CBDC Pilot Announced; Ethereum Upgrade Completed; U.S. Treasury Department Addresses DeFi Risks; Studies Analyze Crypto Taxation, Crime; Hacks Continue

By Robert A. Musiala, Joanna F. Wasick, Keith R. Murphy, Christopher Lamb and Lauren Bass on April 17, 2023 Posted in Blockchain

In this issue:

• Montenegro Announces CBDC Pilot, BIS Compares CBDCs to Stablecoins
• Ethereum Network Completes ‘Shanghai’ Upgrade
• U.S. Treasury Publishes DeFi Risk Assessment; Banque De France Analyzes DeFi
• Study Analyzes 2022 Crypto Tax Compliance Across Various Countries
• EU Report Analyzes Cryptocurrency Use on Darknet Markets
• Hackers Drain Millions from Crypto Exchanges and DeFi Protocol

Montenegro Announces CBDC Pilot, BIS Compares CBDCs to Stablecoins

By Robert A. Musiala Jr.

According to a recent press release, “The Central Bank of Montenegro (CBCG) has agreed to collaborate with the enterprise crypto and blockchain solutions provider Ripple to develop a strategy and pilot programme to launch the country’s first digital currency in the form of a Central Bank Digital Currency (CBDC) or national stablecoin.” The press release notes that the project will analyze the benefits and risks of CBDCs, including “payment availability, security, efficiency, compliance with regulations, and most importantly, the protection of end users’ rights and privacy.”

In related news, the Bank for International Settlements (BIS) recently published a BIS Bulletin titled Stablecoins versus tokenised deposits: implications for the singleness of money. The bulletin compares asset-backed stablecoins to CBDCs with a focus on “singleness,” a key characteristic of money that “ensures that monetary exchange is not subject to fluctuating exchange rates between different forms of money” and enables “an unambiguous unit of account” that “allows money to serve its role as a coordinating device for economic activity.” The bulletin describes singleness as “[a] cornerstone of the modern monetary system.” According to the bulletin, stablecoins “may entail departures in their relative exchange values” in violation of singleness, and CBDCs or “tokenized deposits” are more conducive to singleness when compared to stablecoins. The bulletin also highlights other potential advantages of CBDCs, including “expanded functionality by building on the capacity of programmable ledgers to introduce contingent execution and composability of transactions.”

For more information, please refer to the following links:

Ethereum Network Completes ‘Shanghai’ Upgrade

By Joanna F. Wasick

Ethereum recently announced the completion of its “Shanghai” upgrade (also known as Shapella). This hard fork upgrade marks the completion of Ethereum’s multiyear transition from a proof of work consensus mechanism to proof of stake. Most notably, the upgrade enables network participants who had staked their ether (ETH) on the network to unstake and make withdrawals for the first time. Other technical improvements in the Shanghai upgrade are intended to improve the transactional aspects of the Ethereum network. Despite some concerns that the upgrade would cause ETH prices to drop, the price of ETH remained largely flat during the transition.

For more information, please refer to the following links:

Ethereum’s Shanghai Upgrade Is Complete, Starting New Era of Staking Withdrawals

U.S. Treasury Publishes DeFi Risk Assessment; Banque De France Analyzes DeFi

By Robert A. Musiala Jr.

The U.S. Department of the Treasury recently published its report Illicit Finance Risk Assessment of Decentralized Finance. According to a press release, the report is “the first illicit finance risk assessment conducted on decentralized finance (DeFi) in the world.” The press release notes that threat actors “like the Democratic People’s Republic of Korea (DPRK), cybercriminals, ransomware attackers, thieves, and scammers are using DeFi services to transfer and launder their illicit proceeds” and are exploiting the fact that “many DeFi services that have anti-money laundering and countering the financing of terrorism (AML/CFT) obligations fail to implement them.” According to the press release, “DeFi services engaged in covered activity under the Bank Secrecy Act have AML/CFT obligations regardless of whether the services claim that they currently are or plan to be decentralized.” The risk assessment includes “recommendations for U.S. government actions to mitigate the illicit finance risks associated with DeFi services” including strengthening U.S. AML/CFT supervision, considering additional guidance for the private sector on DeFi AML/CFT obligations, and addressing AML/CFT regulatory gaps related to DeFi services.

