SEC Guidance to Hold Client Cryptoassets on Balance Sheet Meets Resistance and Dampens Bank Plans; Staking Raises Prospect of Ether Being Classified as a Security

Thomas Murray Digital Newsletter

Securities and Exchange Commission Headquarters (SEC)

Reverberations from the SEC’s back-door attempt to move cryptoassets onto banks’ balance sheets – as we reported in May – continue as banks push back while their plans to offer digital asset services in the US falter. And the Ethereum Merge – a major and long-planned upgrade to the most widely used blockchain – passed uneventfully a week ago, shifting its operating model from Proof of Work to Proof of Stake and drastically reducing its energy consumption by an estimated 99.9%. While the change is welcome for environmental reasons, we examine whether the blockchain’s native ether token could be walking into a regulatory trap in which it could be reclassified from a commodity to a security.

Major Digital Asset Developments

      

      
SEC Accounting Guidance Issue Rumbles On
According to an article by Reuters, the US Securities and Exchange Commission’s (SEC) Staff Accounting Bulletin 121 (SEC), published in March earlier this year, is having a material dampening effect on banks looking to engage with digital assets. While ostensibly more of an expectation for organisations wishing to remain on good terms with the regulator than a rule, the accounting guidance requires public companies including banks to hold clients’ crypto assets as liabilities on their balance sheets, rather than off them as is customary for custodians of traditional client assets. This is problematic for banks which are subject to strict regulatory capital ratio rules.
Many of the largest banks in the US have announced intentions to support digital assets in one way or another, with some services already live, albeit primarily with select or private wealth clients. Nonetheless, the article makes clear that banks’ efforts in this space are undermined by the financial burden the capital requirements place on them, and some have had to ‘cease moving forward with [their] plans’. Both State Street and Bank of New York Mellon are reported to have been disrupted.
Nadine Shakar, head of State Street Digital, previously suggested at a recent Fund Forum panel discussion that this was no great imposition, and hinting that it could be an opportunity for large institutions like State Street to gain market share, saying ‘unless you have larger custodians moving into the space and be the big kids at the table, it’s [digital assets] unlikely to see institutional adoption’. It is now reported that she sees the SEC’s expectations as an issue for the bank, one that does not necessarily prevent them from custodying digital assets but that reduces its economic viability: ‘We do have an issue with the premise of doing that, because these are not our assets. This should not be on our balance sheet.’ (Reuters) U.S. Bancorp has paused onboarding new crypto custody clients, and anecdotally several European banks are pulling back from US advances until the issue is addressed.
Until there is clearer guidance, or changes to the capital impact faced by supporting crypto assets for banks – which seems unlikely in the short term – there may be a decline in ecosystem development, which is perhaps already being reflected in the value of the cryptocurrency market.
The Ethereum Merge and Securities Implications
The Ethereum blockchain successfully merged with the Beacon Chain on 15 September (CoinDesk), transforming it from a proof-of-work (PoW) to a proof-of-stake (PoS) protocol. The transition, which was many years in the making, has been welcomed as Ethereum is expected to consume 99.9% or so less energy as a result of the change (see previous newsletter). This, according to Bank of America (FXStreet), is an opportunity for greater institutional adoption of the blockchain’s native ether token, as those that were prohibited from investing in PoW systems due to ESG considerations may now acquire the cryptocurrency.
Ethereum and the thousands of tokens it supports have now removed themselves from potential moves by jurisdictions such as the EU and the US to ban or de-incentivise PoW: the EU has flip-flopped on including a ban in its pending Markets in Crypto-assets (MiCA) regulation, adding (The Block) then ultimately removing (CoinDesk) such clauses; the State of New York has implemented a moratorium on PoW mining using carbon-based energy sources (CoinDesk); and earlier this month one of the first responses to President Biden’s Executive Order on cryptoassets – from the White House Office of Science and Technology – asked the Environmental Protection Agency and the Department of Energy to consider a ban if the US cannot meet its climate goals through other means (Blockchain News).
However, by transitioning to PoS, with its reliance on the process of staking to secure and validate the network and its transactions, ether may have walked directly into the SEC’s securities oversight purview. In return for delegating ether to network validators (if they do not have enough tokens to qualify them to run staking nodes themselves), token-holders are rewarded in more ether tokens, which according to Chairperson Gensler of the SEC (Decrypt) and other regulatory agencies could constitute an investment contract under the US Howey test: ‘a contract, transaction, or scheme whereby a person invests his money in a common enterprise and is led to expect profits solely from the efforts of the promoter or a third party’ (US Supreme Court).
While the SEC has not presented any formal analysis of the issue, it is assumed it does not consider ether to be a security, although the fundamentals are much harder to assess now and there is considerable scope for questions of consistency of approach to arise. Earlier this month, Gensler announced qualified support for Congress to hand more power to the Commodity Futures Trading Commission (CFTC) to regulate non-securities digital assets such as cryptocurrencies (Crypto Slate) so long as the move would not reduce the SEC’s power to regulate securities. He and the SEC have been the subject of notable dissatisfaction from the digital asset community and even the Commissioner of the CFTC due to the SEC’s failure to proactively shape a robust digital asset framework, receiving criticism for frequent cases of ‘regulation by enforcement’. Handing greater responsibility to the CFTC for such assets is seen by the community as a welcome development.
Bolstering the argument that ether and similar tokens should remain classed as commodities, Coin Center, a non-profit research and blockchain advocate, points out that the SEC looks at the economic realities underlying a project, rather than the terms and technologies used to create it, and given that the participation in the consensus mechanism is explicitly designed to be open to anyone, and not reliant solely on the efforts of others (Coin Center), staking, or mining for that matter, should not meet the criteria.

