Weekly Top Stories - 8/23

This week in the newsletter, we write about Mt. Gox distributions coming to an end, an advisor to Kamala Harris signaling soft support for crypto, and Optimism rolling back its permissionless fraud proof system.

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Mt. Gox Distributions Are Probably Finally Over

Mt. Gox transfers 1,265 BTC to Bitstamp, winding down distributions. On Tuesday, the bankruptcy estate of defunct Japanese Bitcoin exchange Mt. Gox moved $700m worth of Bitcoin onchain, but likely only $74.5m was for distribution to Bitstamp, with the rest sent back to a fresh address likely belonging to estate cold storage.

After years of bankruptcy, ultimately the estate held ~142k BTC ($8.5bn at current prices) for the purpose of distributing to more than 20,000 creditors. The estate also held a similar amount of BCH for distribution. Beginning on July 4 of this year, and after more than 10 years, the estate began distributing coins to partner exchanges and custodians, who then distributed to end-creditors. To receive distribution in this first round, creditors had to agree to an “early payout” which included a small haircut, while those who seek a fuller payout need to wait for an undetermined amount of additional time. At the time of writing, the estate has delivered more than 96k BTC to Bitstamp, Kraken, and Bitgo, leaving 46k BTC for future distribution.

Mt. Gox is one of several known “supply overhangs” that have burdened BTCUSD over the past couple months, and with nearly $9bn in its coffers as of June, was also one of the biggest. The German government sold the totality of 50k BTC it had seized from a piracy website between late June and early July 2024. The U.K. government holds approximately 61k BTC confiscated from fraudsters Wen Jian and Qian Zhimin. The US holds at least 200k BTC resulting from multiple criminal confiscations (Silk Road, Ryan Farace (“XANAXMAN”), Potapenko/Turogin, Banmeet Singh, and more) and recoveries (primarily from the Bitfinex hackers). Of the 200k BTC currently held by the U.S. government, almost half was recovered from the Bitfinex hackers.

OUR TAKE:

We estimated in June that only about 95k of the 142k BTC would be distributed to creditors seeking an “early payout.” With 96k having been distributed and all of the largest distribution partners having already received coins, it is likely that this round of Mt. Gox creditor deliveries has mostly concluded. The remaining 46k BTC could take years for the Mt. Gox estate to distribute. With the German government’s sales concluded, the U.K. government’s coins likely embroiled in an effort to return them to mostly Chinese victims, the U.S. coins mostly comprised of theft recovery that should be returned to Bitfinex (not sold by the government), and bankruptcies Genesis, BlockFi, and Celsius having already delivered their coins, it looks like the market is now finally beyond the bulk of Bitcoin supply overhangs. A lack of inorganic sell pressure is constructive for the remainder of the year, though macro conditions and the U.S. presidential election remain important factors. - Alex Thorn

Harris Advisor Signals Tepid Support for Crypto

Responding to a Bloomberg question about crypto, Harris advisor Brian Nelson said Harris is “going to support policies that ensure that emerging technologies and that sort of industry can continue to grow.” Brian Nelson, former Treasury official and current economic advisor to the Harris/Walz campaign, provided the first on-the-record quote from the campaign relating to crypto. Nelson continued to say “obviously, they’ve expressed that one of the things that they need are stable rules, rules of the road,” presumably referring to the crypto industry.

While the crypto industry has faced a number of pressures from the U.S. government and regulatory agencies under the Biden/Harris administration, those emanating from Treasury have largely focused on questions about the traceability of “unhosted wallets,” whether nodes, miners, or validators should be subject to bank-like regulations, and how to prevent terrorist financing. Until recently, Nelson served as the U.S. Department of the Treasury’s Under Secretary for Terrorism and Financial Intelligence, and his work on digital assets has involved specifically pushing for legislation on these issues widely seen by the industry as overly burdensome, stifling, and even prohibitionist.

That being said, Nelson testified to House Majority Whip Rep. Tom Emmer (R-MN) in February 2024 that an October 2023 Wall Street Journal report had overstated the crypto-based fundraising by Hamas, admitting that “we do not expect the number is very high particularly,” an important concession in the face of widespread criticism of the Journal’s reporting following the Oct. 7 attacks on Israel.

