IN TODAY'S ISSUE:

• We review SEC Chairman Gensler’s recent comments on cryptocurrencies and why they might favor bitcoin
• Cooler weather and new mining rigs may make it more expensive for miners to mine
• The potential fall of a mining pool yet again highlights the danger of counterparty risk

Gensler Makes Sharp Comments on Crypto Industry Regulation

In a carefully crafted speech on crypto this week at the Practicing Law Institute’s SEC Speaks conference, SEC Chairman Gary Gensler took the opportunity to make some of his most expansive and direct comments about regulating the crypto industry yet. Gensler’s comments, which were couched with the provision the comments were his and not the SEC’s, touched on a variety of topics including crypto tokens as securities, stablecoins, financial intermediaries, and inter-agency cooperation with the CFTC. Our takeaway of the comments is that despite his urgings over his nearly 18-month tenure for issuers and service providers to register with the appropriate regulatory bodies, few have done so, and as such, Gensler is becoming more emphatic and direct about his messaging. That said, those issuers and service providers would likely argue that rules need to be adapted for crypto before adequate filings can be made.

In his remarks, Gensler notably re-affirmed his position that most crypto assets were securities, potentially including stablecoins. In Gensler’s view, securities law was created with a broad brush to capture as many investment opportunities as possible so that investors can be better protected by the relevant rules (and thus the SEC). Since most cryptocurrencies are issued by centralized entities to the public in exchange for potential profits, the securities laws should apply. As Gensler pointed out to the lawyers that listened to the speech, if they were hired by clients regarding their token projects, they were signing their engagement letters with an entity and not a broad “ecosystem.” On the bright side, while Gensler did not come out and directly say it, the comment that non-security tokens “likely represent only a small number of tokens, even though they may represent a significant portion of the crypto market’s aggregate value” was a nod to the idea that we have long held, that bitcoin is not a security. Further, Gensler argued that the CFTC needed greater authority from Congress to regulate non-security cryptocurrencies (like Bitcoin) and intermediaries. Perhaps not coincidentally, the U.S. Senate is holding a hearing next week on the bipartisan Digital Commodities Consumer Protection Act, which would do just that.

Intermediaries were also prominently featured in Gensler’s comments, which suggested that investors would benefit from the regulation of crypto platforms, whether they be exchanges, broker-dealers, custodians, clearing houses (or as is often the case, all of the above) that deal with security cryptocurrencies. The crypto industry generally does not enjoy the same type of service segmentation as traditional financial markets do, mostly because of the organic nature of the industry’s growth. In crypto, typically one platform, like an exchange, may provide all or many of the services listed previously. Thus, Gensler suggested crypto investors would benefit from a separation and registration of the various activities. As in his security analysis, Gensler indicated that investors are better served when institutions exist under the purview of securities law. In this framework, participants are protected from some of the potential conflicts of interest that arise when various financial institutions sit together.

The thrust of Gensler’s comments is that the SEC already has the power to regulate most of the cryptocurrency market (by number of coins at least, if not by market cap). If what he says is true, the SEC should file suit against thousands of coins and dozens of intermediaries. The only question that remains is when the SEC will attempt to fully assert its authority. At least investors and institutions in non-security cryptocurrencies, like bitcoin, may rest easy knowing that the SEC does not intend to crack down on them.

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Network Difficulty Jumps as Hash Rate Likely Comes Back Online

Last week, Bitcoin’s difficulty saw a jump of +9.3%, its biggest increase since January of this year. As a reminder, difficulty is a unitless number that measures how hard it is for miners to find new blocks. The increase is an acknowledgment by the network that blocks over the preceding 2,016 blocks (the difficulty adjustment window, which should last roughly two weeks), were being produced too quickly versus an expectation of 10 minutes. This is now the third consecutive difficulty increase, helping reverse a negative trend seen starting in May, and implying that more mining rigs have been coming online.

Why have mining rigs been coming back online? Cooler weather in the U.S. is one major reason, especially in Texas. When temperatures rise  and electricity demand is sufficiently high, miners are incentivized to turn off their machines. Miners who have pre-purchased electricity make a windfall by selling back to the grid; those who have not can see their electricity prices rise above their breakeven cost. In both scenarios, miners may turn off as a result. Looking at Texas electricity price data illustrates the impact of the recent cooler weather. Assuming current bitcoin prices and difficulty level, in July and August, it would have only been profitable to run miners in the afternoon, when temperatures are higher, on about half of all days (and given that the chart below does not include cost of cooling, that number is probably lower). As was the case in June, miners have generally been profitable to run in September, leading to higher network hash rates and which in turn has driven difficulty. Similar dynamics have played out across the country. Another driver of rising difficulties has been a backlog of ordered miners coming online, especially the more efficient Antminer S19 XP that Bitmain recently introduced to the market. Of the public miners who have reported the size of their operational mining fleets in August, the operational hash rate at the end of August was 14% higher compared to the end of June.

