IRS Issues Guidance on Non-Fungible Tokens – What It Says and Does Not Say

By Betsy Smith, Nicholas C. Mowbray, Robert A. Musiala and Teresa Goody Guillén on March 27, 2023 Posted in Alert

NFT non fungible token golden coins falling. Trendy cryptocurrencies and coins on the blockchain technology. Close up view of crypto money in 3D rendering

The Proposed Guidance and Implications

The IRS and Treasury Department announced on March 21, 2023, that they intend to issue guidance providing that certain NFTs qualify as collectibles under Section 408(m) of the Code. The Notice is the first guidance issued by the IRS addressing the U.S. federal income tax treatment of NFTs. The IRS originally issued Notice 2014-21 in 2014 addressing virtual currencies and how they should be treated as property for federal income tax purposes. In 2019, the IRS issued Rev. Rul. 2019-24 relating to whether the receipt of cryptocurrencies via a hard fork or airdrop resulted in taxable income to the recipient. The IRS has also released Chief Counsel Advice Memoranda addressing how specific federal income tax principles (e.g., the like-kind exchange rules or when an asset is worthless) apply to cryptocurrencies. None of this prior guidance, however, addressed NFTs. Taxpayers and their advisors have accordingly tried to analogize NFTs to other types of property to draw on how the federal income tax laws treat analogous property.

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New Initiatives Launch in Staking, DeFi, DAOs; IRS Issues NFT Guidance; White House Report Criticizes Crypto; SEC and DOJ Crypto Enforcement Continues

By Robert A. Musiala, Christopher Lamb, Nicholas C. Mowbray, Joanna F. Wasick, Keith R. Murphy and Lauren Bass on March 27, 2023 Posted in Blockchain

In this issue:

• Staking Market Launches, ‘Defi Cover’ Data Published, DAO Buys Golf Course
• IRS Issues Guidance on Non-Fungible Tokens
• Economic Report of the President Criticizes Digital Assets
• SEC Charges Crypto Entrepreneur and Celebrities; DOJ Targets Crypto Fraudster
• U.S. Crypto Exchange Receives SEC Wells Notice, Publishes Staking Analysis
• Moscow Money Mules and Hackers: Digital Asset Threats Continue

Staking Market Launches, ‘Defi Cover’ Data Published, DAO Buys Golf Course

By Christopher Lamb

According to a recent press release, MetaMask Institutional, “the web3 wallet for organizations,” has launched its “institutional staking marketplace” in partnership with three other blockchain companies. According to the press release, “[t]he first-of-its-kind platform is designed to simplify and provide unrivaled access to institutional staking” and will “reduce … complexity by streamlining access to top-tier staking providers.”

A recent report provides data on the emerging “DeFi cover” market, which provides “insurance alternatives” for DeFi market participants. According to the report, DeFi cover providers paid out $34.4 million in claims in 2022. The most notable payouts include “$22.5 million during the collapse of the Terra ecosystem in May 2022 and $4.7 million from the collapse of a major crypto exchange in November 2022.” The report notes the small percentage of DeFi funds that were insured by DeFi cover in 2022, with a mere $231 million worth of DeFi funds insured, “representing just 0.5% of the total value locked in the DeFi industry.” The report provides data on 23 DeFi cover providers that operate across the Ethereum, Polygon, Arbitrum, Optimism, BNB Smart Chain, Astar, and Avalanche blockchain networks.

According to reports, LinksDAO is about to become the first decentralized autonomous organization (DAO) to acquire a golf course, successfully winning a bid to buy the Spey Bay Golf Club in Scotland. The successful bid is reportedly the result of a DAO governance vote where 88.6 percent of LinksDAO token holders voted in favor of making an offer to purchase the golf course.

According to a press release, the Provenance Blockchain Foundation, “which catalyzes the adoption and development of the public and open-source Provenance Blockchain … announced the launch of a $50 million grant program for blockchain developers.” In a quote from the press release, the Head of Developer Ecosystem at Provenance Blockchain Foundation said, “This program is not simply a grant, the Provenance Blockchain Foundation will partner directly with developers.” Interested developers may apply at https://provenance.io/build/grants/grants-program.

For more information, please refer to the following links:

IRS Issues Guidance on Non-Fungible Tokens

By Nicholas C. Mowbray

The IRS issued guidance this week regarding the federal income tax treatment of NFTs. The guidance states that the IRS intends to issue future guidance stating that certain NFTs are collectibles for federal income tax purposes, and requests comments from taxpayers regarding the federal income tax treatment of NFTs. The guidance further states that future guidance addressing whether an NFT is a collectible will adopt a “look through” approach that analyzes the NFT’s underlying right or digital file, and whether it is a collectible.

In general, collectibles that qualify as capital assets are subject to a maximum 28 percent long-term capital gains rate, which is higher than the capital gains rates that apply to capital assets that are not collectibles. In addition, there are negative federal income tax consequences for an individual retirement account that holds a collectible.

For more information, please refer to the following links:

Treatment of certain nonfungible tokens as collectibles

Economic Report of the President Criticizes Digital Assets

By Robert A. Musiala Jr.

This week, the White House released its Economic Report of the President. The 507-page report includes a 37-page chapter devoted to digital assets titled “Digital Assets: Relearning Economic Principles.” The chapter presents an overall skeptical view of “crypto assets,” although it acknowledges that “[t]he development of crypto assets and their underlying distributed ledger technology have the potential to transform industries and business models.” According to the chapter, despite certain perceived benefits, “[s]o far, crypto assets have brought none of these benefits.” The chapter is broken out into three sections titled “The Perceived Appeal of Crypto Assets,” “The Reality of Crypto Assets,” and “Investing in the Nation’s Digital Financial Infrastructure.”

The first section “reviews the potential benefits that crypto assets may offer, as often touted by their proponents.” The section describes “several possible benefits that proponents claim for [the] popularity of crypto assets.” These include use as investment vehicles; faster, “censorship resistant” payments; financial inclusion; and improved financial technology infrastructure.

The second section “evaluates what [crypto assets] have actually achieved.” The section asserts that as investments, crypto assets are “highly risky” and “many … do not have a fundamental value.” The section contrasts this with stocks, “which are claims on the future profits of firms”; debt, which “is a claim on interest and principal payments”; and commodities such as gold and silver, which “can be used in jewelry and for special manufacturing purposes.” In comparing crypto assets to sovereign money, the section asserts that cryptocurrencies are not as effective as the U.S. dollar in serving as a unit of account, medium of exchange, or store of value. The section also cites various risks of crypto assets including the environmental impact of cryptocurrency mining, “run risk” of stablecoins, fraud, lack of disclosures, conflicts of interest at crypto asset platforms that perform multiple functions, potential future systemic risks, illicit finance risks, and ransomware.

The chapter’s final section acknowledges that “[t]he growth of crypto assets has revealed a demand for a faster and more inclusive financial system with a real-time payment system and circulating digital money.” The section explores various potential methods of meeting this demand using alternatives to crypto assets, including central bank digital currencies (CBDCs) and the forthcoming FedNow Instant Payment System.

For more information, please refer to the following links:

SEC Charges Crypto Entrepreneur and Celebrities; DOJ Targets Crypto Fraudster

By Joanna F. Wasick

On Wednesday, the U.S. Securities and Exchange Commission issued a press release announcing charges against crypto asset entrepreneur Justin Sun and three of his wholly owned companies for the unregistered offer and sale of “crypto asset securities” Tronix (TRX) and BitTorrent (BTT). The SEC also charged Sun and his companies with fraudulently manipulating the secondary market for TRX through extensive wash trading, which involves the simultaneous or near-simultaneous purchase and sale of a security to make it appear actively traded without an actual change in beneficial ownership, and for orchestrating a scheme to pay celebrities to tout TRX and BTT without disclosing their compensation. Eight celebrities, including Lindsay Lohan and DeAndre Cortez Way (aka Soulja Boy), were also charged for illegally touting TRX and/or BTT without disclosing that they were compensated for doing so and the amount of their compensation.