In a related development, the French Central Bank recently published a discussion paper addressing DeFi risks. Among other risks, the paper cites the high volatility and complexity of DeFi products and risk of user capital loss. The paper further notes that future DeFi regulation “cannot simply replicate the systems that currently govern traditional finance” and must consider “a combination between traditional financial regulations and regulations inspired by other economic sectors.” The paper explores several proposals for mitigating DeFi risks, including strengthening the security of blockchain networks and smart contracts, further defining the legal status of decentralized autonomous organizations (DAOs), and establishing frameworks for the supervision of intermediaries that facilitate access to DeFi services.

For more information, please refer to the following links:

Study Analyzes 2022 Crypto Tax Compliance Across Various Countries

By Keith R. Murphy

A recently published study conducted by a Swedish crypto tax firm estimates that globally only 0.53% of crypto investors paid taxes related to their cryptocurrency holdings in 2022. The study reportedly used a multistep methodology that analyzed “the relationship between the number of people who declared their cryptocurrency in their tax returns and the search volume for cryptocurrency tax-related keywords.” The study’s methodology used the search volume data “as a proxy to estimate the number of cryptocurrency taxpayers in each country where official figures … were not available” and considered the number of crypto holders in each country as reported by Statista’s Global Cryptocurrency Report.

Findings in the study include that Finland had the highest percentage of investors who paid taxes on their cryptocurrency holdings in 2022, at 4.09%, while the United States ranked 10th, at 1.62%. The study noted several potential reasons for differing tax payment rates among countries of the world, including variation in public awareness of tax reporting requirements, differences in government policies and enforcement that could affect tax reporting and collection, and that owning cryptocurrency does not always mean that taxes may be due. A report commenting on the study notes that tax experts have cast doubt on the study’s findings and methodologies, and further observes that the study itself acknowledges numerous limitations and assumptions upon which it is based that could undermine its conclusions.

For more information, please refer to the following links:

EU Report Analyzes Cryptocurrency Use on Darknet Markets

By Christopher Lamb

A recent report from the European Monitoring Centre for Drugs and Drug Addiction provides findings from an analysis of cryptocurrency use on darknet markets in the European Union and neighboring countries. According to the report, the darknet market (DNM) ecosystem, which “combine[s] the online anonymity-granting functions of Tor with traditional trust-building e-commerce trappings (e.g., vendor rating systems),” has grown significantly since 2011. The report utilizes Chainalysis data from 54 countries in the European Union, spanning April 1, 2019, to October 31, 2021, in reaching its conclusions. The report’s key findings include the following:

DNM expansion grows periodically but is interrupted with market volatility.
Most DNM activity clusters in one or two markets at any point in time.
Moves toward larger DNM volume or higher-priced purchases are occurring over time.
Different regions have sizable differences in total revenue engagement with the DNM.
All regions have a similar pattern showing revenue sent to the DNM is typically less than that received back.
There are notable gaps between the most- and least-engaged countries in the DNM.

The report notes that exchanges are “a common way of initially obtaining cryptocurrency to fund on-chain wallets” despite exchanges being governed by “know your customer (KYC) and anti-money laundering (AML) rules.” The report also notes that “[n]ot all countries in the sample have KYC and AML rules in place for exchanges working within their jurisdictional boundaries” and that “[s]ome national rules are inconsistent in design or application.” Of the 54 European countries included in the sample, eight have banned cryptocurrencies but continue to engage in DNM activity.