OUR TAKE:

On their face, the two comments – that under Harris the crypto “industry can continue to grow” and that the industry needs “stable rules, rules of the road” – tell us almost nothing about the Harris/Walz campaign’s concrete policy ideas on digital assets. One could argue that “stable rules” could be highly restrictive but still stable, or that letting the industry “continue to grow” could require highly restrictive rules that the industry currently opposes. Indeed, the quote isn’t incongruous with the existing Biden administration’s policies and perspectives on the digital assets industry. In fact, the White House’s statement of administration policy (SAP) relating to the passage of H.R. 4763 (“FIT21”), the bipartisan market structure bill passed out of the House in May, could be seen as even more conciliatory, despite the Biden administration’s well-documented disdain for crypto. That SAP said that “the Administration is eager to work with Congress to ensure a comprehensive and balanced regulatory framework for digital assets, building on existing authorities, which will promote the responsible development of digital assets and payment innovation and help reinforce United States leadership in the global financial system.” There’s nothing in Nelson’s statement that suggests daylight between Biden and Harris’s policy positions, and thus it’s reasonable to doubt that the statement from Nelson signals any broad departure from current administration policy to digital assets.

That being said, the statements can be seen as a slightly positive, if small, step forward, for the Harris campaign’s “reset” with the crypto industry. Although the quote is extremely vague, light on details, and even fails to mention the words Bitcoin, crypto, or blockchain, the fact that it was not overtly negative, or made at all, can be seen as neutral to positive. The quote is particularly notable coming from Brian Nelson, given his extensive work in the Biden administration seeking restrictive rules for digital assets. As the top Treasury official for Terrorism and Financial Intelligence, Nelson was deeply involved in an infamous Treasury request to Congress – well known in crypto policy circles – that requested more power for the government to apply existing AML/KYC laws to various parts of the crypto ecosystem, including coders, miners, nodes, and smart contract applications.

Those requests, made in a Nov. 28, 2023 letter to Senate Banking Committee Chair Sen. Sherrod Brown (D-OH) from Treasury Deputy Secretary Wally Adeyemo, have formed the backdrop for several back-and-forths among Senate Banking members regarding AML/KYC policy for digital assets, including the highly problematic Digital Assets Anti-Money Laundering Act (DAAMLA) from Sen. Elizabeth Warren (D-MA). The accompanying legislative requests included: extending Bank Secrecy Act compliance beyond simply centralized virtual asset service providers (VASPs) to nodes, miners, smart contracts, and wallet providers; the explicit authority to sanction blockchain nodes and smart contracts; so-called “extra-territoriality” to allow Treasury to sanction foreign dollar-backed stablecoin issuers; and secondary sanctions on foreign entities with “U.S. touchpoints.” While the letter and legislative proposal was sent by Wally Adeyemo (rumored to be in the running for Treasury Secretary in a Harris administration), as Deputy for Terrorism and Financial Intelligence Brian Nelson was deeply involved in those policy ideas, so seeing him give public quotes that are at least nominally constructive to the industry is somewhat of a win.

Taking all this in, it appears that the Harris/Walz campaign’s current strategy is to signal some support for crypto without formally or explicitly deviating from the current Administration’s policies, hence the lack of concrete policy positions coupled with some private outreach and tepid public statements. Said another way, it appears that the Harris/Walz campaign wants to prevent any defection to Trump by pro-crypto Democrats without engaging in any real effort to win over net-new crypto-focused voters. Granted, this appears to be the Harris/Walz campaign’s strategy across a range of issues – attempting to thread a needle between offering a fresh start and not disowning Biden administration policies, of which Harris was a key figure. We expect this strategy to decay into defining clearer policy distinctions as the race tightens into the Fall, perhaps also on crypto, particularly given that crypto has raised more corporate PAC money than any industry in election history. - Alex Thorn

Optimism Disables Fraud Proofs 2 Months After Launch

On August 16, 2024 OP Labs submitted a proposal to Optimism’s governance forum that, if passed, would upgrade a series of vulnerable smart contracts powering its permissionless fraud proof system. The proposed upgrade, titled Granite, is in addition to the disablement of the Layer 2’s (L2) vulnerable fraud proof system and the reactivation of its previously relied on permissioned system. These actions were prompted by a community-driven discovery of several bugs found in the network’s permissionless fraud proof system just two months after it went live after years of anticipation. Despite twelve vulnerabilities being found, two of which were deemed high severity, user assets were not at risk. This was due to Optimism subsidizing its fraud proof system with a Security Council to ensure the integrity of fraud proofs submitted permissionlessly. In this case, the Security Council is used as a safety net to establish security over user assets as the network experiments with decentralizing itself.