Earlier this week, the U.S. Department of Justice (DOJ) announced the unsealing of charges against Irina Dilkinska in connection with her participation in “the massive OneCoin fraud scheme, which began operations in 2014 in Bulgaria, and marketed and sold a fraudulent cryptocurrency by the same name through a global multi-level-marketing network. According to a DOJ press release, as a result of misrepresentations made about OneCoin, victims invested over $4 billion worldwide in the fraudulent cryptocurrency. A U.S. Attorney stated, “Irina Dilkinska, the supposed Head of Legal and Compliance for the OneCoin cryptocurrency pyramid scheme, accomplished the exact opposite of her job title and allegedly enabled OneCoin to launder millions of dollars of illegal proceeds through shell companies. Dilkinska helped perpetuate a wide-ranging scheme with millions of victims and billions of dollars in losses, and she will now face justice for her alleged crimes.” Dilkinska was reportedly extradited from Bulgaria prior to the announcement.

For more information, please refer to the following links:

U.S. Crypto Exchange Receives SEC Wells Notice, Publishes Staking Analysis

By Keith R. Murphy

According to recent reports and a blog post by the company, a major U.S. cryptocurrency exchange has received a Wells notice issued by the U.S. Securities and Exchange Commission (SEC). According to the company, the notice relates to an unspecified portion of its listed digital assets, as well as its staking business, despite multiple efforts by the company to engage the SEC as to which assets are claimed to be securities and for guidance on how to potentially register some portion of its business with the SEC. In a blog post responding to the Wells notice, the company’s general counsel said, “We are confident in the legality of our assets and services, and if needed, we welcome a legal process to provide the clarity we have been advocating for and to demonstrate that the SEC simply has not been fair or reasonable when it comes to its engagement on digital assets.” The company’s blog post further notes the conflicting positions on these issues by multiple regulatory agencies, and calls for rulemaking, as opposed to enforcement actions, to assist with continued innovation.

Just days prior to receiving the Wells notice, the same cryptocurrency exchange issued a letter to the SEC providing further comment on the company’s petition for rulemaking on digital asset securities regulation previously submitted to the SEC in July 2022. The content of the letter focuses on the securities law treatment of services related to the validation of proof-of-stake protocols (staking). According to reports, the letter was in response to the SEC’s recent enforcement action against another U.S. cryptocurrency exchange’s staking program. In the letter, the company argues that staking is not a “monolith operation concept,” and that while some existing models could fall within the definition of investment contract offerings, others do not and do not meet the criteria of the “Howey test.” According to reports, the company’s chief executive officer indicated that the company is prepared to defend its position on its staking program.

For more information, please refer to the following links:

Moscow Money Mules and Hackers: Digital Asset Threats Continue

By Lauren Bass

According to a recent report by a global anticorruption NGO, Transparency International Russia, cryptocurrency exchanges and OTC desks located in Moscow International Business Center (aka Moscow-City) have been evading international sanctions and know-your-customer protocols to help Russian citizens move money out of Russia. The transactions reportedly happen via encrypted Telegram messages without any verification of identity or source of funds. According to the report, customers in Russia buy USDT, then use OTC desks to exchange the USDT for a foreign currency – often sterling – to be physically delivered by an on-demand courier service to a drop point (or person) in another country. The report suggests that since 2021, over $50 million has been processed through OTC desks as part of this scheme.

OpenZepplin, a leading technology security firm, recently released a report noting that a surge in blockchain-hacking techniques and exploits in 2022 has led to consumer losses exceeding $3.7 billion. The report outlines the top 10 hacks that blockchain proprietors should be mindful of – including software bugs and code vulnerabilities.

For more information, please refer to the following links:

NFTs Used to Serve Complaint; Treasury Official, SEC Chairman Address Crypto Compliance; NYAG Sues Crypto Exchange; DOJ Takes Down Crypto Mixer

By Robert A. Musiala, Christopher Lamb and Joanna F. Wasick on March 20, 2023 Posted in Blockchain

In this issue:
• NFT Integration Software Released; NFTs Used to Serve Complaint in Civil Action
• US Treasury Official Signals Forthcoming DeFi Illicit Finance Risk Assessment
• SEC Chairman Comments on Crypto Activities, NYAG Sues Crypto Exchange
• US and International Law Enforcement ‘Takedown’ Crypto Mixing Service
• Hackers Use ‘Flash Loan Attack’ to Steal $199 Million from DeFi Protocol

NFT Integration Software Released; NFTs Used to Serve Complaint in Civil Action

By Christopher Lamb

According to a recent press release, a major U.S. software company has launched a suite of tools that will allow users to “enter the Web3 and NFT space in a safe way, and buy directly from their trusted brand’s website as opposed to third-party marketplaces.” The new product reportedly includes “drag and drop tools” to help brands set up NFT collections and API integration that allows brands to access data and “link customer activity across Web2 and Web3.” According to the press release, the new tools will allow organizations to obtain “a holistic view of each customer across both physical and digital environments.”

According to a recent report, a Florida federal judge entered a default judgment in favor of a party who served “complaints to more than a dozen unidentified suspects through a non-fungible token.” According to the report, it is “possible to track the NFT when opened.” An attorney for the plaintiff in the case said allowing service through NFTs “is going to pave the way” to start suing fraudsters. The order from the Florida federal judge is reportedly the first of its kind granting a default judgment after service of a complaint through an NFT.

According to recent reports, NFT marketplaces have accounted for $73.8 billion in trading volume, but the report suggests “more than 42% of the volume is fake, with $31.2 billion attributed to wash trading.” The report notes that two popular NFT platforms have flagged 98% and 85% of their transaction volume as suspicious. The report suggests that fake NFT trading volume can “[i]nflate prices and manufactur[e] popularity of certain collections” and allow criminals to use NFTs “as a means of money laundering.”

In a final development, a recently filed class action lawsuit reportedly alleges that a popular NFT platform “illegally sold unregistered securities when it released non-fungible tokens through its own marketplace.” The complaint reportedly alleges that the “NFTs were not decentralized” and the company controlled “every aspect” of the NFTs, including the ledger that recorded their ownership. According to one report, the popular platform “started to lose out to other NFT marketplaces,” and with the decrease in demand for the platform’s NFTs, “their value tanked.”

For more information, please refer to the following links:

US Treasury Official Signals Forthcoming DeFi Illicit Finance Risk Assessment

By Robert A. Musiala Jr.

This week the U.S. Department of the Treasury published prepared remarks made by Assistant Secretary for Terrorist Financing and Financial Crimes Elizabeth Rosenberg at a meeting with banking sector representatives. The Assistant Secretary’s remarks included comments on the illicit finance risk of decentralized finance (DeFi), and she noted that “my team is actively working on and will soon publicly release an illicit finance risk assessment on DeFi.” The Assistant Secretary also expressed concern over the use of digital assets by North Korea-affiliated actors who have “conducted ransomware attacks, stolen hundreds of millions of dollars’ worth of virtual assets, and laundered their ill-gotten funds through mixers and other virtual asset service providers to fund North Korea’s illegal nuclear and ballistic missiles programs.”