Counterparty Risk and Mining Pools

This week, the crypto company Poolin made several important announcements regarding two of its businesses, its wallet service and its mining pool. First, the Poolin Wallet, which appears to hold cryptocurrencies on behalf of its clients, would immediately cease withdrawals amid “liquidity issues.” The news was certainly shocking for a number of its clients but was not entirely out of left field; there had been rumors for weeks that withdrawals were taking longer than expected. Second, the mining pool business would switch from Full Pay-Per-Share (FPPS) to Pay-Per-Last-N-Shares (PPLNS) three days after the announcement, and any rewards earned by miners in that period would be frozen in accounts until further notice. The Poolin Wallet drama feels all too familiar for those following the last few months of crypto fireworks — a depository crypto institution freezes its customer funds amidst rumors of losses and heavy withdrawals. The pool story, however, is relatively novel.

A mining pool aims to smooth the incomes of constituent miners by gathering their combined resources and distributing rewards based on total effort rather than luck. One way of distributing revenue is PPLNS, whereby whenever the pool wins a block, it redistributes the rewards based on which miners contributed more effort. However, in the recent bull market, in order to attract business, many pools have operated the more miner-friendly FPPS scheme, where miners receive rewards based on their effort regardless of whether the pool wins a block. This has little impact over long periods of time, but liquidity issues can arise over the short-term purely because the probabilistic nature of finding blocks might mean that the pool operator must pay out fees to miners even if it is not finding blocks. Poolin’s FPPS paid out daily, but some users chose to keep funds on the platform.

The FPPS structure, while appearing to reduce risk for miners by removing the element of luck, had introduced a new risk, credit risk, to users of the pool. It is also not clear how the issues with the wallet are affecting payouts to the pool, but we would not be surprised for there to be crossover impact given the company posts. Given some of the astonishing news about how crypto entities have been operating their businesses as of late, perhaps there is some connection with customer assets custodied on the wallet, how the wallet was paying yield to its users  (i.e., lending practices), and payouts to the pool participants. With nothing specifically disclosed, we are left to wonder and are also reminded of the counterparty risks in this industry that may be obvious, or not so obvious, in the case of Poolin.

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Market Update

Bitcoin saw losses on the week, dropping 2.6%. Equities were up modestly, as the S&P 500 gained 1.0% and the Nasdaq appreciated by 0.7%. Bonds were mixed: Investment Grade Corporate Bonds fell 0.2%, High Yield Corporate Bonds rose by 1.5%, and Long-Term Treasuries decreased 1.4%. Gold increased by 0.9% on the week as real yields rose and inflation expectations fell.

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Important News This Week

Regulation and Taxation

OSTP Releases Report on Environmental Impact of Mining — White House

Acting Comptroller Hsu Remarks on Crypto and Banking — OCC

SEC Chair Gensler Remarks about SEC Role in Crypto — SEC

Russia Exploring Stablecoin Settlements With Friendly Nations — CoinDesk

Senate Ag Committee Announces Hearing — U.S. Senate

Coinbase Funds Tornado Suit Against Treasury — Washington Post

Companies

Poolin Announces Suspension of Wallet Withdrawals — Poolin

Poolin Mining Pool Switches to PPLNS — Poolin

Cowen Digital Snags Dozens of Clients in Six Months — The Block

Binance to Convert USDC, USDP, TUSD to BUSD (Binance USD) — Binance

Binance.US Introduces Ether Staking — CoinDesk

21.co Raises $25 Million — 21.co

Troubled Crypto Broker Voyager Digital to Auction Off Assets — Decrypt

FTX Ventures to Acquire Stake in SkyBridge Capital —SkyBridge

Investing

DBS Backs Crypto Despite Market Slump — Financial Times

Human Rights Foundation Donates $325K For Bitcoin Development — HRF

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Upcoming Events

September 13th – July CPI data is released

September 14th – Senate Ag Hearing to Review Crypto Regulation Bill

September 21st – Next FOMC interest rate decision

September 30th – CME bitcoin futures and options expiry

October 7th – United States Non-Farm Payrolls

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Thanks for joining us again this week. Please reach out with any questions or comments.

Sincerely,
The NYDIG Team