For more information, please refer to the following links:

EU Report: Cryptocurrencies and drugs: Analysis of cryptocurrency use on darknet markets in the EU and neighbouring countries

Hackers Drain Millions from Crypto Exchanges and DeFi Protocol

By Lauren Bass

According to reports, hackers recently stole nearly $13 million in cryptocurrency from a South Korean centralized exchange. The thieves reportedly siphoned 61 BTC, 350 ETH, 10M WEMIX tokens, and 220k USDT – almost 23% of the exchange’s total custodial assets.

In another recent hack, a DeFi protocol reportedly suffered a similar fate when hackers withdrew almost $11 million. According to reports, hackers exploited a bug in one of the protocol’s tokens to mint 1.2 quadrillion in fake coins, and then traded the counterfeit coins for millions in stablecoins.

In a third recent hack, a Singapore-based cryptocurrency exchange reportedly lost $23 million in ETH, QNT, GALA, SHIB, HOT, and MATIC in an attack that targeted a hot wallet used by the exchange. According to reports, the compromised wallet contained less than 5 percent of the exchange’s reserves.

For more information, please refer to the following links:

U.S. Exchange Closes, Swiss Bank Expands Crypto Offerings; NFA Issues Digital Asset Commodities Rule; Crypto Enforcement Continues; Market Data Published

By Robert A. Musiala, Joanna F. Wasick, Keith R. Murphy and Christopher Lamb on April 10, 2023 Posted in Blockchain

In this issue:
• Crypto Exchange Ends U.S. Operations, Swiss Bank to Expand Crypto Offerings
• National Futures Association Rule Addresses Digital Asset Commodity Activities
• DOJ, Courts and State Securities Regulators Cripple Cryptocurrency Frauds
• Cryptocurrency Crime and Anti-Money Laundering Report Published

Crypto Exchange Ends U.S. Operations, Swiss Bank to Expand Crypto Offerings

By Joanna F. Wasick

Late last month, Bittrex, a leading cryptocurrency exchange founded in Seattle, announced it was closing U.S. operations effective April 30, 2023, due to “regulatory uncertainty” in the country. Bittrex stated that all funds “are safe and can be fully withdrawn immediately” and that its decision does not affect customers of Bittrex Global. Bittrex co-founder and CEO Richie Lai stated that “operating in the U.S. is no longer feasible,” noting that U.S. regulatory requirements “are often unclear and enforced without appropriate discussion or input.”

In contrast to the Bittrex news, on April 5, Sygnum, a Swiss- and Singapore-licensed digital asset bank, announced its partnership with a leading Swiss retail bank in order to expand crypto offerings. The partnership is set to provide customers a range of regulated digital asset banking services through Sygnum’s “fully regulated” B2B banking platform, which will enable “flexible and efficient access to a range of cryptocurrencies” and allow customers to buy, store and sell “leading cryptocurrencies,” including bitcoin and ether. The partnership will also introduce new revenue-generating services, such as staking.

In other news, a major U.S. fashion label recently announced the opening of a new luxury-focused concept store in Miami’s Design District that will serve as the focal point for a targeted push into the city’s active Web3 community. Notably, the store will accept cryptocurrency payments (a first for the label) through a partnership with a major U.S. crypto payment processor. To kick-start its “season of interactive customer experiences,” the label also announced a multitiered partnership with Miami-based Web3 leisure community Poolsuite, the members of which will receive NFTs that will unlock access to an exclusive in-person event.

For more information, please refer to the following links:

National Futures Association Rule Addresses Digital Asset Commodity Activities

By Robert A. Musiala Jr.

The National Futures Association (NFA) recently published a press release announcing the adoption of NFA Compliance Rule 2-51, which “imposes anti-fraud, just and equitable principles of trade, and supervision requirements on NFA Members and Associates that engage in digital asset commodity activities.” Among other things, the rule references prior NFA virtual currency guidance, and notes that for “purposes of this Rule, the term digital asset commodity or commodities means Bitcoin and Ether.” The rule also provides that NFA members engaged in spot digital asset commodity activities must adopt and implement appropriate supervisory policies and procedures. According to the press release, the NFA adopted the rule in part “to provide NFA with the ability to discipline a Member or take other action to protect the public if a Member commits fraud or similar misconduct with respect to its spot digital asset commodity activities.”

