February 17, 2023
Greg Cipolaro

Research Weekly - The Enforcement Awakens


  • What the moves by regulators mean for the future of crypto in the U.S.
  • Ordinals continue to grow, but inscriptions appear to carry low fee rates.
  • Bitcoin’s dominance is rising, but what does that say about how investors view the asset and the current environment?

As Regulatory Fears Run High, We Provide a Mark to Market

Moves by financial market and banking regulators over the past few weeks have had crypto industry participants on alert regarding a regulatory crackdown in the US. While we continue to believe that ongoing regulatory and legal clarity is beneficial for the industry, we understand that given the flurry of news, investors have questions about the state of crypto regulations, how it impacts businesses, and the path ahead. We have long held that regulation in this industry is a journey, not a destination. The events of the recent past are part of that journey as their outcomes continue to evolve and shape how this asset class is viewed. There are important court cases still ahead of us that may have notable impacts, such as the SEC’s cases against XRP and its executives, as well as the recent motion to dismiss the SEC’s Wahi insider trading matter.

Before delving into the individual items, it is vital for investors to understand the current environment we find ourselves in. Last year was a calamitous period for the digital asset industry, not just for price performance but also for U.S. crypto regulatory progress. Prior to the collapse of FTX, we had the introduction of the Digital Commodities Consumer Protection Act from the Senate Agriculture Committee, which was generally viewed as positive for the industry and would have provided regulatory clarity in some, but not all, areas. We were also on the verge of the introduction of bipartisan stablecoin legislation from the House Financial Services Committee, a hot topic with financial regulators and one of the biggest use cases for the digital asset industry. However, with the collapse of FTX and Sam Bankman-Fried’s connection to the political apparatus, the fate of these legislative efforts is at best much delayed, and at worst very much in doubt.

As it stands today, after mid-term elections in November, the composure of the legislature has changed. No longer do we have Democrats in charge of both the House and the Senate, making passing legislation, crypto-related or otherwise, much more complex. Absent new legal authority and in response to the collapse of FTX, regulators have been employing their existing powers in familiar ways – enforcement actions, rulemaking, and less formal industry guidance.

Given that as the table-setting, it is important to unpack each of the regulatory actions individually. We think there is valuable information conveyed in each action that has been taken by these independent agencies across banking, securities, state, and federal jurisdictions.

Bank Regulators

Joint Statement from the Fed, FDIC, and OCC

On January 3rd, in a rare move, three of the nation’s top banking regulators released a joint statement on crypto assets and the risks they pose for the banking system. It acknowledges that banks are not prohibited or discouraged from providing services to any class of customer, which would include crypto companies, but there are specific risks associated with crypto-related companies and assets. They warn banks against issuing or holding cryptocurrencies as principal and said they would closely monitor crypto asset-related exposure.

Fed Policy Statement on Crypto Activities

Following up on the joint statement, the Board of Governors of the Federal Reserve System made a policy statement related to crypto activities and state-chartered banks. It sets out to level the playing field between state-chartered and federally-chartered banks and in a separate statement, it denied Custodia Bank’s application to the Federal Reserve System. Custodia is one of the Special Purpose Depository Institutions (SPDI) chartered in Wyoming hoping to provide a range of digital asset-related activities and services. Digging into the policy statement, the Board communicated there is no authority for national or state-regulated banks to hold crypto assets as principal. This is not how custodial practices for customers would normally be structured, but it likely means that banks cannot hold crypto as an investment asset on the balance sheet. Regarding stablecoins, the Board made it clear that issuing digital assets, such as stablecoins, is presumptively unlikely to be consistent with safe banking practices, but did not rule it out entirely. The Board also raised the concern about verifying parties that may transact with a bank, including unhosted wallets. The Board also noted that nothing in their guidance meant that banks could not custody digital assets if it is done in a regulated, safe, and sound manner.

Bankruptcy Protection Guidance from the New York Department of Financial Services

The NY Department of Financial Services (DFS) released updated guidance designed to protect consumers in the event of a virtual currency service providers, chiefly custodians, insolvency. Given the spate of bankruptcies the past year, it is not surprising to see the updated guidance which includes segregation of ownership, appropriate record keeping, business practices associated with transaction services, disclosures, and sub-custodial arrangements.