In a foreign-based development, the Thailand Securities and Exchange Commission recently published notice that it is seeking public comments on a draft regulation that would prohibit digital asset business operators from (1) accepting deposits of digital assets from customers and lending, investing, staking or employing such digital assets; (2) accepting deposits of digital assets from customers and paying them regular interest or other types of benefits from their own source of funds unless those activities are in accordance with sale promotion rules; and (3) dvertising, persuading or acting in any other manner to support deposit taking and lending services. Comments on the proposed regulation are due by April 7.

For more information, please refer to the following links:

SEC Chairman Comments on Crypto Activities, NYAG Sues Crypto Exchange

By Robert A. Musiala Jr.

The Chairman of the U.S. Securities and Exchange Commission (SEC), Gary Gensler, recently published an Op-Ed article titled Getting crypto firms to do their work within the bounds of the law. Among other things, in the article, Chairman Gensler addressed “the talking point that there’s a lack of clarity in the securities laws” and said he found such claims “unpersuasive.” In paragraphs full of hyperlinks to SEC materials, Chairman Gensler cited to various prior SEC actions addressing crypto market activities including lending, staking, “listing crypto securities,” combining functions, accounting for crypto assets, disclosure obligations, and custody. Key SEC materials cited in Chairman Gensler’s article include the DAO Report; the Framework for “Investment Contract” Analysis of Digital Assets; SEC actions against BlockFi, a U.S. crypto trading platform, a major U.S. crypto exchange, Nexo, Poloniex, and EtherDelta; a prior speech made by the Chairman; Staff Accounting Bulletin No. 121; previously issued disclosure guidance; a recent SEC proposed rule; and a list of SEC crypto enforcement actions. Addressing SEC enforcement actions, Chairman Gensler said, “The goal is to get market participants into compliance with laws and rules and to protect … U.S. investors.”

In separate remarks recently covered by the news media, Chairman Gensler reportedly addressed proof-of-stake tokens and protocols. In his comments, Chairman Gensler reportedly said that staking participants are “anticipating a return … on those proof-of-stake tokens” and suggested that “a protocol that’s often a small group of entrepreneurs and developers” should “seek to come into compliance.”

In another recent development, the New York Attorney General (NYAG) announced a lawsuit against the KuCoin cryptocurrency exchange “for failing to register as a securities and commodities broker-dealer and falsely representing itself as an exchange.” According to a press release, the enforcement action “seeks to stop KuCoin from operating in New York and to block access to its website until it complies with the law.” In a notable statement, the press release stated, “This action is one of the first times a regulator is claiming in court that ETH, one of the largest cryptocurrencies available, is a security.”

For more information, please refer to the following links:

US and International Law Enforcement ‘Takedown’ Crypto Mixing Service

By Joanna F. Wasick

On Wednesday, the U.S. Department of Justice (DOJ) announced a coordinated international “takedown” of ChipMixer, an unlicensed darknet cryptocurrency “mixing” service that according to the DOJ laundered more than $3 billion worth of cryptocurrency from multiple criminal schemes involving ransomware, darknet markets, fraud, cryptocurrency heists and other hacking schemes around the world, including those perpetrated by North Korea’s Lazarus Group. According to the DOJ, ChipMixer allowed customers to deposit bitcoin, which ChipMixer then commingled with other ChipMixer users’ bitcoin in order to prevent enforcement agencies or regulators from tracing criminal transactions. ChipMixer also allegedly offered other additional features to obfuscate its criminal customers’ identities and concealed the operating location of its servers to avoid seizure by law enforcement. As part of the takedown, the U.S. government seized two domains that directed users to the ChipMixer service and one GitHub account, and charged one individual with operating an unlicensed money transmitting business, money laundering and identity theft in connection with ChipMixer’s operation. German law enforcement reportedly seized the ChipMixer back-end servers and more than $46 million in cryptocurrency. Law enforcement in Belgium, Poland and Switzerland also assisted in the criminal investigation, as did Europol.

For more information, please refer to the following links:

Hackers Use ‘Flash Loan Attack’ to Steal $199 Million from DeFi Protocol

By Robert A. Musiala Jr.

According to recent reports, “Crypto lending protocol Euler Finance suffered a loss of $199 million on the morning of March 13th, following a flash-loan attack.” The attacker reportedly exploited a flaw in one of the Euler Finance smart contracts to steal USDC, Dai, WBTC and Staked Ether, and then laundered the proceeds using Tornado Cash, a decentralized mixing service that has previously been sanctioned by the U.S. government. According to reports, blockchain data shows that an address associated with the hack sent 100 ETH to a wallet associated with Lazarus Group, a cybercrime group affiliated with the government of North Korea.

For more information, please refer to the following links:

Australia and BIS Address CBDCs; OCC, PCAOB and U.S. Senators Address Crypto Risks; SEC, DOJ and USSS Continue Crypto Enforcement Actions

By Robert A. Musiala, Amos Kim, Keith R. Murphy, Joanna F. Wasick and Lauren Bass on March 13, 2023 Posted in Blockchain

In this issue:

• Reserve Bank of Australia and BIS Commence Efforts to Advance CBDCs
• Acting Comptroller of the Currency and PCAOB Address Crypto Risks
• Binance and Binance.US Face Inquiry from U.S. Senators
• SEC and DOJ Continue Enforcement Actions Targeting Crypto Fraud Schemes
• Bitcoin ATM Operators Arrested, Charged with Criminal Violations

Reserve Bank of Australia and BIS Commence Efforts to Advance CBDCs

By Amos Kim

In a recent announcement, the Reserve Bank of Australia and the Digital Finance Cooperative Research Centre (DFCRC) released details on an ongoing research project exploring the benefits of a central bank digital currency (CBDC) in Australia, including the use case proposals and providers invited to participate in a live pilot. According to the announcement, the pilot will involve a “limited-scale pilot CBDC that is a real digital claim on the Reserve Bank” and pilot participants range “from smaller fintechs to large financial institutions.” A program director with the DFCRC said the pilot can cover a range of issues that could be addressed by the CBDC, “including some that involve the use of CBDC for atomic settlement of transactions in tokenized assets.”

In another recent announcement, the Bank for International Settlements (BIS) Innovation Hub published a report on the results of Project Icebreaker, a collaboration between the BIS Innovation Hub, the Bank of Israel, Norges Bank and Sveriges Riksbank that seeks to further the G20’s “priority to enhance cross-border payments.” According to the report, Project Icebreaker focuses on retail central bank digital currencies (rCBDCs) and “explores a specific way to interlink rCBDC systems with several additional features” to “promote simplicity and interoperability, reduce settlement risk, and foster competition and transparency for cross-border rCBDC payments.” Among other things, Project Icebreaker proposes an rCBDC model that seeks to eliminate time gaps between payment initiation and settlement “via an atomic payment-versus-payment (PvP) arrangement using Hash Time Locked Contracts (HTLC),” allow payers to “access competitive FX rates independently of the payment service provider,” and “mitigate risk of insufficient liquidity.” The report makes the following key recommendations for central banks seeking to implement an rCBDC for cross-border payments: (1) consider ways to incorporate conditional settlement, e.g., HTLC; (2) consider ways to ensure system availability and short response times 24/7/365 to maximize speed and minimize failed payments; (3) consider adopting current messaging and addressing standards and ensure flexibility in adopting future standards; (4) consider ways to provide instant rCBDC liquidity for FX providers 24/7/365; and (5) promote transparent and competitive incentives for FX providers.

For more information, please refer to the following links:

Acting Comptroller of the Currency and PCAOB Address Crypto Risks

By Robert A. Musiala Jr.