In foreign regulatory news, the Japan Financial Services Agency recently published a warning letter citing four cryptocurrency exchanges as operating in the country illegally without proper registration. And in Australia, the Australian Securities and Investments Commission (ASIC) recently published a notice indicating that ASIC has canceled the Australian financial services license of cryptocurrency exchange Binance in response to a request from the company. Among other things, the ASIC notice states that “ASIC has been conducting a targeted review of Binance financial services business in Australia” and cites the multiple actions against Binance taken by foreign regulators, including the recent enforcement action by the U.S. Commodity Futures Trading Commission.

For more information, please refer to the following links:

DOJ, Courts and State Securities Regulators Cripple Cryptocurrency Frauds

By Keith R. Murphy

The U.S. Department of Justice (DOJ) recently seized cryptocurrency worth approximately $112 million in connection with a “pig-butchering” cryptocurrency investment scam, according to a recent press release. Judges located in Los Angeles, the District of Arizona and the District of Idaho collectively approved the seizure of six virtual currency accounts that were allegedly used to launder the proceeds of various cryptocurrency confidence scams. The fraudsters “fatten-up” victims by making them believe they are in a romantic or other close personal relationship, cultivating long-term online relationships with victims and encouraging them to invest in fraudulent cryptocurrency trading platforms, according to the press release. The release further notes that cryptocurrency scams in 2022, including pig-butchering, increased by 183 percent compared with 2021 figures, with most reported victims falling within the age range of 30-49 years old.

According to multiple reports and press releases, securities regulators in Texas, Montana and Alabama have jointly filed enforcement actions against YieldTrust.ai, alleging the company illegally solicited investments tied to a decentralized application (DApp) that “purportedly uses quantum artificial intelligence to trade digital assets” and is operating a Ponzi scheme. The regulators’ actions accuse the company and its owner of illegally soliciting investments in connection with the company’s DApp that purported to achieve extraordinary returns through the use of AI to trade digital assets. Following the collapse of the scheme, the regulators allege that the respondents are now operating a Ponzi scheme by raising capital from new investors to pay withdrawals from previous investors, as noted in the press releases.

For more information, please refer to the following links:

Cryptocurrency Crime and Anti-Money Laundering Report Published

By Christopher Lamb

Blockchain analytics and investigations firm Ciphertrace recently published its March 2023 cryptocurrency crime and anti-money laundering report, which addresses the state of cryptocurrency at the end of the third quarter of 2022. Among its many findings, the report provides the following key findings as of Q3 2022:

The total market cap of all crypto assets had reached approximately $1.1 trillion, with roughly $54 billion in total value locked (TVL).

The largest blockchain by volume was Ethereum, with 57 percent of virtual assets being held on Ethereum’s blockchain.

Key enforcement activities included the Office of Foreign Assets Control (OFAC) sanctioning Tornado Cash, a virtual currency mixer, for being used to launder “more than $7 billion worth of virtual currency since its creation in 2019” and the IRS seizing “approximately $4 billion in virtual assets vs $3.5 at fiscal year-end 2021.”

The report also mentions that the “third quarter was plagued with bankruptcy filings throughout the industry” in addition to seven major hacks or exploits that totaled $383 million.

In addition, the report indicates that while “NFTs exploded in both market volume and dollar value in 2021, values rapidly eroded in 2022.” The biggest platforms for NFT trading had their total volume reduced from $9.2 billion in the second quarter of 2022 to $2.3 billion in the third quarter – marking a 76 percent reduction.