Other News and Links

White House Releases Inaugural Framework for Crypto Regulation (Crypto Slate)
Following President Biden’s Executive Order in March this year (described previously in our newsletter here), The White House has released a framework which offers a number of recommendations including how to approach the regulation of crypto assets, ways in which to mitigate fraud perpetrated using digital assets, and how to improve standards across the financial industry more broadly. The framework pays particular attention to fraud and fighting illicit finance, and suggests the President may call upon Congress to amend the Bank Secrecy Act so that digital asset exchanges and non-fungible token (NFT) platforms would explicitly fall subject to it.
US Banks Must Maintain Cautious Approach to Crypto, Says Acting OCC Head (Crypto Slate)
Michael Hsu, Acting Head of the Office of the Comptroller of the Currency (OCC), believes that US banks should remain caution when considering digital assets. The OCC was the first to green-light the provision of crypto custody services by national banks and federal savings associations when it issued its Interpretive Letter #1170 in July 2020, which in all likelihood contributed to the crypto bull market. That said, in his speech at the TCH + BPI Annual Conference Hsu made clear that he is much more cautious than the previous head of the OCC, and sees ‘red flags in crypto’s rapid growth’. As such, the agency has reportedly tightened its criteria for acceptance, indicating that these institutions can only engage in certain crypto activities so long as they can demonstrate the activities can be performed in a ‘safe, sound and fair manner.’
Crypto Oversight Should Resemble Traditional Bank Rules, Fed Official Says (CoinDesk)
In his first speech since taking office, Fed Vice Chair for Supervision, Michael Barr, articulated the need for greater regulatory oversight, particularly in how banks engage in crypto activities. He reiterated the need to regulate based on the “same activity, same risk” approach cited by multiple regulators and commentators over the preceding months.
UK Introduces Law to Seize, Freeze and Recover Crypto (CoinDesk)
The Economic Crime and Corporate Transparency bill supplements the Economic Crime (Transparency and Enforcement) Act used to impose sanctions against Russia and freeze UK-held assets – both traditional and digital – and is ostensibly designed to prevent sanctioned Russians from using crypto to evade those measures, as well as aid in combatting criminal activities.
Crypto Exchanges in UK Required to Report Sanction Breaches (Finextra)
The UK has updated its guidance towards sanctions reporting, which now brings crypto exchanges into scope for reporting violations and freezing assets. The guidelines were implemented by the Treasury’s Office of Financial Sanctions Implementation (OFSI) to combat potential breaches conducted with the use of cryptocurrencies.
New French Bill Could Give Authorities Powers to Seize Crypto Assets (CoinDesk)
In line with other countries around the world, such as the UK’s Economic Crime Bill, the French state is attempting to make it easier to freeze and seize the digital assets of suspected criminals. The proposal is due to be discussed next week by France’s Constitutional Law Committee.
Korea to Launch Security Token Guidelines, Pilots This Year (Ledger Insights)
SEC, CFTC Propose Amendments for Large Hedge Fund Crypto Reporting (Crypto Slate)
First announced earlier this month, the Securities and Exchange Commission (SEC) and the Commodities and Futures Trading Commission (CFTC) look set to introduce rules that will require hedge funds to report investments more accurately in digital assets. In particular, the Proposed Rule (Federal Register) will seek to distinguish between assets that have similar characteristics such as digital assets and cash and cash equivalents, and establish a new sub-asset class which will help regulators to more easily monitor systemic risks and economic stability.
Russia to Consider Possible Legalization of Cryptos for Cross-border Payments (AMBCrypto)
