Top Stories of the Week - 3/10

In the newsletter, we talk a lot of legal and regulatory. we examine Silvergate’s collapse, the NYAG’s lawsuit against KuCoin, and the SEC’s troubles in court. Subscribe here and receive Galaxy's Weekly Top Stories, and more, directly to your inbox.

Silvergate Bank to Close its Doors

Silvergate Capital Corp to wind down operations and liquidate. One of crypto’s mainstay banks, which became widely used as a means for crypto companies to affect instant USD settlement through its Silvergate Exchange Network (SEN), announced Wednesday that it was closing its doors and would liquidate.

In regulatory filing, the bank wrote Wednesday that “in light of recent industry and regulatory developments, Silvergate believes that an orderly wind down of Bank operations and a voluntary liquidation of the Bank is the best path forward.”

Silvergate had been hit with massive deposit outflows following the collapse of FTX in November, with its deposits falling nearly 70% from $11.9bn to $3.8bn in Q4 alone. To meet withdrawal demands, the bank was forced to liquidate significant portions of its fixed income portfolio, ultimately taking a realized loss of more than $700m. To help with short-term liquidity issues, the bank had tapped a line at the Federal Home Loan Bank (FHLB), a private consortium created during the Great Depression to help service banks that offer home financing and community lending. It’s unclear exactly why, but Silvergate fully repaid their FHLB advances, likely exacerbating their liquidity issues and contributing to their decision to close.

Our Take

This is a sad day for the crypto industry and Silvergate specifically. Silvergate and its SEN were quite instrumental in bridging crypto from the 2017-era (when exchanges relied on Tether and no one had a bank account) to a much more professional present. While there are other banks beyond Silvergate, and the industry can soldier on without them, it’s a loss that hurts to many in the space given the personal connection they have to their La Jolla, CA bankers. Said simply, the folks at Silvergate are seen as good actors, kind and hardworking bankers, and committed partners to the crypto industry who helped it grow, so their fall is painful for many, even though most market participants can continue without them.

Why did the Federal Home Loan Bank of San Francisco call their advance (wholesale loan) from Silvergate? This is a big question, and it could be merely the terms and structure of the advance; however, if the reason is bowing to political pressure—that’s yet another troubling example of politics intervening in banking. There is no constitutional right to have a bank account in America, but having one is seen by many as the sort of inalienable right that is necessary to operate any legal business in the country. If legal businesses are unable to open and maintain safe banking relationships due to pressures from federal politicians and bureaucrats, more than just crypto needs to be worried. -AT

NYAG Cracks Down on Crypto Exchange KuCoin and Claims ETH, LUNA, and UST Are Securities

On March 9, the New York Attorney General (NYAG) filed a lawsuit against cryptocurrency exchange KuCoin for operating an unregistered commodities and securities exchange. The lawsuit highlights ETH, LUNA, and UST as three assets offered, sold and purchased from KuCoin that under the guidelines of the Waldstein test and the Howey test should all be classified as securities. The Howey test is a legal test created by the US Supreme Court for determining whether a given asset or transaction satisfies the definition of an “investment contract” and therefore a security under section 2 of the Securities Act of 1933. The Waldstein test is the New York state’s version of this test that adopts a similar set of rules for determining what transactions qualify as an investment contract. 

According to the suit, all three assets should be classified as securities because they were all marketed to the general public for purchase and a large portion of the supply of these assets were reserved for the asset’s “respective founders, management teams, and developers, thereby tying the fortunes of the token holder to the fortunes of management.” Thirdly, according to the suit, the development teams behind ETH, LUNA, and UST promoted their respective cryptocurrencies as profit opportunities. In the case of ETH, the suit highlights that the Ethereum Foundation’s website explicitly refers to ETH as an “investment.” Based on their arguments, the NYAG petitions the courts to issue multiple orders against KuCoin, including:

• Disgorgement payments

• Implementation of geo-blocking based on IP addresses and GPS location to prevent access to KuCoin’s mobile app, website, and services from New York

• A permanent injunction banning KuCoin from selling and buying securities and commodities to and from New Yorkers.

Since news of the NYAG’s suit was publicized, the crypto markets responded negatively. At time of writing, ETH is trending at $1405 on Coinbase and Bitcoin trading as low as $20,180. Other factors at play of course impacting market fluctuations include ongoing bank struggles -- both inside and outside crypto -- and a macro situation in which the Fed has significantly increased its hawkish language and viewpoint.

Our Take

Some important things to note here. KuCoin is not an American company and has a history of ignoring US law suits. If they ignore this suit as well, that means KuCoin will not respond to this complaint and the case will therefore end in a default judgment against KuCoin. Should this happen, NY courts will not need to hear NYAG’s argument on the merits, and therefore the case will have limited precedential value on the question of whether ETH is a security.  Despite that, the NYAG’s assertion on ETH is nonetheless notable for several reasons. First, it tells us that NYAG is willing to make this case against ETH, albeit against a respondent who is unlikely to appear and defend themselves.  Second, the NYAG is not arguing that the initial ETH issuance was an unregistered securities offering (i.e., the ICO that Bill Hinman’s SEC determined could have been an unregistered securities offering at the time but now the network is sufficiently decentralized to no longer constitute a security); rather the NYAG is instead arguing that ETH is security today, not just due to its initial offering but also due to ongoing factors. This seemingly ignores the Hinman guidance, which could be substantial and meaningful, though it could be solely because the Martin Act (New York’s securities law) has a statute of limitations that precludes bringing a complaint about an offering that happened 9 years ago. 

