Thomas Murray Digital Newsletter
In this issue:
- Leading exchange FTX and its sister hedge fund Alameda Research file for bankruptcy after revelations of a balance sheet black hole and unauthorised lending of customer deposits; further retail-focused crypto exchanges may also be vulnerable.
- Germany finalises legislation to authorise the issuance of DLT-based securities, adding asset classes including equities and funds to the existing digital bearer bonds.
- EU delays approval vote on the Markets in Crypto Assets Regulation (MiCA) to February 2023, further pushing back its implementation date.
- UBS becomes first bank to issue a bond on a regulated digital exchange, with components trading on both SDX and the traditional SIX exchange.
Major Digital Asset Developments
|FTX Bites the Dust as It Too Fails to Implement Sound Governance and Financial Risk Management|
With major and serious development efforts taking place in the institutional digital assets ecosystem, it is disappointing that the narrative dominating the media is once again the failure of a poorly-governed and now failed exchange (and its related hedge fund) that enabled the retail trading primarily of unbacked cryptocurrencies. This series of failures is due in part to a lack of regulation and oversight, and particularly to the tendency of digital asset firms such as exchanges to operate from jurisdictions (in this latest case, the Bahamas) with weak requirements for firms to implement sound corporate governance and financial risk management. This year has been strewn with stories of bankruptcies, insider trading, and the persistent threat of contagion.
This week FTX, one of the world’s largest digital asset exchanges, filed for bankruptcy – firstly for its non-US trading arm, and then its US entity following an application for Chapter 11 Bankruptcy protection (Finextra).
A leaked balance sheet for FTX founder Sam Bankman-Fried’s trading firm, Alameda Research, was the subject of a CoinDesk article on 2 November. It purported to show that almost a third of Alameda’s USD 14.6 billion was allocated to FTT, the native token of the FTX exchange, and that this represented more than 50% of the token’s total circulating supply.
Binance, the largest cryptocurrency exchange, was an early investor in FTX and had exited its equity position in mid 2021, in return receiving USD 2.1 billion in a combination of BUSD (the native stablecoin of the Binance ecosystem) and FTT. Once news of the weak balance sheet got out, and in apparent retaliation for rumours of FTX briefing the press against Binance, the latter announced the divestment of its remaining FTT tokens, sending their price crashing and causing a run on FTX. Alameda Research might have been able to survive the liquidity squeeze if not for the fact that it had apparently borrowed heavily against FTT and a basket of closely related tokens.
Allegedly, in order to support the value of the token, Alameda received lines of credit from the FTX exchange in the form of user deposits (The Verge), which it then used to bet on other cryptocurrencies as well as misguided attempts to support other embattled ventures like Voyager Digital which filed for Chapter 11 bankruptcy protection (CoinDesk) in July this year. Perversely, Alameda Research actually owed Voyager an estimated USD 200 million for funds it had borrowed in 2021, and by repaying the debt (which it did loudly and proudly) it was able to recoup the collateral it had posted with the firm for the loans it had taken. Ironically, FTX actually won a bankruptcy auction for Voyager Digital’s assets (CNBC) in September.
Despite its size, FTX’s management team comprised a small clique of inexperienced executives, and the group’s entities had no financial audits from large or reputable audit firms, nor any controls environment or IT security certifications. Despite this, even seasoned investors including BlackRock, Ontario Teachers’ Pension Plan, and Sequoia Capital were caught asleep at the wheel.
Given yet another case of signs of serious internal malfeasance and even fraud, serious due diligence and ongoing assessment of digital asset service providers remain paramount. The failures that the industry continues to witness are – as Dan Morehead, CEO of Pantera Capital articulated following the collapse of hedge fund Three Arrows Capital (3AC) earlier this year – down to old-fashioned over-leverage and poor risk management, rather than symptomatic of risks specific to the digital asset sector.