Due to the impact of financial sanctions on Russia, its Ministry of Finance is considering using cryptocurrencies as a means to support cross-border payments. This comes after Putin signed an order effectively banning the use of crypto-based assets for domestic payments in July earlier this year. Views are said to be softening in light of the ongoing financial situation, with Prime Minister Mikhail Mishustin suggesting the country needs to look to digital assets as a ‘safe alternative’ to support cross-border commerce. The Central Bank has tried to limit the use of crypto assets in the country as it looks to develop its own digital ruble, and once rolled out, may try to impose another ban on cryptocurrencies.
Australian Senator Releases Draft Bill to Push for Crypto Regulation (Crypto Slate)
Australian Senator Andrew Bragg has released a draft Digital Assets (Market Regulation) Bill 2022 (Andrew Bragg). It seeks to apply pressure to the Australian regulatory system in order to push forward with the regulation and oversight of the digital asset market and its constituent components. At a high level, the bill proposes to provide a framework for digital asset exchanges, digital asset custody, issuance of stablecoins, and the protection of consumers while promoting investment in Australia. Interestingly, another objective of the bill is to provide for the reporting of information from banks that facilitate the use or availability of China’s digital yuan in Australia. Consultation on the bill is being received until October 31, 2022.
Colorado Enables Crypto Payment for Taxes (Crypto Slate)
House Stablecoin Bill Would Put Two-Year Ban on Terra-Like Coins (Bloomberg)
Nigeria Plans to Create a Virtual Free Zone with Binance Crypto Exchange (CoinDesk)
Nigeria’s Export Processing Zones Authority (NEPZA) is looking to create a digital city to support the growing digital asset economy. It is reportedly looking to partner with Binance, the largest cryptocurrency exchange by volume, which signed an agreement to assist Dubai with the establishment of a similar industry hub for digital assets in December 2021.
Binance Secures Licence in Dubai to Offer More Crypto Services (CoinDesk)
Coinbase Is Helping Sue the US Treasury Over Tornado Cash Sanctions (Bloomberg UK)
Coinbase is challenging the authority of the US Treasury Department after it publicly declared its intention to pay the legal costs of a lawsuit brought by six individuals who are contesting the legality of the Treasury’s sanction of Tornado Cash. The plaintiffs argue that the move by the US Treasury’s Office of Foreign Assets Control (OFAC) to sanction wallets associated with the application, as well as the smart contract code itself, was unprecedented, as neutral technologies and tools are reportedly out of the scope of sanctions law. Brian Armstrong, CEO of Coinbase, stated that the Treasury issued a blanket-wide sanction rather than targeting the wallets of those known to have committed an offence, further suggesting that it was used by many law-abiding citizens looking for increased privacy, who now have funds trapped on the platform. Crypto Investment firm Paradigm strongly agrees with the action brought by the lawsuit, as it too stated in a legal argument (Paradigm) that blockchain infrastructures and the providers that support them should not be subject to US Treasury sanctions, as monitoring or censoring Specially Designated Nationals and Blocked Persons (SDN List) would jeopardise the neutrality of base blockchain layers and compromise their integrity and core functionality.
Coinbase Gains Regulatory Approval in the Netherlands (Coinbase)
Deutsche Börse to Issue Digital Securities on DLT-ready D7 Platform (Ledger Insights)
Societe Generale Securities Services Extends Its Offer to Funds Investing in Digital Assets (Societe Generale)
SGSS now offers asset managers to act as a fund custodian, valuator and liability manager, and has onboarded its first client, Arquant Capital.
Hong Kong’s HashKey Receives Approval to Manage 100% Crypto Portfolio (CoinDesk)
