Top Stories of the Week - 6/9

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SEC Sues Binance & Coinbase

The U.S. Securities & Exchange Commission (SEC) filed civil suits against the world’s two biggest cryptocurrency exchanges, Binance and Coinbase. The two actions are the most ambitious and incisive enforcement activity from the SEC to date and represent the start of a new chapter in the push and pull between cryptocurrency businesses and the US securities regulator.

On Monday, the SEC sued Binance (complaint, SEC press release), Binance.US, and Changpeng Zhao (CZ). Broadly speaking, the suit alleges that Binance both domestically and internationally is operating an unregistered securities exchange. The suit also alleges more troubling misconduct including comingling client and proprietary funds, and other fraud related to mishandling customer funds. “Defendants have enriched themselves by billions of U.S. dollars while placing investors’ assets at significant risk,” the SEC asserts. In the Binance suit, the Binance founder & CEO CZ is named 193 times in the 136-page complaint, and SEC Chair Gary Gensler accused CZ and Binance of engaging “in an extensive web of deception, conflicts of interest, lack of disclosure, and calculated evasion of the law.”

In addition to all the standard items (disgorgement of ill-gotten funds, enjoinment from operating the exchange, etc.), the SEC notably seeks a temporary restraining order (TRO) to freeze Binance.US’s assets, which would effectively close its business. Binance’s response to the motion seeking the TRO is due Monday by 5pm and the hearing on the TRO is set for 2pm on Tuesday, June 13. The judge assigned to the case, Amy Berman Jackson, was appointed to the US District Court for the District of Columbia by Pres. Obama in 2011 and has ruled in some notable cases. She oversaw the criminal cases brought by Special Counsel Robert Mueller against Paul Manafort and Rick Gates, as well as the criminal case against Roger Stone, an informal advisor to Pres. Donald Trump’s 2016 presidential campaign.

On Tuesday, the SEC sued Coinbase broadly (complaint, SEC press release) alleging that it operates an unregistered securities exchange, broker, and clearing agency, and also that its staking program itself is an unregistered security. Brian Armstrong isn’t a named defendant and the SEC only mentions his name once in the 101-page complaint. Armstrong tweeted “btw, in case it’s not obvious, the Coinbase suit is very different from others out there – the complaint filed against us is exclusively focused on what is or is not a security. And we are confident in our facts and the law.” Coinbase’s response to the complaint is due August 7, 2023.

Our take

These cases are now the tip of the spear in the SEC’s war on crypto. The Binance suit certainly matters because of the size and importance of the exchange to the market, but the Coinbase case is more consequential for the future long-term legitimacy of US crypto firms given that it will ultimately determine what it means to be a legal cryptocurrency business in America.

Most of the accusations against Binance have been known to market participants, but the allegations of mishandling client funds are mostly new and allow the SEC to cast the exchange more like FTX than Coinbase. That the SEC is seeking a temporary restraining order against Binance.US shows their concerns about the safety of customer assets. The TRO would effectively close Binance.US’s business since a key function of operating a cryptocurrency exchange is the ability to process withdrawals and handle money movement. Regardless of the TRO, our initial impression is that Binance is unlikely to escape without significant damage, and recall that the Department of Justice is also reportedly investigating the exchange.

The enforcement-first approach that US market regulators have taken towards regulating the cryptocurrency industry will invariably harm American competitiveness as other jurisdictions pursue a more principles-based methodology towards regulating the sector. The actions themselves, and the chilling effect that they are having and will have on the industry, create an environment that alienates entrepreneurs, developers, and businesses operating at the frontier of monetary innovation. One cannot blame each regulator for attempting to tackle issues within the disruptive industry within their individual mandates, but in almost every case, these often noble albeit myopic and misguided efforts combine to work contrary to interests of American global leadership. While the US essentially creates the world’s most restrictive environment for crypto, the EU, UK, parts of South America and the Middle East, and even Hong Kong are moving in the opposite direction and producing progressive regulatory frameworks that support innovation and protect consumers. Senator Tommy Tuberville (R-AL) wrote a powerful op-ed in the Wall Street Journal this week arguing that FINRA and the SEC “seem oblivious” that China and other adversaries are beating the U.S. on crypto.