Halting Creation of BUSD by the New York Department of Financial Services

In the wake of the controversy around the BUSD stablecoin, also known as the Binance USD, the NY DFS ordered the halting of the creation or minting of new tokens, and its issuer, Paxos Trust Company, announced its intention to end its relationship with Binance. While no specific reason was given for the halt, at contention could have been the issuance of BUSD on other blockchains, so-called Binance pegged BUSD, which was not approved by the DFS. We have detailed several times (here, here, and here) the issues with BUSD, including allegations of insufficient backing for pegged assets, comingling of client funds, and attempts to create an interest-paying stablecoin.

Securities Regulators

Paxos Receives Wells Notice from SEC

In addition to the halting of BUSD by Paxos issued by the DFS, the SEC sent a Wells notice to Paxos indicating it is considering action against Paxos. While the notice is not public, the press release from Paxos indicates the SEC considers BUSD to be a security and its offering was not registered under federal securities law. Paxos publicly disagrees with the securities distinction. Importantly, the notice does not cover Paxos’s other stablecoins, such as Pax Dollar. Paxos's competitor, Circle, which issues the second largest stablecoin, USD Coin (USDC), indicated it has not received a Wells notice.

Kraken Settles with SEC Over Staking Service

Last week, the SEC filed a complaint and settled charges with Kraken regarding its staking-as-a-service offering. Kraken paid $30M to settle the charges and agreed to end its services, which have been increasingly popular over the years. Ethereum, the second largest digital asset by market cap, transitioned its consensus process to proof of stake from proof of work last fall, but many newer cryptocurrencies have similar mechanisms, allowing owners of the coin to generate returns by participating in the block-building process. SEC Chairman Gary Gensler has been vocal for quite some time that staking services might trigger securities regulation, but this is the first such enforcement action. It is important to understand the distinction is not that underlying assets used to stake are securities themselves, but the service activity is. A helpful analogy may be that bitcoin is not a security itself, but the interests offered in a bitcoin-backed financial product, such as an ETF, are. In the wake of the enforcement action, Coinbase, which also runs a popular staking service for its users, published a blog post highlighting its view that its staking services are not securities.

SEC Proposes Updated Custody Rules for RIAs

The SEC proposed enhanced protections for investors under the Investment Advisers Act of 1940. While this is still just a proposal, it expands the definition of assets that need to be held with a qualified custodian (QC) to include digital assets, specifies the minimum custodial practices for QCs, requires written agreements between RIAs and QCs, and requires updated policies and procedures for RIAs. The proposal will now enter a comment period, may be adjusted based on the comments the SEC receives, and then be subject to an implementation period. We don’t expect any of these changes to go into effect until the Summer of 2024 at the earliest.

SEC Brings Charges Against Genesis and Gemini, Do Kwon and Terraform Labs

In the wake of the bankruptcy of the lending arm of Genesis, which caught up with it the balances of users in the Gemini Earn program, the SEC charged both entities with their involvement in the unregistered sale of securities to retail investors. The complaint alleges that the Gemini Earn program in concert with Genesis constituted an offer and sale of securities, which should have been registered.

The SEC also charged Terraform Labs and its CEO for fraud related to the offering of crypto asset securities Mirror (MIR), Terra (LUNA), and Terra USD (UST). It is important to note that the SEC complaint alleges that both the MIR token, commonly marketed as a “governance token” for the Mirror Protocol, and UST, an algorithmic stablecoin, UST, are securities.

Pushback on SEC’s Authority in Wahi Case

Two weeks ago, lawyers from Jones Day submitted an important legal brief in the insider trading case brought against Ismail Wahi and two co-defendants. Wahi has already pleaded guilty to wire fraud charges brought by the DOJ, but the SEC also brought civil charges related to insider trading of securities, which is the subject of the brief. This case is important because the SEC is asserting that these 9 tokens are securities, which could have second-order impacts for Coinbase as the exchange that listed and allowed trading of the tokens and the issuers behind the tokens themselves. The case is still in progress, but this case, along with the outcome of the 2+ year litigation between XRP and the SEC, will have important implications for the definition of securities in the context of the digital asset industry.