HashKey, a Hong Kong based asset manager, has received a Type 9 (Asset Management) Licence (Offshorelicense) from the Securities and Futures Commission (SFC) of Hong Kong, permitting it – alongside a growing number of virtual asset managers – to manage portfolios that are 100% invested in digital assets.
Nasdaq Launches Crypto Custody Service (Nasdaq)
Nasdaq is moving into the digital asset business, citing growing institutional demand from its financial institution clients. It is set to launch a digital asset custody offering which, following regulatory approval, will incorporate liquidity and execution services, effectively creating a full-service solution that may take a lead from Switzerland’s SDX.
Royal Family of Dubai Company Seed Group Partners with Coincorner to Facilitate Bitcoin Transactions in the UAE (Bitcoin Magazine)
Brazil Exceeds 1M Registered Crypto Users in July for First Time as Number Grows 68% in a Month (CoinDesk)
Abra Launching First US Regulated Crypto Bank (Blockworks)
Abra, a crypto exchange and lending platform, has successfully acquired a licence to become the first US regulated crypto bank. With the licence comes an ability to offer clients regulated interest-bearing crypto accounts, an activity that some providers have had to discontinue. For example, BlockFi was sued successfully by the SEC for USD 100 million (The Verge) as its offering was considered an unregistered security and the firm was not registered as an investment company. Abra is due to launch in the US in Q1/2 2023.
Tokenization of Illiquid Assets to Reach $16T by 2030: Report (Cointelegraph)
A report by Boston Consulting Group (BCG) and ADDX, a digital asset exchange, estimates that illiquid assets such as pre-IPO stock, real estate, art, and private debt will become a USD 16.1 trillion tokenised market by 2030.
Singapore’s Financial Authority Grants License to SBI’s Digital Asset Arm (Cointelegraph)
The Monetary Authority of Singapore (MAS) has granted Japan-based SBI Holdings a Capital Markets Services licence for its digital subsidiary SBI Digital Markets. In-principal approval was granted in May this year, however the full licence will now permit the firm to offer digital asset custody, capital markets products, and financial advisory services in Singapore as a regulated business.
Singapore’s Largest Bank DBS to Offer Crypto Services to 300,000 Investors (Crypto Slate)
Fidelity to Launch Bitcoin Retail Trading in November (Crypto Slate)
ErisX Introduces Settlement Service for OTC Crypto Transactions (Finextra)
ErisX, a leading digital asset exchange, has launched a new settlement service for OTC transactions that is designed to eliminate counterparty risk by routing orders through a US-licensed crypto spot exchange, thus reducing the risk and operational burden associated with OTC transactions.
Broadridge Integrates with Coinbase (Finextra)
Broadridge, a leading provider of shareholder services, has partnered with Coinbase’s Prime offering, enabling enhanced liquidity and the ability for Broadridge’s clients to route orders to Coinbase Prime via its NYFIX order-routing network.
Crypto Custody Specialist Anchorage Digital Offers Japanese Yen Stablecoin (CoinDesk)
Gunvor, Total Execute First Physical Oil Trade Confirmation using VAKT Blockchain (Ledger Insights)
VAKT, a post-trade blockchain startup backed by oil majors including BP, Saudi Aramco, Shell, Total and Chevron, has launched an electronic trade confirmation solution which is designed to replace manual processing of oil contracts, which according to VAKT’s own analysis is responsible for a 15% error rate.
Major Fund Administrator Apex Offers Blockchain-based Valuation Data for Private Assets (Ledger Insights)
SWIFT Runs Blockchain Pilot for Corporate Actions Data (Finextra)
The banking infrastructure provider is trialling a new blockchain system for corporate actions with the aid of Symbiont, a private technology platform, as well as seven securities market participants. Corporate actions are seen as one of a number of key areas in which post-trade can be better served by blockchain technology, with SWIFT estimating as much as 30% of the costs associated with processing corporate actions are related to manual processing.
CME Group Launches Ether Options (Finextra)