This week, Acting Comptroller of the Currency Michael J. Hsu delivered a speech titled “Trust and Global Banking: Lessons for Crypto.” In the speech, the Acting Comptroller drew parallels between the recent failure of the FTX exchange and the 1991 failure of the Bank of Credit and Commerce International (BCCI), “which failed in 1991 and led to significant changes in how global banks are supervised.” Among other things, the Acting Comptroller emphasized the importance of global coordination on banking matters and the role of the Basel Committee on Banking Supervision (BCBS) in establishing such standards as articulated in the first, second, and third Basel accords, and in the recently developed BCBS prudential standards for crypto-asset exposures.

Addressing the crypto markets, the Acting Comptroller said that while Satoshi Nakamoto’s bitcoin whitepaper is “elegant in its arguments,” in practice crypto “has proven to be extraordinarily messy and complex.” According to the Acting Comptroller, “Intermediaries are required for crypto to operate at any scale.” In drawing parallels between the failures of BCCI and FTX, the Acting Comptroller noted that both “faced fragmented supervision;” lacked a “lead or ‘home’ regulator with authority and responsibility for developing a consolidated and holistic view of the firms;” operated across jurisdictions that lacked informationsharing frameworks; and “used multiple auditors to ensure that no one could have a holistic view of their firms.” According to the Acting Comptroller, “[a]s a result, BCCI and FTX were able to carry out and obfuscate fraudulent activity and operate with a stunning lack of basic risk management and internal controls for an extended period of time.” In closing, among other things the Acting Comptroller highlighted the need for a “comprehensive global supervisory and regulatory framework for crypto participants.”

In a related development, this week the Public Company Accounting and Oversight Board (PCAOB) issued an Investor Advisory addressing so called “proof of reserve reports” (PoR Reports). According to the Investor Advisory, “Crypto entities may engage a service provider to issue a PoR Report in an attempt to reassure customers in response to widespread concerns about, for example, the type of reserve holdings, or, the safety and availability of customers’ digital assets in the event that some or all of the customers decide to withdraw their assets (e.g., if there is a run on a crypto exchange or stablecoin issuer).” Among other things, the Investor Advisory cautioned that PoR engagements are “not subject to PCAOB auditing standards” and “are not subject to PCAOB inspection,” and PoR Reports “do not provide assurance that such reserves will be adequate as of the date of the PoR Report, in the future, or that customer assets will be protected.”

For more information, please refer to the following links:

Binance and Binance.US Face Inquiry from U.S. Senators

By Keith R. Murphy

According to recent reports and a letter published by the office of U.S. Senator Elizabeth Warren, cryptocurrency exchange Binance and its U.S. arm Binance.US are the subjects of a broad request by U.S. Senators Elizabeth Warren, Chris Van Hollen, and Roger Marshall, M.D., to turn over documents and provide answers regarding the companies’ balance sheets, users, and policies and procedures, including with respect to the relationship between Binance and Binance.US. According to the letter, a related press release and related news reports, the request is based on growing concerns over the finances, risk management and regulatory compliance of the two companies and other related entities. As stated in the letter, the Senators assert that the “companies’ apparent attempts at evading the enforcement of anti-money laundering laws, securities laws, information reporting requirements, and other financial regulations cast serious doubt on the stability and legitimacy of Binance and its related entities, and on your commitment to your customers.”

The letter notes that Binance faces investigations on multiple fronts, including criminal sanctions evasion, money laundering conspiracy, unlicensed money transmission, questions about the company’s financial health, and rising scrutiny over an opaque corporate structure, and states that “Binance and its related entities have purposefully evaded regulators, moved assets to criminals and sanctions evaders, and hidden basic financial information from its customers and the public.” One of the allegations raised in the letter is that “Binance has intentionally allowed U.S.-based users to illegally access and trade unregulated products on the main exchange,” which is not licensed to operate in the U.S. The Senators further raise concern in the letter about the safety of customer assets and the potential impact of the companies’ activities on the stability of the cryptocurrency market and broader financial market. According to a report, Binance responded that there are significant misconceptions about its regulatory dealings, and that the companies will be responding to the information requests. The letter seeks a response by March 16, 2023.

For more information, please refer to the following links:

SEC and DOJ Continue Enforcement Actions Targeting Crypto Fraud Schemes

By Joanna F. Wasick

On Monday, the U.S. Securities and Exchange Commission (SEC) announced it had filed an emergency action and successfully obtained an asset freeze, appointment of a receiver and other emergency relief against Miami-based investment adviser BK Coin Management LLC (BKCoin) and one of its principals, Kevin Kang, in connection with a four-year-long crypto asset fraud scheme, through which BKCoin collected approximately $100 million from at least 55 investors. According to the SEC’s complaint, BKCoin and Kang told investors that their money would be used to trade crypto assets and represented that BKCoin would generate returns for investors through separately managed accounts and private funds. Instead, the SEC asserts, the defendants disregarded fund structure, commingled investor assets and used more than $3.6 million to make Ponzi-like payments. The complaint further alleges that Kang misappropriated at least $371,000 of investor money for his personal use.

On Wednesday, the U.S. Department of Justice announced the guilty pleas of six individuals for their roles in an internationally coordinated fraud and money laundering ring that deceived individuals into investing in AirBit Club, a purported cryptocurrency mining and trading company. As part of their guilty pleas, the defendants collectively have been ordered to forfeit their fraudulent proceeds consisting of U.S. fiat currency, bitcoin and real estate valued at $100 million. A U.S. Attorney stated, “The defendants took advantage of the growing hype around cryptocurrency to con unsuspecting victims around the world out of millions of dollars with false promises that their money was being invested in cryptocurrency trading and mining.”

For more information, please refer to the following links:

Bitcoin ATM Operators Arrested, Charged with Criminal Violations

By Lauren Bass

According to a press release by the U.S. Secret Service (USSS), three individuals were recently arrested for illegally owning and operating bitcoin kiosks (ATMs) across Ohio without a money transmission license. The individuals, along with their business entity, were reportedly indicted on charges including conspiracy, money laundering, receipt of stolen property and engaging in a pattern of corrupt activity. Reports indicate that in connection with these arrests, the USSS’ Cyber Fraud and Money Laundering Task Force seized over 50 bitcoin ATMs across Ohio.

For more information, please refer to the following links:

U.S. District Court Signals That In Certain Cases, NFTs May Qualify as Securities

By Teresa Goody Guillén, Christopher Lamb, Robert A. Musiala, Veronica Reynolds, Michelle Tanney and Joanna F. Wasick on March 9, 2023 Posted in NFTs

Dapper Labs was founded in 2018 shortly after the debut of its first NFT collection, “CryptoKitties,” which was so successful it created a bottleneck of transactions on the decentralized Ethereum Network. Seeking faster transaction throughput, Dapper Labs later launched its own decentralized “Flow Blockchain” and native FLOW token. In 2019, Dapper Labs launched the NBA Top Shots (Top Shots) platform on the Flow Blockchain as a joint venture between itself, the National Basketball Association (NBA), and the National Basketball Players Association. Dapper Labs then announced the creation of Moments – NFTs individually marked with unique identifiers that refer to video clip highlights of basketball games. Moments can be acquired through “packs” sold directly by Dapper Labs on the Top Shots platform, or individually through secondary sales on the marketplace.

Read the full alert.

