Digital Yuan Payments System to Hong Kong

On Friday, May 17, the Hong Kong Monetary Authority (HKMA) and the People’s Bank of China (PBoC) announced that they will expand the scope of the e-CNY pilot to Hong Kong and facilitate the set up and use of e-CNY wallets by Hong Kong residents. e-CNY, also known as the digital yuan, is a central bank digital currency (CBDC) issued by the Chinese government that has been piloted in mainland China since as early as 2019. It is the world’s largest and most advanced CBDC pilot. According to an article in the Atlantic Council from 2023, there is 13.61bn RMB in circulation and 260m wallets on the e-CNY network.

For the first time, the e-CNY is now being piloted outside of mainland China. Eddie Yue, Chief Executive of the HKMA, said, “We are delighted that Hong Kong, being the first place in conducting cross-boundary e-CNY pilot, has also become the first place outside the Mainland that enables its residents to set up e-CNY wallets locally. By expanding the e-CNY pilot in Hong Kong and leveraging the 24x7 operating hours and real-time transfer advantages of the FPS, users may now top up their e-CNY wallets anytime, anywhere without having to open a Mainland bank account, thereby facilitating merchant payments in the Mainland by Hong Kong residents. We will continue to work closely with the PBoC to gradually expand the applications of e-CNY, enrich the range of functionalities of the e-CNY wallet available to Hong Kong residents and step up efforts in promoting the acceptance of e-CNY by more retail merchants in the two places.”

The HKMA announced earlier this year that they were advancing testing efforts for a CBDC of their own national currency called the e-HKD. It is important to note that unlike other CBDCs being experimented by state authorities around the world, the e-CNY does not use blockchain or distributed ledger technology. However, the Chinese government in parallel to their efforts on the e-CNY is also working on the Blockchain-based Service Network (BSN). The BSN is a general-purpose blockchain like Ethereum where companies and software developers can build blockchain-based applications. In December 2023, China’s Ministry of Public Security announced they were rolling out a decentralized identity service called RealDID on the BSN.

On Thursday, May 23, 2024, the U.S. House of Representatives passed a Republican-led bill blocking the Federal Reserve Bank from issuing a CBDC to individuals. House Majority Whip Rep. Tom Emmer, R-Minn., introduced the bill in September 2023 and stated at the time, “If not designed to be open, permissionless, and private – emulating cash – a government-issued CBDC is nothing more than a CCP-style surveillance tool that would be used to undermine the American way of life.”

OUR TAKE:

The U.S. and China continue to pursue starkly different approaches to digitizing their national currencies. China, recognizing the obvious benefits of a digital yuan (streamlined cross-border payments, extended public access to the yuan, 24x7 operating hours, and real-time transfer advantages), is doubling down on the e-CNY system by expanding it to its first region outside of mainland China. As the international gateway to mainland China, Hong Kong is an important global financial hub where the e-CNY system will for the first time be debuted for use by a global audience.

Meanwhile, it does not appear that the U.S. Federal Reserve ambivalent stance on CBDCs has meaningfully changed since their study on the technology in 2022, which you can read about more in this prior Galaxy Research newsletter. At the same time, lawmakers in the U.S., primarily Republicans, are doubling down on their anti-CBDC stance, having recently passed legislation, the CBDC Anti-Surveillance State Act, restricting the Fed from even trying to develop anything close to China’s e-CNY in an effort to protect civil liberties and freedom. Instead, U.S. lawmakers may advance legislation to create a comprehensive regulatory framework for stablecoins issued by private companies. Last month, US Senators Cynthia Lummis from the Senate Banking Committee and Kirsten Gillibrand from the Senate Agriculture Committee introduced the Lummis-Gillibrand Payment Stablecoin Act, which you can read about more in this prior Galaxy Research newsletter.

Assuming the U.S. and China continue to pursue divergent policies when it comes to the use of CBDCs and other digital currencies, it appears likely that China will lead innovation in CBDC infrastructure while the US leads adoption for privately-issued, dollar-denominated stablecoins. As stated by former CFTC chair J. Christopher Giancarlo in an interview with CoinDesk, CBDCs may be increasingly used as a form of statecraft by countries that have been subjected to U.S. sanctions and seek to ways to avoid them in the future. Without exporting a CBDC network of their own, the U.S. may have to assert the central role of the U.S. dollar in global finance and compete in a new digital era through privately-owned, U.S.-based stablecoin issuers, which does have the advantage of protecting Americans’ right to financial privacy but the disadvantages of capital inefficiency. To learn more about the advantages and disadvantages of stablecoins, read the Galaxy Research Digital Dollars report. - Christine Kim

Charts of the Week

Last week we highlighted the total value of all assets deposited into the restaking platforms EigenLayer and Karak. This week we narrow the scope to look at a subset of the assets deposited into Karak, liquid restaking tokens (LRTs).

LRTs are tokenized claims on restaked assets deposited into EigenLayer. In effect, restaking these LRTs on Karak is the equivalent of using EigenLayer deposits to secure Karak actively validated services (AVSs). This idea is similar to the dynamic of Beacon Chain deposits securing AVSs through liquid staking token (LST) deposits on restaking apps. This can lead to scenarios where EigenLayer delegations and AVSs are impacted by faults in Karak node operators, which is not a desirable outcome. The trend, however, is incentivized by points programs that let users stack and multiply points from many sources.

The chart below shows the trend in the top LRTs being deposited into Karak. As of May 23, 2024 there are 66,500 units of these LRTs on the restaking app. Excluded from the chart are Magpie LRTs.

To frame these deposits, we can look at them relative to the total supply of the respective LRT. The chart below tracks the share of each LRT’s supply that has been deposited on Karak. Swell’s restaked ETH, rswETH, has the greatest share of its supply deposited on Karak of the observed LRTs at 10.63%. Users depositing rswETH on Karak earn points from the restaking app itself, in addition to a three times multiplier on Swell points. Bedrock’s uniETH has the second greatest share at 6.5%, with depositors earning a 1.5 times multiplier on Karak points and a five times multiplier on Bedrock points. Each of the remaining LRTs have more insignificant supply shares on the restaking app at 2% or less each, but still enjoy two times points multipliers.

Other News

• MetaMask intends to add Bitcoin support

• Phantom wallet beats PayPal to secure No. 2 app in Google Play store

• Trump campaign to accept crypto donations, including dogecoin and shiba inu

• Hong Kong may allow staking for spot Ethereum ETFs

• ZkSync planning on token generation this week with airdrop in middle of June

• Uniswap Labs responds to Wells notice, calls SEC's legal case 'weak and wrong'

• Yuga Labs will 'no longer touch' CryptoPunks amid new collection backlash

• US House of Representatives pass Republican-led anti-CBDC bill

• London Stock Exchange set to List crypto ETPs for first time