Key: Legal/Regulatory             Technology            Ecosystem              Markets 

CBDC Corner

HKMA’s Policy Stance on e-HKD (Hong Kong Monetary Authority)
HKMA has concluded several consultations under its ‘Fintech 2025’ strategy and will take steps to prepare for a possible future retail CBDC based on broad support by working on technical and legal foundations while exploring application, implementation, and design issues.
IMF Says Crypto and Central Banks Could Set the Stage for Rich and Diverse Monetary Ecosystem – Here’s How (DailyHodl)
Crypto’s Adaptability, Openness Key to Ideal Monetary System, Say BIS Execs (Cointelegraph)
India’s Central Bank Plans CBDC Launch in 2022 with Help from Fintechs, Public Banks (Crypto Slate)
Digital Dollar Project Launches Sandbox Programme (Finextra)
Brazil, India Join CDBC Race: Will Start Pilot Projects in 2022 (The Tokenist)
Norwegian Central Bank Taps Ethereum for CBDC Work (Finextra)
ECB Taps CaixaBank and Amazon for Digital Euro Prototypes (Finextra)
China to Extend CBDC Trial to Most Populous Province, Guangdong, Three Others: Report (CoinDesk)
Iran to Start Testing a Digital Rial This Week (CoinDesk)

Thomas Murray Digital

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Merge Ahead; Billions Flow into Crypto Funds; ECB and Fed Look at Licensing; Tether’s Fortunes Change

Thomas Murray Digital Newsletter

The Merge (Ethereum.org)
The Merge (Ethereum.org)

In this issue:

  • Exploring the implications of the Ethereum blockchain’s upcoming major upgrade, known as ‘The Merge’.
  • Billions more dollars are going into cryptoasset, blockchain and metaverse asset trading and venture capital funds, including those run by Steve Cohen, Brevan Howard, Invesco, Andreessen Horowitz, CoinFund, and Temasek.
  • In regulatory news, the European Central Bank seeks to head off more country-level differences from emerging in the regulation of crypto-related activities by banks – and corresponding regulatory arbitration opportunities – by looking at introducing an EU-wide licensing regime. In the US, the Federal Reserve opens the door for non-bank financial institutions to access master accounts and payment services.
  • The beleaguered Tether stablecoin has seen a small reversal of fortunes as it appoints a more prominent audit firm to attest to its reserves and divests the commercial paper holdings that they currently contain, while its decision not to block addresses related to the sanctioned Tornado Cash crypto mixer is at odds with that of rival Circle.