This is negative for the industry, but given that it’s unlikely to have any precedential value, we simply need to wait and see whether NYAG decides to bring a case against a more motivated party in which the issues can actually be litigated in order to gain clarity on the core question -AT

The SEC and Their Terrible, Horrible, No Good, Very Bad Day

On March 7, the judges presiding over two legal proceedings involving high-profile crypto companies pushed back against the decisions and objections raised by the U.S. Securities Exchange Commission (SEC). Judge Michael E. Wiles of the New York Southern Bankruptcy Court slammed the SEC on Tuesday for their objection against Binance.US’ acquisition of distressed crypto brokerage firm Voyager. "I have no idea how long I can do nothing and wait until Congress and the competing regulatory authority sort out amongst themselves, just who has what authority over what aspects of this, what kind of authority. I have no idea how long that's going to take and we can't do that in bankruptcy," Wiles said. "... [W]e can't just put everything on pause just because we don't know for sure how the regulators will eventually make up their minds on points that they seem to have been debating for years."

The SEC argued in late February that Voyager’s VGX token may be an unregistered security and transactions to return these assets to customers “may violate” rules against the sale of unregistered securities. The agency also added that they believe Binance.US is operating an unregistered securities exchange. To these objections, Wiles pushed back based on the urgency of bankruptcy court proceedings and that fact that the SEC could only suggest a potential violation of securities rules, rather than a firm stance on the matter. Voyager is now approved to sell its assets and transfer its customers to Binance US. However, before the sale becomes final, Voyager has a window of up to four weeks to review additional questions about Binance. US’ regulatory compliance and security of customer deposits.

Separately, a panel of judges on the District of Columbia Circuit Court of Appeals heard oral arguments from Grayscale and the SEC on Tuesday over the SEC's rejection of Grayscale’s spot-based Bitcoin ETF application. Crypto asset manager Grayscale operates the world’s largest Bitcoin fund, known as the Grayscale Bitcoin Trust (GBTC). For years, Grayscale has tried to convert their trust into an exchange traded fund (ETF) to easily allow customer redemptions of the underlying bitcoin held in its trust. However, the SEC has notoriously and repeatedly rejected all spot-based Bitcoin ETF applications, arguing that the likes of Grayscale and other applicants lacked evidence to support the claim that the bitcoin spot market is resilient against market manipulation and fraud. To this, the judges overseeing court proceedings again pushed back on the SEC’s arguments.

"It seems to me that the commission really needs to explain how it understands the relationship between bitcoin futures and the spot price of bitcoin," Judge Neomi said, adding “It seems like it's fine for an agency to say okay, we need some more information, but it seems there's quite a bit of information here on how these markets work together, and the SEC has not offered any explanation... that the petitioners here are wrong.” Based on the comments from Judges Sri Srinivasan, Neomi Rao and Harry Edwards of the District of Columbia Circuit Court of Appeals, Senior Litigation Analysts at Bloomberg have changed their probability of a successful Grayscale suit from 40% to 70%. In addition, the GBTC discount to NAV has narrowed significantly for the first time in over a year due to renewed positive sentiment around the possibility of the GBTC converting to a spot bitcoin ETF.

Our Take

In both legal proceedings, judges have raised pointed questions against the SEC’s opposition of the actions proposed by high-profile crypto companies including Binance.US and Grayscale. In the case of Binance.US, the judge’s statements suggest there is a lack of regulatory clarity around the classification of cryptocurrencies in the U.S. Therefore, without a clear framework for classifying cryptocurrencies as a security or not, court proceedings should not be delayed or otherwise impacted while the SEC and other federal agencies figure out a path forward. Finally, a practical voice stepping in to protect investors – in this case approving the deal will allow investors to get some of their money back. In the case of Grayscale, the panel of judges highlighted the lack of a clear rationale for approving futures-based bitcoin ETFs but not spot-based ones given that “99.9% of the time,” as stated by to Judge Neomi, the two markets move in tandem. 

These statements echo long-held frustrations expressed by many companies and stakeholders in the cryptocurrency industry against the SEC and the reiteration of them by judges in the court of law should be a considered a small win for crypto advocates. However, in the grand scheme of things, these sentiments do not materially change much about the ongoing and uphill battle the crypto industry faces with the SEC and other regulatory agencies. Despite the judges’ sympathy for Grayscale’s arguments against the SEC, a decision one way or the other is likely to be delayed until later this year. Even if the judges presiding over the suit rule in favor of Grayscale, the SEC may simply deny Grayscale’s ETF application again for a different reason. Therefore, despite one bad day for the SEC, the crypto industry will have to be prepared to weather several potential bad months ahead in order to make it out of this regulatory storm unscathed. -CK

In other news

• Coinbase rolls out new Wallet-as-a-Service product

• Jack Dorsey's Block reveals plans for Bitcoin mining development kit

• Algorand third-party wallet app MyAlgo suffers exploit

• Biden proposes crypto tax changes in 2024 budget request

• Hedera blockchain undergoes technical irregularities

• CFTC Chair reiterates claims that Ethereum is a commodity

• Vitalik’s quadradic funding charity NFT project raised $781k for public goods

• Mt. Gox registration and repayment deadlines pushed back

• Major eSports organization TSM is launching a new gaming platform on Avalanche

• Bitcoin NFT market to hit $4.5bn by 2025: Galaxy