New ERC-4337 Standard Released; US Bank Regulators, G20, IMF and OSC Address Crypto Risks; DeFi Hack Victims Regain Crypto Via Code Exploit

By Robert A. Musiala, Christopher Lamb, Amos Kim and Christina Gotsis on March 6, 2023 Posted in Blockchain

In this issue:
• New ERC-4337 Smart Contract Standard Released to Enhance Wallet Security
• US Federal Bank Regulators Issue Joint Statement on Crypto Liquidity Risks
• G20 Announces Forthcoming Reports Addressing Global Crypto Regulation
• IMF Addresses Crypto Policy; OSC Issues Notice for Crypto Trading Platforms
• DeFi Hack Victims Exploit Code Vulnerability to Regain Control of Hacked Crypto

New ERC-4337 Smart Contract Standard Released to Enhance Wallet Security

By Christopher Lamb

According to reports, Ethereum has deployed a new feature known as “account abstraction,” which has been in development for two years and can “make it easier for users to recover crypto if they lose private keys to an online wallet.” Deployed via a smart contract called EntryPoint (formally known as ERC-4337), account abstraction “turns users’ wallets into smart contract accounts, in order to make Ethereum wallets more user-friendly and to prevent any loss of keys.” According to reports, account abstraction works by taking external owned accounts (EOAs), such as accounts used on MetaMask or Coinbase Wallet, and merges the code-based operation of contract accounts (CAs) “creating built-in mechanisms that can allow users to keep access to their crypto” in the event that users lose their private keys. Recovery systems include a “social recovery system” and the ability to create “multi-sig wallets” (where multiple users must sign off on a transaction) as an “extra safety mechanism.”

According to reports, the new ERC-4337 standard is “expected to help mainstream adoption by finally making crypto user friendly.” ERC-4337 has passed an audit and will be made available on every Ethereum Virtual Machine-compatible blockchain network. A major function of the new feature is that “[n]ew users will no longer need to learn about complicated seed phrases or the technical process of setting up a wallet to onboard into the decentralized world of crypto.” According to reports, in addition to the recovery of users’ wallets, the benefits include “two-factor authentication, signing transactions on your phone, the setting of monthly spending limits on an account, the use of session keys to play blockchain games without constantly having to approve transactions, [and] decentralized recovery of wallets; [and] smart accounts can be configured to autopay bills and subscriptions.”

For more information, please refer to the following links:

US Federal Bank Regulators Issue Joint Statement on Crypto Liquidity Risks

By Robert A. Musiala Jr.

The three main US federal banking regulators recently published the “Joint Statement on Liquidity Risks to Banking Organizations Resulting from Crypto-Asset Market Vulnerabilities.” Among other things, the statement “highlights key liquidity risks associated with crypto-assets and cryptoasset sector participants that banking organizations should be aware of.” The statement specifically highlights certain liquidity risks related to “[d]eposits placed by a crypto-asset-related entity that are for the benefit of the crypto-asset-related entity’s customers (end customers)” and risks related to “[d]eposits that constitute stablecoin-related reserves.” The statement cautions that “when a banking organization’s deposit funding base is concentrated in crypto-asset-related entities that are highly interconnected or share similar risk profiles, deposit fluctuations may also be correlated, and liquidity risk therefore may be further heightened.”

According to the statement, “it is important for banking organizations that use certain sources of funding from crypto-asset-related entities … to actively monitor the liquidity risks inherent in such funding sources and establish and maintain effective risk management and controls commensurate with the level of liquidity risks.” In this regard, the statement lists the following effective risk management practices:

Understanding the direct and indirect drivers of potential behavior of deposits from crypto-asset-related entities and the extent to which those deposits are susceptible to unpredictable volatility.
Assessing potential concentration or interconnectedness across deposits from cryptoasset-related entities and the associated liquidity risks.
Incorporating the liquidity risks or funding volatility associated with crypto-asset-related deposits into contingency funding planning, including liquidity stress testing and, as appropriate, other asset-liability governance and risk management processes.
Performing robust due diligence and ongoing monitoring of crypto-asset-related entities that establish deposit accounts, including assessing the representations made by those crypto-asset-related entities to their end customers about such deposit accounts that, if inaccurate, could lead to rapid outflows of such deposits.

For more information, please refer to the following links:

G20 Announces Forthcoming Reports Addressing Global Crypto Regulation

By Amos Kim

According to a recent announcement by the G20 – a group of the 20 largest economies in the world – the Financial Stability Board (FSB), the International Monetary Fund (IMF) and the Bank for International Settlements (BIS) expect to release various reports in 2023 with the goal of setting standards “to ensure that the crypto-assets ecosystem, including so-called stablecoins, is closely monitored and subject to robust regulation, supervision, and oversight to mitigate potential risks to financial stability.” Among other things, the FSB intends to release recommendations on the regulation, supervision and oversight of global stablecoins, cryptocurrency asset activities and markets in July and its joint “synthesis paper integrating the macroeconomic and regulatory perspectives of crypto assets” with the IMF in September. The IMF will also report on the “potential macro-financial implication of widespread adoption of [central bank digital currencies]” that same month.

According to the announcement, other expected reports include BIS’s “report on analytical and conceptual issues and possible risk mitigation strategies related to crypto assets” and a report from the Financial Action Task Force (FATF) on “the use of crypto assets to make transfers for terrorist financing.” These announcements were made after the conclusion of a two-day G20 financial meeting in India. According to reports, at the meeting, US Treasury Secretary Janet Yellen said it was “critical to put in place a strong regulatory framework” for cryptocurrency-related activities but noted that the US was not suggesting “outright banning of crypto activities.” In contrast, IMF Managing Director Kristalina Georgieva reportedly said that banning crypto should be an option for G20 countries.

For more information, please refer to the following links:

IMF Addresses Crypto Policy; OSC Issues Notice for Crypto Trading Platforms

By Robert A. Musiala Jr.

The International Monetary Fund (IMF) recently published a policy paper titled “Elements of Effective Policies for Crypto Assets” to address questions by IMF members on “how to respond to the rise of crypto assets and the associated risks.” Among other things, the paper “presents a policy framework for crypto assets that aims to achieve key policy objectives such as macroeconomic stability, financial stability, consumer protection, and market and financial integrity” and “outlines key elements that are necessary to ensure that these objectives are met.”

According to a recent press release by the Ontario Securities Commission (OSC), the OSC has published a new Staff Notice that describes “a change in the CSA staff practice in connection with our expectation that crypto asset trading platforms (CTPs) that continue to operate in Canada while they seek registration and related exemptive relief file a pre-registration undertaking (a PRU) with the CSA.” The Staff Notice also provides additional guidance to CTPs, including a list of areas where the OSC is requesting “new commitments” from unregistered CTPs and new expectations for unregistered CTPs that are continuing to operate in Canada while pursuing applications for registration.

For more information, please refer to the following links:

DeFi Hack Victims Exploit Code Vulnerability to Regain Control of Hacked Crypto

By Christina O. Gotsis

According to reports, this week, a Web3 infrastructure firm and decentralized finance (DeFi) platform conducted a “counter exploit” on the Wormhole protocol hacker that stole roughly $321 million of wrapped ETH via a vulnerability in the protocol’s token bridge. The Web3 infrastructure firm and DeFi platform first became aware of the possibility of retrieving these assets when a Whitehat group reached out in February with a proposal to exploit a previously unknown vulnerability in the DeFi platform’s code. According to a blog post by the DeFi platform, on February 21, the High Court of England and Wales granted an order allowing the retrieval of the assets from addresses associated with the Wormhole exploit. The counter-exploit essentially allowed the DeFi platform to hack the hacker’s addresses and claw back $225 million of digital assets into a safe wallet.

For more information, please refer to the following links:

DOJ, CFTC and SEC Bring Separate Actions for the Same Conduct: Alleged Digital Asset Manipulation and Fraud Scheme on Mango Markets Platform

By Teresa Goody Guillén, Joanna F. Wasick, Veronica Reynolds and Sydney Park on March 1, 2023 Posted in Enforcement

Mango Markets is a decentralized cryptocurrency exchange that allows users to purchase and borrow cryptocurrencies and cryptocurrency-related financial products. Mango Markets is run by the Mango Decentralized Autonomous Organization (Mango DAO), which has its own crypto token named MNGO. Holders of MNGO tokens can vote on changes to Mango Markets and other issues related to the governance of the Mango DAO.