Major Digital Asset Developments

Ethereum Blockchain Upgrade Approaches, Reducing Energy Use and Making Ether a Deflationary Asset
Ethereum, the second largest public blockchain network by market capitalisation and most popular as a host to thousands of crypto tokens, is due to migrate to a new Proof-of-Stake (PoS) protocol on or around 15 September. Staking entails depositing ether and using it in a voting mechanism to validate transactions, with rewards for correct behaviour and penalties for dishonesty. This system makes it economically unviable for bad actors to attempt a ‘51% attack’ to take control of the blockchain. The upgrade will replace the current Proof-of-Work system that is similar to that used by Bitcoin and a number of other first-generation blockchain projects. The Merge (Ethereum.org), as the upgrade is commonly known (borrowing a term from software engineering), is being heralded as an important step that helps to solve elements of the ‘blockchain trilemma’ of decentralisation vs scalability/speed vs security (CertiK). Until now, the Ethereum blockchain has suffered from low transaction throughput and high gas (transaction) fees despite, or as a result of, its great popularity as the most popular platform for tokens and smart contracts. By moving to PoS, Ethereum expects to be able to introduce a number of measures to improve its speed and usability, adding scaling solutions such as Zero-Knowledge Succinct Non-Interactive Argument of Knowledge, aka zk-SNARKs (Consensys) and sharding (Ethereum.org). Additionally, PoS will also offer greatly improved green credentials, as the new model replaces the need for the mining of new tokens with staking rewards, and is estimated to reduce electricity use by 99.95%. The Merge will see the existing execution layer that is used today (known as Mainnet) adopt a separate consensus layer called the Beacon Chain, which is currently running in parallel in the background. Concluding a successful merge, the Mainnet will act as the consensus engine for all network data, including execution layer transactions and account balances. At the same time, the issuance rate of new ether tokens will drop by 90%. This, coupled with tokens that are ‘burned’ as transaction fees, deducted as penalties from validators’ stakes, or simply lost, should combine to make the available supply of ether deflationary (Pantera Capital) as new token issuance will drop to about 1,600 ETH per day for staking rewards, which is approximately equal to the amount of ETH burned as base transaction fees.
ECB Supervision Newsletter: Licensing of Crypto-asset Activities
Following on from the draft Markets in Crypto-Assets (MiCA) legislation (Finextra) and the latest proposals on capital adequacy from the Basel Committee on Banking Supervision (Bank for International Settlements), the European Central Bank has announced a framework for the licensing of banks on a pan-European Union basis (European Central Bank). The approach will be similar to existing requirements in Germany. The move is an attempt to avoid fragmented national-level approaches that are already emerging within the EU (CoinDesk). The framework is based on the Capital Requirements Directive (CRD) and will examine the risks and capabilities of providers of crypto services, including their business models, internal governance, and risk management practices – which include cybersecurity, AML/CFT and fraud risks – under ‘fit and proper’ assessments. A workstream of the Single Supervisory Mechanism (SSM) will report more broadly on banks’ digital transformations, including their adoption of crypto technologies, by the end of 2022.
More Asset Managers Set Up Crypto-related Funds
Hedge fund mogul Steve Cohen – former founder of insider-trading fund SAC Capital Advisors and now running Point72Asset management – is reportedly establishing a cryptocurrency-only investment firm (Blockworks). It is believed the firm will trade spot cryptocurrencies as well as digital asset derivatives. It has also been reported that BH Digital, Brevan Howard’s crypto-focused fund, raised over USD 1 billion on its launch earlier this year (Blockworks). BH Digital claims the figure exceeds the capacity of the current cryptocurrency market for liquid investment, leading it to invest some of its capital in VC deals and to leave some uninvested for the present time. Its VC activity goes up against that of Andreessen Horowitz, which raised USD 4.5 billion earlier this year for its own fund called a16z (Axios). Meanwhile CoinFund, a VC firm that claims already to have invested over USD 1 billion in over 100 crypto companies since 2015, has raised USD 300 million to start a new web3 fund, CoinFund Ventures I (Yahoo! Finance). Invesco – with USD 1.6 trillion AuM – launches its Invesco Metaverse Fund (Finextra), an actively managed approach to the ‘metaverse value chain’ that it says could contribute USD 1.4 trillion to the global economy by 2030. It follows similar funds launched by Axa, Fidelity and HSBC. Singapore’s Temasek has also invested SGD 100 million in convertible bonds issued by Animoca Brands (Blockworks), a metaverse company that owns properties such as The Sandbox and Decentraland.
Tether Moves Towards Greater Transparency, Reduces Commercial Paper Holdings
Tether, the embattled issuer of what remains the most widely adopted stablecoin, has appointed BDO Italia (CoinDesk) to succeed MHA Cayman in producing attestation reports on the reserve assets that back its tokens. It will also move from a quarterly to a monthly publication schedule. The move marks a further step towards a full audit of those reserves, the lack of which – together with alarming reports of the quality of assets that make them up – has become a major reputational risk for the firm in past months, as well as a cause of potential financial stability concerns should the widely-used stablecoin fail. Tether has cited the reluctance of major, reputable accounting firms to take on crypto businesses as clients as the main factor in its lack of progress towards full transparency. It has also promised to assuage concerns by reducing its once-dominant form of backing, commercial paper, to zero (BeInCrypto). It stated that such holdings would be reduced to USD 3.5 billion by the end of July (out of a total issuance at the time of over USD 66 billion) from a March figure of USD 20 billion. It has also denied that it holds any Chinese commercial paper or that it remains exposed to Celsius Network or Three Arrows Capital. Tether has stated that it expected commercial paper holdings to decline to just USD 200 million by the end of August and for them to be eliminated from its balance sheet completely by year end (CoinDesk).