For now, this industry’s battles will be fought mostly in court, and court cases are expensive, take a long time to resolve, and even in the case that your side wins, the precedent set may not actually be the result that helps. Cases can be decided on technicalities or with nuance that doesn’t ultimately advance the larger cause. The industry’s only other real option is Congress, but it would be surprising to see anything comprehensive become law until after the 2024 election cycle. One silver lining, at least for now, is that the SEC has not said that BTC, ETH, or stablecoins generally are unregistered securities, and those assets account for at least 75% of crypto’s total market cap. -AT

New Crypto Market Structure Bill

Patrick McHenry (NC-10), Chairman of the House Financial Services Committee, and Glenn Thompson (PA-15), Chairman of the House Agriculture Committee, released a discussion draft of legislation providing a statutory framework for crypto regulation. The proposed Digital Asset Market Structure Bill (Bill) seeks to provide digital asset firms and consumers with regulatory clarity to fill the evident regulatory gap that exists between the Commodity Futures Trading Commission (CFTC) and the SEC. The bill defines the CFTC and SEC’s jurisdictions within the digital asset sector through cementing clear definitions for digital commodities and digital assets offered as part of an investment contract.

The Bill's provisions offer a pathway for projects to demonstrate that it is sufficiently decentralized to have its tokens no longer qualify as investment contracts. If these conditions are met, the asset is deemed decentralized and can be considered a digital commodity regulated by the CFTC. To be exempted from SEC oversight requires digital asset issuers to demonstrate that their digital assets fulfil certain requirements including:

• No issuer or decentralized organization owned more than 20% of the outstanding supply of tokens affiliated with the network 12 months prior to registration

• No marketing or token issuance for the project was done the three months prior to certification as a decentralized network.

• The issuer’s total sales of the digital asset over the prior 12 months does not exceed $75mn

• A non-accredited investor’s purchases of the digital asset from the issuer over the prior 12 months are less than 5% of the purchaser’s annual income or 5% of their net worth

• The purchaser does not own more than 10% of the units of the digital asset after the completion of the transaction

• The transaction does not involve equity or debt securities

The SEC may object to the certification if they determine the certification is inconsistent with the Bill but must provide a detailed analysis of its reasons for doing so. Conversely, the proposed definition for digital commodities entails that tokens with large initial sales to insiders and pre-mines are not decentralized, therefore they would be subject to regulation under the SEC’s jurisdiction. This approach of providing clear definitions aligns with the view that formulating effective regulation for the crypto market requires a comprehensive understanding of the decentralized nature of digital assets.

As for exchanges, the Bill would enable crypto trading platforms to register as Alternative Trading Systems (ATS) along with permitting the offer of digital commodities and payment stablecoins. So long as the trading platform trades digital assets (not including synthetic tokenized securities), the SEC is unable to deny the registration for an ATS. The Bill also establishes a framework for Digital Commodity Exchanges similar to the existing guidelines within the Commodity Exchange Act (CEA). As a result, registered Digital Commodity Exchanges would be required to comply with existing regulations for Designated Contract Markets and Swap Execution Facilities. The details on Broker Dealer requirements for Digital Asset Commodity Exchanges include registering with a certified futures association and meeting prescriptive business conduct requirements. Notably, entities will be able to register with the CFTC and SEC to facilitate digital commodities and securities. The Bill also builds on the existing commodity market requirements imposed on Futures Commission Merchants (FCMs) to protect customer assets. Digital Commodity Exchanges would be required to segregate customer assets and hold them in digital commodity custodians that are subject to minimum standards for supervision set by the CFTC.

If the Bill is enacted, there will be a transition period for entities to come into temporary compliance with both the SEC and CFTC. Existing digital assets are eligible for a safe harbor and are permitted to trade during this period, until the SEC or CFTC issues a notice to the trading venue that they are not digital commodities. However, today this is just a discussion draft and the Bill has not yet been introduced for consideration.