The upgrade will be executed on September 10, 2024 at 16:00:01 UTC if it passes governance. Node operators must upgrade their node software to support the new changes to avoid a chain split by September 11, 2024.

OUR TAKE:

Fraud proofs are key infrastructure that allow for the disputing of fraudulent or incorrect transactions on L2 networks. Granting users the ability to freely submit disputes around their assets, as opposed to trusting a set of permissioned entities to act in their best interest, is a key component of L2 decentralization. L2s that achieve this feat are assigned the Stage 1 decentralization title. As of August 22, 2024 only five of 72 rollups assessed by L2Beat have earned at least this level of decentralization. Given this, the takeaway from Optimism’s bout with fraud proofs are threefold: 1) permissionless fraud proofs are difficult to implement, 2) proper vetting of systems pushed to mainnet is paramount, and 3) L2s have broadly not reached their promise of decentralized scaling.

Permissionless fraud proofs require a juggling act of security, timeliness, and decentralization to be properly implemented. They must be secure such that malicious actors cannot exploit them for personal gain; they must be timely in that disputes can be settled in a reasonable amount of time and can’t be artificially extended by malicious actors; and they must be decentralized such that the barriers to submitting and voting on them are low. However, packaging these three components into a single system is difficult to implement. Fraud proofs are also not one size fits all. Different L2s are built on different tech stacks, and fraud proof systems implemented on one network cannot necessarily be translated to others. This has led to L2s building these systems in silos without the ability to benefit from each other’s work.

Secondly, ensuring contracts pushed to mainnet are secure beyond reasonable doubt and properly vetted is crucial. Vulnerabilities in a fraud proof system potentially put the entire L2’s total value locked (TVL) at risk. Prematurely launching such features and putting the advancement of the network’s status above user safety is improper practice. However, it is important to note that introducing decentralizing features to L2s, like most areas of blockchain development, is an experiment. In the case of Optimism, this is something they identified and accounted for with the use of their Security Council despite prematurely launching vulnerable contracts.

Lastly, L2s are still largely centralized. Only 7% of the rollups assessed by L2Beat's industry standard decentralization scorecard have gotten off Stage 0. This highlights the majority of rollups are controlled by central operators. Even in Stage 1 centralized security councils are used as a check on the smart contracts governing the network, as was the case with Optimism's implementation of fraud proofs. Today, only two rollups have reached Stage 2 and are fully governed by smart contracts free of centralized entities. – Zack Pokorny

Charts of the Week

The last three months for bitcoin have been marked by mass selling and asset transfers by governments and bankruptcy distributions. Notably, the German government sold ~50,000 BTC from mid-June to mid-July 2024, the U.S. government has been continuously moving BTC to Coinbase, Genesis has distributed ~45,000 BTC since June 2024, and Mt. Gox distributed ~96,000 BTC since the beginning of July 2024. Many of these big entities have exhausted their stockpiles of BTC, leaving only the US government, by way of Silk Road and Bitfinex funds, with a substantial amount of BTC. The chart below highlights some of the largest known entities holding BTC that are vulnerable to selling. In total, we have identified as much as $18.6 billion in BTC supply overhang.

Ethereum also faces noteworthy supply overhang from the U.S. government and a number of bankruptcies, although much less than Bitcoin. The US government holds ~$130 million worth of ETH from Silk Road and Prime Trust, BlockFi, and Celsius bankruptcies include ~$110.3 million worth of ETH.

Other News

• Bureau of Labor Statistics releases largest downward jobs revision since 2009

• McDonald’s Instagram account hacked to promote token scam

• Bitcoin “staking” protocol Babylon launches

• Ex-FTX insider Ryan Salame says Dept. of Justice broke deal on charging girlfriend

• Mining firm Stronghold Digital acquired by Bitfarms

• Grayscale launches Avalanche Trust

• Crypto-supporter RFK Jr. reportedly will drop out of presidential race, mulling Trump endorsement

• SEC-registered crypto platform Prometheum to list “securities” UNI and ARB