Two Worlds Collide: Crypto Navigates Murky Regulatory Waters

Increasingly it seems US regulators, politicians, and the crypto industry have been unable to align on a path forward when it comes to regulating crypto in the United States. There have been committee hearings held in Congress, regulatory actions taken by regulators such as the US Securities and Exchange Commission (SEC), and advocacy performed by major cryptocurrency companies. The SEC has made clear that it believes digital assets are subject to existing securities requirements and has continued to enforce regulatory actions in support of this belief. We continue to see increased friction between the SEC and cryptocurrency companies who assert that current guidance is not clear enough to set them up for compliance.

Amidst this environment—enter Ripple Labs. Ripple aims to evolve the ability for financial institutions to quickly clear cross-border money transfers. To do this, Ripple created a cryptocurrency called XRP that can be settled and cleared in real time on the RippleNet network. As XRP grew, the SEC sued Ripple in late 2020 and alleged that Ripple executives raised capital on an initial public offering of XRP that constituted an unlawful unregistered security offering.

Ripple responded unconventionally. Instead of settling and agreeing to pay penalties, Ripple engaged in a legal battle against the SEC. In July, the Southern District of New York (SDNY) partially ruled in favor of the company, an outcome that has been seen as a significant win for Ripple Labs. The judge ruled that Ripple did not break laws when selling XRP on public exchanges¹. In SEC v. Terraform Labs, however, another judge in the SDNY specifically came to a different conclusion and fundamentally disagreed with the decisioning made in the Ripple case². The legal battle between the SEC and Ripple is ongoing and we eagerly await developments.

Although Ripple was found to have broken certain laws, the partial win Ripple secured in court has been seen as a boon for the crypto industry at large. It created precedent for crypto companies under regulatory scrutiny to be able to push back against allegations and potentially win.

This is one example of recent strife between regulators and the crypto industry. However, while navigating this friction, digital asset services have continued to grow, expand, and innovate the financial services industry.

In this edition of the Two Worlds Colliding series, we explore regulatory activity, crypto adoption both domestically and globally, security concerns, and the potential future of digital finance.

Heightened Tensions between the SEC and Crypto Industry

This quarter saw increased friction and tension between the SEC and the crypto industry. Some politicians and crypto companies have criticized the SEC online and in the media. Criticism has done little to stop the SEC in pursuing regulatory action and maintaining their position on crypto regulation.

• SEC Chair Gary Gensler asserted again that securities laws “have been on the books for decades,” referring to how he has viewed crypto to this point. He is facing criticism from certain politicians, such as Patrick McHenry, R-NC, the Chair of the House Financial Services Committee. McHenry has asserted that Gensler is “punishing digital asset firms for allegedly not adhering to the law when they don’t know if it will apply to them. That’s nonsensical.”³
• The SEC has moved to delay deciding on the proposed Global X Bitcoin Trust to November and ARK 21Shares Bitcoin ETF into January 2024. Notably, this delay was announced very shortly after a group of politicians pressed Gensler to approve on the spot Bitcoin exchange-traded fund. The delays will most likely impact several other applications under review for Bitcoin ETFs⁴.
• As of September, the relationship between a major crypto exchange and the SEC became strained over concerns the regulator currently has in the bankruptcy plan for a separate cryptocurrency lending company. The bankrupt company would like to leverage the major crypto-exchange to distribute crypto to international customers. However, the SEC is hesitant to provide this approval, based on previous actions the SEC has taken with the major crypto-exchange⁵.
• The trial of Sam Bankman-Fried—known as the founder of the crypto-exchange FTX—began in early October. Bankman-Fried’s lawyers have continued to attempt to release him prior to the trial on the argument that it is “exceedingly difficult” to adequately prepare with “restrictions on access currently in place.” Eyes will certainly be watching this trial as it unfolds⁶.

Decentralized Finance (DeFi) Organizations Targeted by Hackers

August 2023 saw a staggering decline of nearly 92% in crypto-related thefts from July, falling to $23.4 million compared to $320 million the previous month⁷. However DeFi organizations remain a prominent target for hackers, as DeFi typically leverages open-source coding that has been prone to attracting illicit behavior.

• In July 2023, cross-chain bridge protocol Multichain experienced unauthorized withdrawals of upward of $125 million, resulting in the company closing operations. After the CEO was arrested for disappearing with user funds, the Multichain attack falls under the increasingly prevalent “Rug Pull” scam⁸.
• Payment-processing platform Alphapo fell victim to a crypto-hack inflicted by the North Korean hacking group known as Lazarus. The theft drew a total of $60 million in funds through coins including TRON, BTC, USDT, and USDC, all drained through user hot wallets⁹.
• DeFi protocol Exactly was exploited August 18 in a cyberattack amounting to $7.2 million in losses. On the same day, Harbor, an interchain stablecoin protocol, disclosed that they were also hacked, resulting in losses that have yet to be disclosed at the time of this article’s publication¹⁰.