Our Take

The collaboration between Patrick McHenry (NC-10) and Glenn Thompson (PA-15) on the proposed Bill is a significant move reflecting the GOPs willingness to put forth a comprehensive solution to the regulatory vacuum faced by the crypto industry in the U.S.—tabling some not-so-insignificant jurisdictional lines that exist between the two House Committees. The fact that these committees are working together is also quite notable and rare and further demonstrates the authors’ conviction to act. The Bill offers, for the first time, explicit definitions for digital commodities and securities, providing much-needed clarity amidst the SEC's aggressive yet sometimes inconsistent regulatory approach. Most importantly, the Bill establishes a sound framework to determine whether a protocol is decentralized or centralized. From this, a key takeaway is the Bill places more emphasis on token ownership concentration over network control by validators/miners. The Bill considers insider ownership of 20% outstanding supply to be deemed centralized, which could ensnare protocols like Solana, Arbitrum, and Uniswap in which insiders hold larger percentages of the supply. In the event this Bill is enacted, these protocols, among many others, will be heavily incentivized to reduce insider token concentration to avoid legal pressure in the U.S. Protocols with large DAO treasuries will have to evaluate the tradeoffs between decentralizing to avoid securities regulation and retaining tokens to innovate towards product market fit.

Additionally, the Bill provides a clear roadmap for U.S. crypto exchanges to register domestically to mitigate the trend of U.S crypto entities moving operations overseas due to regulatory uncertainties. The proposed path for crypto exchanges to register as Alternative Trading Services (ATS) will require the SEC to revise their guidelines for ATSs to exempt exchanges that offer digital assets, digital commodities, and payment stablecoins from registration as a national securities exchanges. This requirement also involves the SEC modifying their rules to allow broker dealers to custody digital assets among other regulations for digital assets. The pressure imposed on the SEC to update their outdated legal frameworks would help foster growth for U.S crypto exchanges, enabling the U.S. to sustain its global dominance in the digital asset space in light of crypto dominance rapidly growing overseas. Ultimately, on the question of exchanges, the Bill provides all the workable clarity that the SEC currently lacks, and clearly addresses all the registration points the SEC is arguing in court.

Despite the positivity around this Bill, it is just a draft. It hasn’t been introduced, and even if it was, its chances of becoming law in the near-term are low. Plainly, we believe any bill from the House needs a Suspension-esque vote total [2/3 of the Chamber supporting the measure] to be seriously considered by the Senate, and that’s a tough level to reach in such a divided Congress with slim majorities in both Chambers. To be clear, it’s possible—but a lot needs to go right between now and the fall as both committees continue their deliberation and activities on the Bill. Nonetheless, the Bill represents an enormous amount of work by the two committees and advances many powerful and practical legal and regulatory concepts that will undoubtedly form the basis for a future regulatory regime if one does, ever, become law. -GP

Optimism’s Bedrock Upgrade

Optimism deploys Bedrock upgrade, setting the foundation for the Superchain vision. After the network was paused for ~ 3 hours on June 6, OP Mainnet completed its migration to Bedrock—Optimism’s long-awaited foundational network upgrade.

Immediate user-facing benefits of Bedrock include more optimized fees and added security measures such as: (i) an estimated 47% reduction in protocol costs and security fees, (ii) faster deposit times from L1 to Optimism from ~10 minutes to ~2.5 minutes, and (iii) increased security with a new 2-step withdrawal process. Bedrock also introduces a new block storage method in a compressed format to minimize L1 gas expense, incorporates priority fees through EIP-1559-style pricing structure for L2 computation gas costs, adds a private mempool for the Sequencer, and introduces has a new block production method producing blocks every 2 seconds (vs. previously producing a block for every transaction). Additionally, Bedrock modularizes the OP Stack by separating consensus and execution to align with Post-Merge Ethereum).