Read the full alert.

PoS Principles Published; Crypto Market Analysis and POC Announced; Court Interprets NFTs Under Howey; SEC, CFTC and DOJ Continue Crypto Enforcement

By Robert A. Musiala, Amos Kim, Christopher Lamb, Keith R. Murphy and Joanna F. Wasick on February 27, 2023 Posted in Blockchain

In this issue:
• Proof of Stake Alliance Publishes Analysis, Advocates for Industry Standards
• BIS Analyzes Crypto Market Data, Digital Asset PoC and Consultation Announced
• U.S. District Court Denies Motion to Dismiss Claims that NFTs Are Securities
• SEC and CFTC Actions Pursue Crypto Misrepresentation and Fraud Actions
• DOJ and New York State Actions Target Crypto Fraud and Other Violations

Proof of Stake Alliance Publishes Analysis, Advocates for Industry Standards

By Amos Kim

This week the Proof of Stake Alliance (POSA), a nonprofit industry alliance focused on proof of stake (PoS) ecosystems, announced their newly developed industry principles for liquid staking. These principles are the product of two legal white papers developed by “POSA’s liquid staking working group of members from over 10 industry organizations” that includes representatives from the legal and software development industries, as well as Lido, a liquid staking solution for Ethereum and other PoS blockchains.

According to the announcement, POSA’s liquid staking working group “represent[s] the first collaborative industry effort to define and consider key legal questions around liquid staking and to call upon the industry to self-regulate.” POSA’s newly developed legal working papers “address regulatory and tax considerations for liquid staking in the U.S., representing the first legal research and conclusions on the regulatory and tax status of liquid staking receipt tokens, the lack of clarity around which has been cited as a primary barrier to liquid staking’s widespread adoption and development domestically in the United States and globally.” According to the Executive Director of POSA, “In the wake of recent SEC actions against staking-as-a-service providers, we believe that revisiting and updating our industry principles to reflect new innovations like liquid staking will help unite those who participate in staking ecosystems and strengthen all of our advocacy efforts.”

The announcement highlights the following “industry-driven standards” that are being advocated by the POSA for adoption by “those who are engaged in liquid staking and developing liquid staking protocols”: (1) Use appropriate terminology to describe liquid staking tokens (LSTs) and the nature of activities; (2) focus on increased liquidity, without sacrificing what is of utmost importance – security and participation; (3) develop tools to enable direct staking with access to liquidity, not staking-backed yield products; and (4) refrain from providing investment advice.

For more information, please refer to the following links:

BIS Analyzes Crypto Market Data, Digital Asset PoC and Consultation Announced

By Christopher Lamb

According to a recent bulletin published by the Bank for International Settlements (BIS), data collected and analyzed by BIS shows that “crypto trading activity increased markedly” in the wake of the recent collapses of major cryptocurrency exchanges and algorithmic stablecoins, with “large and sophisticated investors selling and small retail investors buying.” The bulletin reports that, in 2022, over $1.8 trillion of crypto value dissolved – with roughly $650 billion of these losses following the collapse of major algorithmic stablecoins and crypto exchanges. Data referenced in the bulletin also indicates that, over the period of August 2015 to December 2022, “a majority of investors probably lost money on their bitcoin investment.” However, the bulletin indicates that the broader financial system suffered limited impact from the collapse in valuation over the course of 2022, and that there is “at best a weak correlation between broader stress and crypto losses.” According to the bulletin, despite the weak correlation between the cryptocurrency market and the broader financial system, the patterns between retail trading and sophisticated investor selling indicate a need for further investor protection in the digital asset market.

In other news, a German multinational investment bank and financial services company recently completed a proof of concept known as Project DAMA (Digital Assets Management Access) to serve as a “one-stop digital fund investment servicing platform” and to address challenges associated with launching and accessing digital funds. According to a press release, Project DAMA was awarded the Monetary Authority of Singapore’s Financial Section Technology and Innovation (FSTI) Proof of Concept grant in August 2022.

According to a recent press release, the Hong Kong Securities and Futures Commission (SFC) has launched a consultation on the proposed requirements for operators of virtual asset trading platforms. The press release notes that the proposed requirements are “comparable to those required by licensed securities brokers and automated trading venues.” The SFC is seeking input “particularly on whether to allow licensed platform operators to serve as retail investors, and if so, the measures to be implemented in addition to the proposed range of robust investor protection measures ….” Interested parties can submit their comments to the SFC on or before March 31, 2023.

For more information, please refer to the following links:

U.S. District Court Denies Motion to Dismiss Claims that NFTs Are Securities

By Robert A. Musiala Jr.

This week the U.S. District Court for the Southern District of New York (Court) issued a decision and order (Order) in an ongoing class action lawsuit denying the defendants’ motion to dismiss claims that certain popular basketball-focused nonfungible tokens (NFTs), referred to as “Moments,” were “investment contracts” and therefore securities under the standard set forth by the U.S. Supreme Court in SEC v. W.J. Howey Co. In Howey, the U.S. Supreme Court found that a contract, scheme or transaction is deemed an investment contract, and thus a security, if it involves (1) an investment of money (2) in a common enterprise (3) with a reasonable expectation of profits (4) based on the entrepreneurial or managerial efforts of others. Here, the Court found that the plaintiffs’ allegations claiming the NFTs met the Howey test were “facially plausible” and therefore survived the defendants’ motion to dismiss the alleged violation of Sections 5 and 12 of the Securities Act.

According to the Order, the plaintiffs’ allegation that the Moments existed on the Flow blockchain, a private blockchain maintained and controlled by the defendants – unlike public blockchains like the Bitcoin Network – was “fundamental” to the Howey analysis because the plaintiffs’ control over the Flow blockchain network “significantly, if not entirely, dictates Moments’ use and value.” The Order further stated, “By privatizing the blockchain on which Moments’ value depends and restricting the trade of Moments to only the Flow Blockchain, purchasers must rely on [defendants’] expertise and managerial efforts, as well as its continued success and existence.”

The Order also found that the defendants marketed the Moments NFTs “as a means for purchasers to realize substantial profits through the low sale prices for packs and marketing of the substantial profits others had made through sale on [defendants’] proprietary Marketplace.” In conclusion, the Order found that without the defendants’ “essential efforts in maintaining the Flow Blockchain and Marketplace, Moments would be valueless.” The Court emphasized that its conclusion is “narrow” and that “[n]ot all NFTs offered or sold by any company will constitute a security, and each scheme must be assessed on a case-by-case basis.”

For more information, please refer to the following links:

NBA-Tied Crypto Co. Can’t Dodge Unregistered Securities Suit

SEC and CFTC Actions Pursue Crypto Misrepresentation and Fraud Actions

By Keith R. Murphy

According to a recent press release, the U.S. Securities and Exchange Commission (SEC) has charged Singapore-based Terraform Labs PTE Ltd and Do Hyeong Kwon with operating a “multi-billion dollar crypto asset securities fraud” in connection with the Terra USD (UST), Luna and MIR tokens. According to the SEC press release, among other things the defendants marketed crypto asset securities to investors seeking to earn profits, repeatedly claimed that their tokens would increase in value, and misled investors about the stability of the UST token, which in May 2022 de-pegged from the U.S. dollar and saw its price decline to zero. In a quote from the SEC press release, Gurbir S. Grewal, the Director of the SEC’s Division of Enforcement, stated that the defendants’ “ecosystem was neither decentralized, nor finance. It was simply a fraud propped up by a so-called algorithmic ‘stablecoin’ – the price of which was controlled by the defendants, not any code.”