For more information, please refer to the following links:

Crypto Crimes & Anti-Money Laundering (AML) Report March 2023

Zero Knowledge EVMs Launch; U.S. Central Bank Publishes Custodia Denial Order; CFTC Charges Binance Exchange; SEC, DOJ Bring Enforcement Actions

By Robert A. Musiala, Lauren Bass, Christopher Lamb and Christina Gotsis on April 3, 2023 Posted in Blockchain

In this issue:
• “Z” Doors Are Open: Rival Zero Knowledge EVMs Launched by Matter, Polygon
• U.S. Central Bank Publishes Order Denying Custodia Bank Application
• CFTC Charges Binance Alleging Numerous Commodity Exchange Act Violations
• SEC Charges Crypto Exchange; DOJ Charges Crypto ATM; Do Kwon Arrested

“Z” Doors Are Open: Rival Zero Knowledge EVMs Launch

By Lauren Bass

Earlier this week, a technology innovation lab reportedly released a public Alpha version of its “zero-knowledge Ethereum Virtual Machine” (zkEVM), which has been described as a layer 2 protocol that scales Ethereum’s security and values through zero-knowledge cryptography. According to reports, a zkEVM is software that executes smart contracts to make it easier for developers to reconfigure and design applications on the Ethereum network that offer lower costs and enhanced speed, security, and privacy. Because the protocol is still in Alpha test mode, the innovation lab has reportedly employed heightened security and risk procedures to monitor anomalies and vulnerabilities.

Mere days after that debut, a cryptocurrency and technology platform reportedly launched its own zkEVM beta, which the platform touted as “the first zero-knowledge scaling solution that is fully equivalent to an EVM.” According to reports, the technology platform will make all aspects of its zkEVM open source to allow developers to study, share, and contribute to innovations in the zero-knowledge space.

For more information, please refer to the following links:

U.S. Central Bank Publishes Order Denying Custodia Bank Application

By Robert A. Musiala Jr.

Last week, the U.S. central bank publicly released an order, dated January 27, 2023, providing the reasons for its decision to deny the application of Custodia Bank (“Custodia”) to hold a master account and become a member of the U.S. central bank. As described by the order, Custodia is a Wyoming state-chartered special purpose depository institution (SPDI) that “intends to focus its business model almost entirely on the crypto-asset sector.”

The 86-page denial order provides an analysis and evaluation of Custodia’s general character of management (“Managerial Factor”), financial condition (“Financial Factor”), whether the corporate powers to be exercised are consistent with the purposes of applicable law (“Corporate Powers Factor”), and Custodia’s ability to meet the convenience and needs of the community (“Convenience and Needs Factor”). The order concludes that Custodia’s application “would be inconsistent with the financial, managerial, and corporate powers factors.”

With respect to the Managerial Factor, the order cites concerns related to Custodia’s status as an uninsured depository institution and its plans to focus “almost exclusively on offering products and services related to the crypto-asset sector, which presents heightened illicit finance and safety and soundness risks.” The order also cites risk management concerns related to Bank Secrecy Act and sanctions compliance, information technology, internal audit, financial projections, and liquidity management.

Addressing the Financial Factor, the order cites concerns over Custodia’s lack of a diversified business, stating “Custodia’s revenue and funding model relies almost solely upon the existence of an active and vibrant market for crypto-assets. However, crypto-asset markets have exhibited significant volatility.”

With respect to the Corporate Powers Factor, the order finds that approval of Custodia’s application would be inconsistent with applicable law governing the U.S. central banking system given the “speculative and volatile” crypto-asset ecosystem and Custodia’s “novel and unprecedented” crypto-focused business model. The order also cites a concern that “[t]he absence of deposit insurance coverage … could increase the firm’s risk of runs and contagion … This is especially concerning because the global crypto-asset industry … is highly susceptible to runs, as recent events have demonstrated.”

Finally, addressing the Convenience and Needs Factor, the order notes safety and soundness concerns “indicate[] Custodia will not be able to meet the convenience and needs of its community” and “could in fact pose significant risk to its community.” Notably, Custodia’s application was denied without prejudice, which allows Custodia to reapply in the future.