Regulatory Considerations Help Drive M&A

Regulatory strategy was a common theme found in M&A activity throughout the third quarter of this year. Notable acquisitions and partnership dissolutions both held regulatory consideration as a key motivator during decision-making. For example, some companies used acquisitions to obtain regulatory licenses for expansion into new markets, while other strategic partnerships dissolved due to uncertainty and regulatory pressure.

• Fortress Trust, a chartered trust company that provides financial and regulatory structure for blockchain companies, was acquired by Ripple. The acquisition adds Nevada to Ripple’s list of regulatory licenses, which currently includes a New York BitLicense and other money transmitter licenses in 30 states. According to Monica Long, Ripple’s president, the acquisition will help Ripple achieve its goal of “becoming the one-stop shop for enterprises looking to convert, store, and move value on blockchain.”¹¹
• B2C2, a London-based liquidity provider, acquired the French firm Woorton. The acquisition provides B2C2 access to Woorton’s regulatory licenses, permitting them to serve institutional clients in the EU. With SBI Holdings’ acquisition of B2C2 in 2020, the Woorton transaction makes them the first major financial group to own a crypto-trading firm¹².
• Robinhood and Jump Trading quietly ended their crypto-partnership after Jump reportedly started backing away from the US market amid heightened regulatory scrutiny. B2C2 has reaped most of the benefit by taking a majority of Robinhood’s crypto flow¹³.
• Binance was dealt a setback with the ending of its Mastercard partnership amid legal and regulatory challenges by US regulators. The four crypto-card programs alongside Mastercard based in Argentina, Brazil, Colombia, and Bahrain that allowed users to make payments in traditional currencies funded by cryptocurrency holdings ended in September. Despite declining to comment specifically on Binance, Raj Dhamodharan, Mastercard’s head of crypto and blockchain, indicated that Mastercard remains committed to partnering with crypto firms¹⁴.

Blockchain-Based Ownership and Identity Services Emerge as a Trend in Products & Services

There is an emerging trend in the blockchain community that emphasizes blockchain-based ownership and identity services. Worldcoin's introduction of a new cryptocurrency, WLD, given freely in exchange for users' biometric data, represents a move toward integrating personal data into the blockchain. The goal is to create a proof-of-personhood system where real-world identities can be stored on the blockchain. In parallel, companies like Animoca Brands aim to create blockchain-based digital identities, empowering users to have greater control over their online personas on gaming platforms.

• Worldcoin, a project spearheaded by OpenAI's CEO Sam Altman, debuted on July 24. Worldcoin’s WLD is distributed freely to individuals who undergo biometric data collection at one of Worldcoin's scanning facilities. These biometric data points, including iris scans, are transformed into unique codes, and securely stored on a decentralized blockchain. Worldcoin's rationale behind the iris scans is to prevent double-claiming of WLD tokens and to ensure that each recipient is a distinct and verifiable human entry within the Worldcoin database. However, there is concern that these collection practices could violate the European Union’s General Data Protection Regulations¹⁵.
• Animoca Brands, a Web3 investor, has secured $20 million in funding for its Mocaverse project. Mocaverse aims to establish a decentralized system that empowers users with full ownership and control of their online identities. This vision will be realized through the introduction of Moca ID, a non-transferrable (NFT) collection that allows users to build blockchain-based identities tailored for gaming and entertainment platforms¹⁶.
• Take-Two, the publisher renowned for gaming franchises like "Grand Theft Auto," is entering the world of NFT-based gaming with "Sugartown" on the Ethereum blockchain. Players need to purchase Ethereum to participate in the game and can have the chance to earn in-game currency. This move could have a significant influence on the video game sector by motivating other developers to integrate blockchain-based currencies into their gaming products¹⁷.
• Venmo, a widely used payment app, is set to offer PayPal's USD-backed stablecoin, PYUSD in the coming weeks. This will enable users to purchase and transfer PYUSD seamlessly between Venmo and PayPal. This expansion of cryptocurrency offerings follows Venmo's earlier introduction of cryptocurrency purchases in April 2021, which initially included Bitcoin, Ethereum, Litecoin, and Bitcoin Cash¹⁸.

The US Government’s Influence of US Adoption of Cryptocurrency

The largest influencer of the US crypto industry is the nation’s government itself. The directional impact of this influence varies by entity, with the National Futures Association allowing the expansion of leveraged crypto-futures while the SEC’s inconsistent regulatory enforcement sometimes encourages companies to seek friendlier jurisdictional waters. Despite the lack of a national unified approach to managing cryptocurrency, its adoption continues to expand.