In another recent press release, the SEC published an order and announced that it has settled charges against a former professional basketball player for making false and misleading statements on social media regarding “crypto asset securities” and for failing to disclose that he received payment for his endorsements. The SEC’s order found violations of the anti-touting and anti-fraud provisions of the federal securities laws. The former professional basketball player settled the matter for $1.409 million without admitting or denying the SEC’s findings, according to the press release. In a quote from the SEC press release, Gurbir S. Grewal, the Director of the SEC’s Division of Enforcement, stated that “the federal securities laws are clear that any celebrity or other individual who promotes a crypto asset security must disclose the nature, source, and amount of compensation they received in exchange for the promotion.”

A recent press release by the U.S. Commodity Futures Trading Commission (CFTC) announced charges against a California technology company and its chief executive officer, alleging fraudulent solicitation and misappropriation of customers’ bitcoin and ether “digital asset commodities” through a “Ponzi-like scheme.” According to the press release, the defendants falsely advertised to customers that the company would trade their digital assets and obtain significant returns, and that investors’ assets would be traded using “Robot Traders,” despite no such program existing. Through the litigation, the CFTC seeks restitution, disgorgement, various bans and civil monetary penalties.

For more information, please refer to the following links:

DOJ and New York State Actions Target Crypto Fraud and Other Violations

By Joanna F. Wasick

On Wednesday, the U.S. Department of Justice (DOJ) announced that a federal grand jury charged four Russian national founders of Forsage, a purported DeFi cryptocurrency investment platform, for their roles in a global Ponzi and pyramid scheme that took in $340 million from victim-investors. According to a DOJ press release, the defendants coded and deployed smart contracts that systematized a combined Ponzi-pyramid scheme on the Ethereum, Binance Smart Chain and Tron blockchains. As soon as an investor invested in Forsage by purchasing a “slot” in a Forsage smart contract, the smart contract automatically diverted the investor’s funds to other Forsage investors, such that earlier investors were paid with funds from later investors. The DOJ’s case follows a related action brought by the U.S. Securities and Exchange Commission (SEC) in August against 11 people tied to Forsage.

Also this week, the New York Attorney General (AG) sued the cryptocurrency platform CoinEx for failing to register as a securities and commodities broker-dealer and for falsely representing itself as a crypto exchange. According to a press release, New Yorkers were able to buy and sell cryptocurrencies on CoinEx even though the company is not registered in the state, in violation of New York law. In addition, according to the press release, CoinEx claimed to be an exchange but is not registered with the SEC as a national securities exchange or appropriately designated by the Commodity Futures Trading Commission (CFTC), as is required under New York law. The AG also alleged that CoinEx failed to comply with a subpoena issued to provide more information about its digital asset trading activities in the state. Through this enforcement action, the AG seeks to permanently stop CoinEx from operating in New York through its website and mobile apps.

Last week, the Manhattan District Attorney announced the indictment of Nan Wu and his four accomplices, including a U.S. Postal Service employee, for operating a dark web marketplace from New York and California that shipped more than 10,000 packages of cocaine, MDMA, ketamine and other substances to customers throughout the United States. As alleged, the defendants operated the dark web vendor “FireBunnyUSA” and laundered $7.2 million, including over $3.1 million in proceeds, through domestic and foreign cryptocurrency exchanges.

For more information, please refer to the following links:

DeFi Protocols Announce Updates; FSB Addresses DeFi Risks; Museum to Host NFT Exhibit; Crypto Enforcement Continues; Crypto Crime Reports Published

By Robert A. Musiala, Christopher Lamb, Joanna F. Wasick and Amos Kim on February 17, 2023 Posted in Blockchain

In this issue:

• DeFi Protocols Announce Updates, US Bank Introduces Deposit Token Concept
• Financial Stability Board Addresses DeFi Risks in New Report
• French Museum to Host NFT Exhibit, New Report Provides 2022 NFT Market Data
• SEC Proposes to Expand Scope of Custody Rule to Cover All Crypto Assets
• DFS Orders End to BUSD; US, UK Agencies Take Crypto Enforcement Actions
• Reports Provide Data and Analysis on 2022 Cryptocurrency Illicit Activities

DeFi Protocols Announce Updates, US Bank Introduces Deposit Token Concept

By Christopher Lamb

According to recent reports, Rocket Pool, a decentralized finance (DeFi) protocol used as an Ethereum (ETH) staking service, has reached $1 billion in total value locked (TVL) less than two years after the protocol’s mainnet launch in 2021. Rocket Pool allows users to run their own ETH node with just 16 ETH – half of what is normally required. The other 16 ETH come from a decentralized node operator that only requires users to deposit 0.01 ETH to participate.

In a recent press release, MakerDAO, the DeFi lending protocol and creator of DAI (a decentralized stablecoin), announced that it has successfully onboarded Chainlink Automation as part of its Keeper Network. The Keeper Network provides price and debt ceiling updates through an automated system to promote DAI’s stability by using a network of automated bots. According to the press release, the integration of Chainlink will further decentralize MakerDAO and increase the number of third-party actors tasked with performing essential duties.

A report recently published by a major U.S. bank introduced the concept of “deposit tokens,” which the report defines as “transferable tokens issued on a blockchain by a licensed depository institution which evidence a deposit claim against the issuer.” Among other things, the report argues that bank-issued deposit tokens “are much safer than stablecoins for major institutions looking to transfer value across chains” and increased interest in blockchain emphasizes the need to have “cash equivalents” on the blockchain. According to the report, deposit tokens are different from central bank digital currencies and function similar to traditional deposits at licensed institutions like commercial banks. These deposit tokens would be “supported by the issuer’s regulatory framework, capital and liquidity requirements, contingency funding access as well as ‘robust’ consumer protection policies.”

For more information, please refer to the following links:

Financial Stability Board Addresses DeFi Risks in New Report

By Joanna F. Wasick

This week, the Financial Stability Board (FSB), an international body that monitors and makes recommendations about the global financial system, published a report on the financial stability risks of decentralized finance (DeFi). The FSB defines DeFi as “an umbrella term commonly used to describe a variety of services in crypto asset markets that aim to replicate some functions of the traditional financial system while seemingly disintermediating their provision and decentralising their governance.”

The report discusses an array of vulnerabilities in DeFi, the “most concerning” of which it identifies as “the different liquidity and maturity profile of liabilities and assets of relevant entities.” Other identified “operational fragilities” in DeFi include “easy-to-manipulate DeFi governance frameworks,” dependence on congested or unreliable blockchains, oracles and cross-chain bridges that can expose users to disruptions and thefts, and coding errors in smart contracts. The report concludes that, in light of its findings, FSB should (1) analyze financial vulnerabilities of the DeFi ecosystem as part of its regular monitoring of the wider crypto asset markets, (2) explore approaches to fill certain data gaps regarding DeFi and (3) study how proposed policy recommendations for international crypto regulation may need to be enhanced in light of DeFi-specific risks.

For more information, please refer to the following links:

French Museum to Host NFT Exhibit, New Report Provides 2022 NFT Market Data

By Amos Kim

A leading French modern art museum recently announced “an upcoming permanent exhibition targeting the intersection between art and the blockchain represented by nonfungible tokens (NFTs).” The exhibition will feature NFTs from many different artists, including “the next installment of the Punks Legacy Project” by Yuga Labs, a blockchain technology company that is a contributor to ApeCoin. Yuga Labs simultaneously announced that CryptoPunk #110 will be joining the museum’s permanent collection in Paris as “Yuga Labs’ Punks Legacy Project aims to bring awareness to the provenance and cultural relevance of Cryptopunks, one of the first NFT projects ….” The CryptoPunk #110 donation is the second donation from Yuga Labs. CryptoPunk #110 will be unveiled and installed at the Paris museum “this spring as part of an exhibition dedicated to celebrating digital art.”