For more information, please refer to the following links:

CFTC Charges Binance Alleging Numerous Commodity Exchange Act Violations

By Christopher Lamb

According to a press release published this week by the Commodity Futures Trading Commission (CFTC), the CFTC has filed a civil enforcement action in the U.S. District Court for the Northern District of Illinois against Changpeng Zhao and three entities that operate the Binance cryptocurrency exchange platform, finding “numerous violations of the Commodity Exchange Act (CEA) and CFTC regulations.” According to the press release, the CFTC alleges that “Binance Holdings Limited, Binance Holdings (IE) Limited, and Binance (Services) Holdings Limited (together, Binance) operate the Binance centralized digital asset trading platform … through an intentionally opaque common enterprise, with Zhao at the helm as Binance’s owner and chief executive officer.”

The press release states that Binance “offered and executed commodity derivatives transactions to and for U.S. persons from July 2019 through the present” and that “Binance has instructed its employees and customers to circumvent compliance controls in order to maximize corporate profits.” According to the release, Binance did not require identity verification of customers to trade on the platform and “failed to implement basic compliance procedures designed to prevent and detect terrorist financing and money laundering.” The complaint alleges a number of infractions, including but not limited to failure to diligently supervise Binance’s activities as a Futures Commission Merchant, failure to restrict U.S. customers from trading on its platform, and willful evasion of the requirements of the CEA. The complaint also alleges that Zhao is liable for “violations based on his control over Binance and his long-running failure to act in good faith” and for being “responsible for all major strategic decisions at Binance, including devising the secret plot to instruct U.S.-based VIP customers to evade Binance’s compliance controls.”

In addition to Zhao, the CFTC charged Binance’s CCO, Lim, for “willfully aiding and abetting Binance’s violations through intentional conduct that undermined Binance’s compliance program.” The CFTC’s Enforcement Division principal deputy director and chief counsel is quoted as saying, “The defendants’ own emails and chats reflect that Binance’s compliance efforts have been a sham and Binance deliberately chose – over and over – to place profits over following the law.” According to reports, following the issuance of the CFTC complaint, Binance has seen over $400 million on Ethereum withdrawn from its platform. Additionally, according to reports, the bitcoin balance held at the exchange has been reduced by over 3,900 bitcoin, with 3,400 bitcoin withdrawn within 24 hours of the complaint being filed.

For more information, please refer to the following links:

SEC Charges Crypto Exchange; DOJ Charges Crypto ATM; Do Kwon Arrested

By Christina O. Gotsis

According to a press release published this week by the U.S. Securities and Exchange Commission (SEC), the SEC has charged Beaxy, a “crypto asset trading platform,” and its executives for failing to register as a national securities exchange, broker and clearing agency. The SEC also charged Beaxy’s founder with raising $8 million in an unregistered offering of the Beaxy token (BXY) and alleged that he misappropriated at least $900,000 for personal use. Finally, the SEC charged market makers using the platform as unregistered dealers. Certain Beaxy executives and market makers have agreed to shut down the platform, return assets to customers, and pay $165,800 in civil penalties. The SEC is litigating its charges against Beaxy and its founder.

Also this week, a press release from the U.S. Department of Justice (DOJ) announced the arrest of the founder of Coindawg, a cryptocurrency ATM business, in connection with a scheme to steal and launder over $1 million in Small Business Administration loans. The DOJ alleged that the individual fraudulently obtained the loans, which were intended to provide COVID-related relief, and converted approximately $700,000 into bitcoin for his co-conspirators. The individual then allegedly stole approximately $300,000, which he used, in part, to purchase cryptocurrency ATMs and promotional services to start Coindawg. Law enforcement seized 18 Coindawg cryptocurrency ATMs that had exchanged over $3 million worth of cryptocurrency and charged 15% in transaction fees.

According to reports, international enforcement agencies also took action this week, with Interpol arresting South Korean national Do Kwon, founder of a collapsed crypto company that in a matter of days wiped out about $40 billion in value from the crypto market. Kwon is wanted in several countries, including the U.S., South Korea, and Singapore. Kwon was arrested in Montenegro with counterfeit documentation.

For more information, please refer to the following links:

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.

Read full alert.

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.