There could be further dominoes to fall in the ranks of exchanges as they scramble to reassure customers of their stability before they too are subject to runs and liquidity crunches. Several have urgently commissioned ‘proof of reserve’ audits to demonstrate that they hold, and have not lent out without customers’ agreement, the assets that they claim to have. Crypto.com, a retail exchange and investment platform that spent profligately on marketing before pulling up the drawbridge (Wall Street Journal) and making major layoffs (Coingeek) earlier this year, is reported to hold 20% of its reserves in Shiba Inu (SHIB), a meme token, although now comprising the fourteenth-largest cryptocurrency by market capitalisation. Its efforts to promote itself as stable and competently run took a hit when it purportedly sent over USD 400 million in Ether tokens to another exchange, Gate.io, by mistake, instead of sending them to its own cold storage wallet. The tokens – representing over 80% of its Ether holdings – were returned a week later. Even Binance, the world’s largest exchange group whose CEO Changpeng “CZ” Zhao has been extremely critical of other exchanges, appears to have 40% of its token reserves in its own-brand stablecoin Binance USD (BUSD) (c.USD 23 billion) and in-house token Binance Coin (c.USD 6.4 billion) (Bloomberg). The stablecoin reserves are, however, fully dollar-backed with third-party monthly attestations, with reserves managed by Paxos Trust Company.
While there continue to be centrally-managed organisations fulfilling essential market-making and custody functions in this growing industry, there also needs to be respect for the rules that exist for traditional non-crypto firms and that have been built up to protect investors over several decades. Blockchain and the use of distributed ledgers do not obviate the need for well governed, transparent and fiscally prudent management of these service providers.
Custody and Post Trade Developments
|New German Regulations Enable the Issuance of Securities on Distributed Ledger Technology (Bundesgesetzblatt) (German)|
The German government has published in its official journal, Bundesgesetzblatt, regulations and requirements that set out how electronic securities registers (eWpRV) can be used to support the issuance of securities, including equities and funds on a Distributed Ledger. This completes Germany’s approach to securities issuance using DLT, since only digital bearer bonds were supported in law until now.
|HSBC to Launch Orion Blockchain Bond Tokenization Platform (Ledger Insights)|
HSBC has announced plans to launch a permissioned DLT-based bond tokenisation platform, Orion. The solution is expected to be able to support the issuance and trading of digital bonds as well as the tokenisation of currencies such as GBP, such that assets can benefit from atomic settlement – the simultaneous exchange and instant settlement of assets – or true delivery versus payment (DvP).
|Binance Custody Turns to TRM Labs for Institutional Compliance (Finextra)|
In an effort to improve its institutional credentials and mitigate its many past regulatory challenges, Binance – the largest digital asset exchange by market capitalisation – is calling upon TRM, a leading blockchain analytics and intelligence firm, to bolster its risk management and compliance frameworks to support its custody activities, which it launched in December 2021. In signs of a maturing industry, the firm has reportedly secured specie insurance, certification under International Organisation for Standardisation (ISO) standards 27001 and 27701, as well as a SOC 2 Type 1 external audit attestation, and is currently pursuing a SOC 2 Type 2. These are standard credentials for traditional institutionally-focused custodians, and increasingly common for digital custodians.
| ||UBS Launches Bond Traded on Blockchain-based Exchange (Finextra)|
UBS has become the first banking entity to launch a bond on a regulated digital exchange. The CHF 375 million digital bond is trading on Switzerland’s SIX Digital Exchange (SDX) and also on the traditional SIX Swiss Exchange, in the same way that SIX’s own bond is traded following the launch of the Digital Exchange in November 2021. Utilising SDX’s atomic settlement technology, the bond is able to settle instantaneously within SDX’s distributed ledger-based CSD without the need for clearing via a Central Counterparty (CCP). Meanwhile, the analogue part will settle through traditional means via SIX Swiss Exchange. This Swiss dual digital/traditional model demonstrates a gentle path for other markets to introduce the tokenisation of traditional assets and the listing of digitally native securities.
Other News and Links
|EU Delays Vote on MiCA Crypto Legislation Until February (CoinDesk)|
Further to our previous newsletter, the EU has decided to delay its vote on the implementation of the Markets in Crypto Assets Regulation (MiCA) until February next year, reportedly due to the complex and technical nature of the text. The delaying of the vote, which was anticipated to take place this December, means that MiCA will most certainly not be published in the Official Journal of the European Union (OJEU) originally slated for Q1 2023, which formally signifies the full applicability of the law. As such, this will likely impact the timing of the implementation of the regulatory and licensing regime which was due to come into effect in 2024, approximately 12 to 18 months after its publication in OJEU.
|UK Lawmakers Votes to Recognize Crypto as Regulated Financial Instrument (CryptoSlate)|
A proposal introduced to the House of Commons to recognise crypto assets as regulated financial instruments has received approval by the lower house after a second reading on October 25.