In other recent news, DappRadar, a global app store for decentralized applications, reported a 59.6 percent “loss in market capitalization in 2022” in NFT collections on the Ethereum blockchain. According to DappRadar, the NFT market began falling from its peak in February 2022 a few months later in May, when the “Terra collapse” occurred, and hit its low of $2.2 billion in November. From that low point in November, “the market finished the year up 68%.” The report notes that “this retraction of the NFT market was not a reflection of NFT’s utility, but rather a result of bad actors and market manipulations.” Other key takeaways from the DappRadar report include the following: (1) The market cap for the 81 collections analyzed by DappRadar showed a decrease of 59.60 percent in USD value; (2) Yuga Labs has established itself as a leading player in the NFT industry, even though most collections faced depreciation at the end of the year; (3) only three NFT collections (Azuki, Pudgy Penguins and Degen Toonz) that were launched in 2021 or early 2022 experienced significant market cap growth; and (4) NFT collections launched after the Terra Luna collapse managed to appreciate their market cap by the end of 2022.

For more information, please refer to the following links:

SEC Proposes to Expand Scope of Custody Rule to Cover All Crypto Assets

By Robert A. Musiala Jr.

This week the U.S. Securities and Exchange Commission (SEC) published a proposed rule under the Investment Advisor’s Act of 1940 to address how investment advisers safeguard client assets. According to an SEC fact sheet, the proposed rule would, among other things, “expand the scope of the current custody rule beyond client funds and securities to include any client assets of which an adviser has custody.” The SEC fact sheet notes that the proposed rule would define “assets” as “funds, securities, or other positions held in a client’s account” and would include all assets that investment advisers custody for their clients. Accordingly, with limited exceptions, advisers would be required to maintain client assets with a qualified custodian, such as a federal or state-chartered bank or savings association, certain trust companies, a registered broker-dealer, a registered futures commission merchant, or certain foreign financial institutions.

The proposed rule discusses “crypto assets” at length. According to the proposed rule, “most crypto assets are likely to be funds or crypto asset securities covered by the current rule” and therefore investment advisers are already required to maintain such “crypto assets” with a qualified custodian. The proposed rule goes on to state that the proposed new definition of “assets” would include “all crypto assets, even in the instances where such assets are neither funds nor securities.” Accordingly, “to comply with the proposed rule, an adviser with custody of client crypto assets would generally need to ensure those assets are maintained with a qualified custodian that has possession or control of the assets at all times in which the adviser has custody.” As a result, under the new proposed rule, an investment adviser with custody of client crypto assets who trades the assets on a crypto asset trading platform that is not a qualified custodian would be in violation of the rule. According to a statement by SEC Chair Gary Gensler, “[b]ased upon how crypto platforms generally operate, investment advisers cannot rely on them as qualified custodians.” The proposed rule seeks comments, which should be received on or before the end of the 60-day period from the date the proposed rule is published in the Federal Register.

For more information, please refer to the following links:

DFS Orders End to BUSD; US, UK Agencies Take Crypto Enforcement Actions

By Robert A. Musiala Jr.

This week the New York State Department of Financial Services (DFS) published a consumer alert to provide notice that “DFS has ordered Paxos to cease minting Paxos-issued BUSD as a result of several unresolved issues related to Paxos’ oversight of its relationship with Binance in regard to Paxos-issued BUSD.” According to the consumer alert and a blog post by Paxos, “[i]n response, on February 13, 2023, Paxos notified customers of its intent to end its relationship with Binance for BUSD.” The DFS consumer alert noted that “Paxos is required to redeem their Paxos-issued BUSD tokens for U.S. dollars through Paxos at a 1:1 exchange rate pursuant to compliance protocols for customers in good standing” and stated that DFS “is monitoring Paxos closely to verify that the company can facilitate redemptions in an orderly fashion subject to enhanced, risk-based, compliance protocols.”

In other news, this week the federal agency that oversees federal bank deposit insurance published a press release stating that it had issued two letters to crypto industry firms demanding that the firms “cease and desist from making false and misleading statements about … deposit insurance and take immediate corrective action.” Additionally, the agency directed two crypto industry websites “to remove similar false and misleading statements.” The agency published the four letters as part of the press release.

In the U.K., this week the Financial Conduct Authority (FCA) published a press release announcing that it had taken enforcement action against unregistered crypto ATMs that the FCA alleges were operating in the country illegally. The FCA’s action was conducted with assistance from the West Yorkshire Police’s Digital Intelligence and Investigation Unit.

For more information, please refer to the following links:

Reports Provide Data and Analysis on 2022 Cryptocurrency Illicit Activities

By Robert A. Musiala Jr.

This week blockchain analytics firm Chainalysis published its 2023 Crypto Crime Report. The report provides detailed analyses on cryptocurrency illicit activities in the areas of Sanctions, Ransomware, Money Laundering, Stolen Funds, Oracle Manipulation Attacks, Darknet Markets, Scams, and Pump and Dump Tokens. Among its many findings, the report notes the following: (1) Illicit cryptocurrency transaction volume “rose for the second consecutive year, hitting an all-time high of $20.6 billion”; (2) “43% of 2022’s illicit transaction volume came from activity associated with sanctioned entities”; (3) “[t]ransaction volumes fell across all of the other, more conventional categories of cryptocurrency-related crime, with the exception of stolen funds, which rose 7% year-over-year”; (4) “[o]verall, the share of all cryptocurrency activity associated with illicit activity has risen for the first time since 2019, from 0.12% in 2021 to 0.24% in 2022”; and (5) “[o]verall, illicit activity in cryptocurrency remains a small share of total volume at less than 1%” while “crime as a share of all crypto activity is still trending downwards.”

Another recent report published by CoinGecko provides additional 2022 data on illicit activity involving cryptocurrencies. Among other findings, the report notes the following: (1) “Cryptocurrency hacks and exploits caused $2.8 billion in losses [in 2022], the highest since 2013”; (2) “47% of these funds were stolen using a diverse range of hacking and exploitation methods” including “bypassing verification processes, market manipulation, ‘crowd looting’, [and] taking advantage of smart contract errors or loopholes”; and (3) the largest hacks in 2022 were the Ronin bridge hack ($625 million), the Wormhole hack ($326 million), the Nomad Bridge hack ($190 million) and the Mango Markets hack ($116 million). In a related development, a report this week noted that the Wormhole hacker recently moved $46 million of stolen crypto funds, according to blockchain transactional data.

For more information, please refer to the following links:

New Congressional Subcommittees Foreshadow Pending Digital Asset Legislation

By Kevin Edgar, Teresa Goody Guillén, Michelle Tanney and Veronica Reynolds on February 13, 2023 Posted in Alert

Takeaways

Two new congressional subcommittees have been created by the U.S. House of Representatives to consider issues and potential legislative action concerning cryptocurrency and digital assets.
The creation of these subcommittees signals Congress’ intent to consider how digital assets are regulated, which agencies should have the authority to regulate and enforce the asset class, and the scope of any such authority. The subcommittees will sit under the U.S. House Financial Services Committee (Financial Services Committee) and the U.S. House Agriculture Committee (Agriculture Committee), which maintain jurisdiction over the U.S. equities markets and U.S. commodities markets, respectively.

Overview
Two congressional committees of the U.S. House of Representatives commenced the new year by announcing the creation of new subcommittees for the 118th Congress that are expected to analyze issues concerning cryptocurrency and digital assets. The creation of these subcommittees signals the potential for legislative action in the wake of jurisdictional uncertainty regarding federal agency regulation and enforcement of these assets.

Real full alert.