The primary philosophies behind Bedrock are to increase the level of compatibility with Ethereum to reuse as much of the existing Ethereum infrastructure (i.e., “minimal diff” to cut down differences in geth codebase) and push forward a shared technical standard via a modular architecture to ultimately form the basis for the Superchain. The Superchain is Optimism’s vision for a network of chains that share bridging, governance, communication and more—all built on the same technical standard, the “OP Stack”. So far, several third-parties have joined OP Labs in building out the OP Stack including Coinbase (launching its own L2 called “Base”), a16z (building a new rollup client for Optimism written in Rust called “Magi”), Test in Prod (developed alternative execution client, op-erigon), and Worldcoin (committed to migrating to OP Mainnet). The next near-term technical milestone for Optimism will be CANNON, which will (re)-enable fraud proofs on the network (the old fraud proof system was disabled in November 2021 with the EVM-equivalence upgrade).

Our take

Bedrock is a huge milestone that saw a lot of engineering work go into the release. It provides users with shorter deposit times and significantly lower fees – in the 48 hours since migration, the total user savings were estimated to be >$100k, representing over ~55% in savings in gas and in dollar-terms per user transaction. Bedrock’s compression and storage efficiencies will be important for Optimism to be more competitive with Arbitrum, which has had lower transaction fees thanks to advanced calldata compression as part of the Nitro upgrade in August 2022—YTD through May, average L2 fees per transaction have been nearly 50% more expensive on Optimism than on Arbitrum ($0.36 per transaction on Optimism vs. $0.24 on Arbitrum) despite Optimism seeing ~60% fewer total transactions.

However, instead of looking at the reduction in fees or level of network activity relative to Arbitrum, Bedrock’s primary KPI or measure of success should be the added security/decentralization benefits and technical developments towards achieving the Superchain vision. First, Optimism will have to implement its next-gen fraud proof system via CANNON (which follows a similar interactive, multi-round process like Arbitrum’s existing fraud proof system). Then, due to OP Lab's “minimal diff" philosophy to approach Ethereum-level equivalence and reuse of its codebase, Optimism should be set up seamlessly implement Ethereum-level upgrades including account abstraction using alt mempool (ERC-4337) and proto-danksharding (EIP-4844 expected later this year), which are expected to deliver even further UX improvements for rollups. Modularizing the tech stack also enables Optimism to potentially switch consensus from fraud proofs to validity proofs (used by zk-rollups) in the future. The proof system is essential as it secures communication throughout the Superchain. The multi-client implementation also provides Optimism with redundancies so if one client fails, then the network system uptime can be preserved (a related incident but due to a separate issue, Arbitrum stopped processing transactions for an hour on June 7 after its Sequencer ran out of ETH to cover L1 gas fees).

To reiterate, Bedrock is the first foundational step for the Superchain. The OP Stack becomes the shared standard for the Superchain, pushing forward a more secure code base with greater adoption from builders and third-party contributors. Optimism already has a strong set of contributions from important companies and projects including a16z and Coinbase. Once going live on Mainnet, Base will contribute platform fees towards Optimism's Retroative Public Goods Funding (RetroPGF) initiative to encourage the development of non-profit projects that benefit the entire OP Collective. So the open-source / modular nature of Bedrock enables more people to leverage and contribute to the development of the OP Stack, and RetroPGF provides the economic incentives to build out the best platform for end users – all of which plugs into the Optimism flywheel and theoretically provides a sustainable path of growth for the broader OP ecosystem. -CY

Other News

• Senator Tommy Tuberville (R-AL) writes oped on crypto in the WSJ

• Aave prepares to launch GHO stablecoin

• Redemptions surge for Coinbase's staked ether following SEC lawsuit

• Louis Vuitton to release $39,000 physical-backed NFTs

• SWIFT and Chainlink will test connecting over a dozen financial institutions to blockchain networks

• Binance adds Bitcoin NFTs to its marketplace one day after SEC lawsuit

• 1 million wallets deploy Coinbase-backed Base's smart contracts during testing

• Kraken NFT marketplace launches with support for Ethereum, Solana and Polygon