The proposal seeks to include crypto assets and the services that support them under the Financial Services and Markets Bill which, if successful, will result in types of crypto assets including stablecoins falling under the same laws as other financial assets. If approved in law, the UK Treasury department would be empowered to enforce regulation over the crypto industry.
|IRS 2022 Tax Guidelines to Treat NFTs as Stablecoins, Cryptocurrencies (Decrypt)|
The US’s Internal Revenue Service (IRS) has introduced a draft update to its tax language which now considers a broader definition for digital assets as being “any digital representations of value that are recorded on a cryptographically secured distributed ledger or any similar technology”. As such, NFTs are now considered in scope, alongside virtual currencies such as stablecoins, and cryptocurrencies, all of which are set to be taxed under the same rules. Interestingly, the IRS has decided not to categorise NFTs as collectibles, such as art, which suffer from a the higher 28% rate of taxation, versus traditional equities bonds, and cryptocurrencies which are taxed at 0%, 15%, or 20% depending on the income level.
|South African Crypto Platforms Must be Licensed in 2023 – Regulator (Reuters)|
South Africa’s Financial Sector Conduct Authority (FCSA) has announced the need for companies that support cryptocurrency activities to apply for a licence in a time window between 1 June and 30 November, 2023, in order to operate legally within the country. NFTs are not covered under the announcement at present, given that they are considered to have characteristics more like traditional works of art. It appears that the licensing regime is being implemented in some part to mitigate the risk of potentially being added to the Financial Action Task Force’s so-called ‘grey list’, which has apparently identified material weaknesses in the country’s AML and CTF regime.
|Singapore Lays Down the Law for Crypto Trading and Stablecoins (Finextra)|
|Japan Greenlights Tougher Anti-Money-Laundering Rules for Crypto (CoinDesk)|
|UK Law Commission to Review International Laws on Crypto to Consider Legal Reforms (Coin Telegraph)|
|Coinbase Piles on Support for Grayscale’s EFT by Filing Amicus Brief in Effort to Reverse SEC’s Rejection (CoinDesk)|
|Canada Announces Crypto, Stablecoin Consultation in New Budget Statement (CoinDesk)|
|EU Countries Must Be Ready to Block Crypto Mining, Commission Says (CoinDesk)|
The European Commission is once again coming after bitcoin and other proof-of-work cryptocurrencies on sustainability grounds, following an announcement in response to concerns over energy security this winter. Mining is fundamental to securing and ensuring the validity of the network, and therefore banning it across the EU would further undermine the decentralised nature of the blockchain which is integral to its security. The majority of bitcoin mining takes place in the US, China, Kazakhstan, Russia and Canada, with the EU’s Germany and Ireland considered key markets representing 4.48% and 4.68% of the hash rate respectively.
|HK to Legalize Retail Crypto Trading (Bloomberg Markets and Finance via YouTube)|
|Stablecoin Issuer Paxos Receives Operating License from Singapore Regulator (CoinDesk)|
|Fidelity 2022 Institutional Investor Digital Assets Survey: 58% of Institutional Investors Allocate to Digital Assets|
|DBS Goes Live on SGX Unit’s Crypto Platform; Launches Programmable Money Pilot (Finextra)|
|Israeli Government to Trial Blockchain Bonds with Stock Exchange TASE (Ledger Insights)|
|France, Switzerland, Singapore to Test DeFi in Forex Markets (CoinDesk)|
Coordinated by the Innovation Hub of the Bank for International Settlements, Central Banks from France, Switzerland, and Singapore are collaborating on Project Mariana, which is designed to test the automation of foreign exchange markets across a decentralised financial infrastructure.
|JP Morgan to Launch Blockchain Euro Deposits Soon. Sees NFT Opportunity (Ledger Insights)|
|Ethereum Records 1st Deflationary Month in History as Circulating Supply Declines (CryptoSlate)|
Following Ethereum’s transition to a proof-of-stake blockchain on 15 September 2022 the network has recorded its first deflationary month, in which more ETH was burned (introduced under the EIP-1559 proposal) than produced. As such, the circulating supply has been reducing by approximately 3,318 ETH daily.
|Ripple Begins Testing XRP Ledger Sidechain That’s Compatible with Ethereum Smart Contracts (CoinDesk)|
|Key:||Legal/Regulatory Technology Ecosystem Markets|
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