• A Coinbase research report took a bullish position on Bitcoin’s long-term prospects. According to David Duong, Coinbase’s head of institutional research, the combined effect of expansionary and fiscal policies should support Bitcoin long-term as a hedge against fiat debasement and profligate spending. The report highlights the fact that increased US government spending is keeping economic growth stable while increasing the cost of servicing the country’s debt¹⁹.
• In an interview with Bloomberg, Ripple CEO Brad Garlinghouse said 80% of Ripple hiring will be outside the US due to lack of regulatory clarity. This sentiment is no surprise, with Ripple and the SEC in an ongoing, multiyear dispute about whether XRP token transactions should be considered an investment contract²⁰.
• Coinbase became the “first crypto-native leader” to directly offer traditional spot crypto trading alongside regulated and leveraged crypto futures after receiving regulatory approval from the National Futures Association. This regulatory milestone was reached despite an ongoing lawsuit with the SEC, which accused Coinbase of operating as an unregistered exchange, broker, and clearing house²¹.
• With increased applications for Bitcoin-based ETFs, we are keen to observe how this will impact Bitcoin pricing and US adoption:

• The assets under management for Fidelity, BlackRock, and Invesco, individually, are significantly greater than the entire Bitcoin market capitalization, demonstrating the possibility of severe fluctuations in the underlying Bitcoin price. The reallocation of billions of dollars in funds from traditional asset classes into crypto ETFs is forecasted to draw between 30,000-100,000 BTC within the first few months of trading, propelling the price upward²².
• Regulatory approval of a Bitcoin ETF will attract and encourage investors, both domestically and internationally, to provide new capital that has yet to be invested, as well as capital that is being reapportioned from other asset classes such as equities or bonds. Investors who were previously squeamish about holding cryptocurrencies, due to their volatility, will now have the option to use a spot ETF as an alternative investment, one that more greatly protects and hedges within the market²³.

Cryptocurrency Activity Heard Around the World

The Society for Worldwide Interbank Financial Telecommunication (SWIFT) has started testing new technology to interlink Central Bank Digital Currency (CBDC), allowing the exchange of CBDCs between central banks on different blockchain platforms. Additionally, this quarter has seen significant advances in the availability and breadth of cryptocurrency services in many countries across Southern and Eastern Asia and South America.

• SWIFT, the global financial messaging network, has started beta testing its new technology to advance CBDC interoperability. This solution will enable the exchange of CBDCs among central banks even if they are built on different blockchain platforms. More than 30 financial institutions across the world are participating in the experiment, including the Hong Kong Monetary Authority and the National Bank of Kazakhstan²⁴. This development underscores SWIFT's commitment to exploring the integration of CBDCs into the global financial system, potentially reshaping future cross-border transactions.
• The Brazilian market, the largest economy in South America, is becoming more crypto-friendly, thanks to the integration of Pix a digital payment platform. This development benefits both cryptocurrency buyers and Web3 companies seeking to enter the Brazilian market. Szymon Sypniewicz, CEO of the Ramp Network (Pix's parent company), expressed the significance of this change, stating, "Now, people in Brazil can join the Web3 economy within seconds, compared to the hours it took previously."²⁵
• Ant Group, the fintech affiliate of Chinese internet conglomerates Alibaba and Alipay, launched a new suite of blockchain products called ZAN in September²⁶. Although blockchain transactions are banned in China, ZAN is aimed at serving overseas clients with processes such as anti-money laundering, security protection, and customer identity authentication.
• India is leading the world in "grassroots crypto adoption," according to a report by Chainalysis released on September 12th²⁷. This ranking comes despite India’s high capital gains tax of 30% on cryptocurrency. Instead of looking at raw transaction data, the index evaluates which countries have the most people investing a significant portion of their wealth in cryptocurrencies. Other countries in the Central and Southern Asia and Oceania regions, such as Vietnam, the Philippines, Indonesia, Pakistan, and Thailand, also rank high in crypto adoption. Despite recent market fluctuations, the report indicates resilience in these regions and growing institutional adoption, suggesting that crypto will play an ongoing role within these economies.

Quotes from Industry Leaders and Notable Figures

• “I anticipate that, with previous technologies like the internet, the web, and cryptography, clear heads will prevail,” Joseph Lubin, co-founder of Ethereum, regarding the SEC’s dispute with crypto firms on whether crypto tokens are considered securities²⁸.
• “Bitcoin is the most important asset in crypto and we're excited to do our part to enable faster/cheaper Bitcoin transactions,” Brian Armstrong, CEO of Coinbase, tweeted on implementing the Lightning Network into Coinbase and BTC transactions.²⁹
• “As the digital asset space is expected to encompass trillions of dollars of assets, it's bound to be seen as one of the priorities for investors and corporations alike. Our focus is not just on cryptocurrencies but supporting our clients in the overall digital assets ecosystem,” Paul Maley, Deutsche Bank's global head of securities services, on offering crypto custody services.³⁰