The Path Forward

It is important to understand that while there has been a flurry of regulatory activity in this space, none of it is existential. Nothing we have seen so far nor foresee on the horizon portends the banning or outlawing of digital assets. Certainly, the business practices of some industry participants are being called into question as is the regulatory designation for certain assets. However, we ultimately feel that sensible guardrails and knowing the rules of the road allow investors to confidently deploy capital in the asset class, benefitting prices.

Ordinals Drive Growth in Cheap, Low Priority Fees

In the third (first and second) part of our ongoing investigation of the impact of Ordinals inscriptions on the Bitcoin blockchain, we take a deeper look at the growth of the mempool, the waiting room of transactions waiting to be confirmed by miners, by fee rate. Our analysis shows that while the mempool is growing and so have blocks, most of that growth is due to low fee rate transaction volume, implying that the immediacy for transactions, and therefore time preference, is low. Stepping back, it appears that on-chain transaction fees are beginning to inflect upwards. Perhaps it took some time for fees to catch up to the growth in Ordinals inscriptions, which is just hitting one month old.

Digging into the mempool, however, reveals why it has been so slow to grow fees. Even though the mempool continues to grow, its growth largely comes from low fee rate transactions. Most of the transaction volume in the mempool is 1 - 2 sats/vB (the default minimum fee rate is 1 sat/vB). This implies that while the growth of Ordinals inscriptions is increasing demand for block space, there is little transaction immediacy associated with them. This may change if the demand for inscriptions remains high. We have also begun to see the minting of NFT portfolios come to Bitcoin, which may also result in higher time preferences.

Bitcoin Dominance Rises as Crypto Bounces Back

Bitcoin’s dominance, its share of the crypto industry market cap, has been on the rise recently. While bitcoin’s dominance hit a low around the price peak of 2021 and then gained again throughout the drawdown of 2022, its resurgence in the rally thus far in 2023 is noted, especially during the positive price movement on Wednesday. We have documented that bitcoin is often the first mover up from the trough in a drawdown and this cycle appears to be no different. One of the factors that might be helping bitcoin rebound in this cycle is the regulatory environment and the clarity US investors have around bitcoin as a commodity that does not exist for so many other digital assets. That and the fact that bitcoin has product-market fit as a non-sovereign issued store of value, puts it ahead of most of the rest of the cryptocurrency competition. Regardless of the reason, the outcome appears to be similar as many of the hallmarks of prior cycles continue to repeat.

Market Update

Bitcoin had another strong week, largely driven by a midweek rally as fears of overly aggressive regulations in the US abated. Year-to-date bitcoin is up 48.4%, far outpacing other asset classes. Equities were up on the week, with the S&P 500 up 0.3% and Nasdaq Composite up 0.6%. Commodities were mixed, with gold falling 1.3% despite a higher-than-expected inflation print, and oil up 0.6%. Bonds fell on the week with investment grade bonds down 1.8%, high yield bonds down 1.4%, and long-term US Treasuries down 2.8%. Real yields and inflation expectations rose on the week.

Important News This Week


Bitcoin’s Future Depends on Six Mysterious Coders - WSJ

CME Group to Launch Event Contracts on Bitcoin Futures in March - CME

Regulation and Taxation:

Consumer Notice Regarding Paxos-Issued Binance USD - NY DFS

Paxos Will Halt Minting New BUSD Tokens - Paxos

Paxos Issues Statement - Paxos

Coinbase’s Staking Services Are Not Securities. And Here's Why. - Coinbase

Circle (USDC) Alerted New York Over Binance-peg BUSD Issues - Bloomberg

Crypto-Assets: A New Standard for Banks - ECB

SEC Proposes Enhanced Safeguarding Rule for RIAs - SEC

Binance Expects to Pay Penalties to Resolve U.S. Investigations - WSJ

SEC Charges Terraform and CEO Do Kwon with Defrauding Investors - SEC


Binance Moved $400M from U.S. Partner to Firm Managed by CEO Zhao - Reuters

Bakkt to Enhance Focus on Scalable Business-to-Business-to-Consumer Solutions and Sunset Consumer App - Bakkt

Bankrupt Crypto Lender Celsius Proposes Sale Plan to NovaWulf - The Block

Upcoming Events

Feb 24 - CME Futures and Options Expiry

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