Merge Shines Amidst Regulatory Clouds
September 2022 Commentary
Cooler September weather continued to cast a chill over investor sentiment as did the higher than expected US CPI report of 8.3% per annum. As expected, the US Federal Reserve continued to show their commitment to fighting inflation by raising the Fed Funds rate by another 75 basis points to a target range of 3% to 3.25%. The higher rates and continued geopolitical uncertainty led many investors to flee to the US Dollar. At its weakest, the EUR was priced below $0.96, and the GBP reached the $1.07 handle, levels we haven’t seen for 20 years for the EUR and over 37 years for the GBP! The flight to safety drove global equities down over 9% for the month and over 26% year-to-date (in USD terms). Considering the higher volatility that one generally sees, the overall digital assets market did not fare all that badly and had a drop of a tad over 4% for the month.
Weighing down on the crypto markets was also the concern about the long arm of two of the US financial regulators, the CFTC and the SEC. The CFTC took action against the Ooki DAO, and the SEC complaint against the earlier 2018 SPRK ICO suggested that the SEC should have jurisdiction over Ethereum. Despite the macro and regulatory clouds, the sun was shining on the Ethereum protocol. In the wee hours of Sept 15, Ethereum completed its Merge, switching from its previous Proof-of-Work consensus mechanism to Proof-of-Stake. The successful switch is a huge boon to environmentalists as it brought along a 99.95% drop in energy usage. Both the regulatory actions and the Merge deserve some attention in this month’s commentary.
Regulatory [Over-] Reach
Among the crypto-community are some sharp-eyed individuals who pick up quirks in the troves of code and documents being published every day. Such was the case on September 19 when the US Securities and Exchange Commission (SEC) issued a complaint against Ian Balina, a crypto influencer on social media who allegedly promoted and sold unregistered, non-exempt SPRK tokens for Sparkster, Ltd. back in the middle of 2018. To put it simply, Balina violated federal securities law as a US resident selling these unregistered tokens to US and other residents.
Broadly, the crypto-community had no issue with the main body of the SEC complaint. However, a couple of news sites picked on a specific paragraph within the complaint. That paragraph is reproduced here:
“69. The U.S.-based investors in Balina’s pool irrevocably committed to the transaction when, from within the United States, they sent their ETH contributions to Balina’s pool. At that point, their ETH contributions were validated by a network of nodes on the Ethereum blockchain, which are clustered more densely in the United States than in any other country. As a result, those transactions took place in the United States.”
The last sentence caused a bit of an uproar. On the same day, Decrypt released an article titled, “SEC Claims All of Ethereum Falls Under US Jurisdiction.” Was this truly the SEC’s intention or was the reaction more of a tempest in a teapot? Let’s come back to this later.
Separately, Ooki is a decentralized finance (DeFi) platform built on Ethereum. It is not a large platform and has a total value locked of only about $750,000 towards the end of Sept, according to Defi Llama. On September 22, the US Commodities and Futures Trading Commission (CFTC) filed and settled charges against bZeroX, LLC and its founders, Tom Bean and Kyle Kistner, for “illegally offering leveraged and margined retail commodity transactions in digital assets; engaging in activities only registered futures commission merchants (FCM) can perform; and failing to adopt a customer identification program as part of a Bank Secrecy Act compliance program, as required of FCMs ”, over a period from 2019 to 2021. In the same order, it similarly charged the Ooki Decentralized Autonomous Organization, the successor to bZeroX and operator of the “same software protocol,” for the same activities without properly registering as an FCM.
Among digital assets, decentralized autonomous organizations (DAOs) are a ubiquitous experiment in platform governance. Instead of shareholders of a company voting on a limited set of issues raised by a board of directors or by shareholders, token holders of a platform can propose a wider range of changes and enhancements that are voted upon by other token holders. These proposals cover a wide range of issues from setting fees and changing token issuance to making technological improvements in the platform. Proposals are discussed in public forums before voting occurs. Similar to shares in a corporation, token holders are motivated by the economics of their token to vote in a way that best improves the utility and attractiveness of their platform. Successful votes are implemented and deployed by open-source developers into the platform’s software, unlike a corporation that requires the board to empower the C-suite to execute the approved resolutions. Not having a centralized coterie of executives is the key distinction of what makes DAOs decentralized. Quite often, DAOs are unincorporated entities.
In an interesting response, one of the five CFTC’s Commissioners, Summer Mersinger, offered a dissenting opinion on the CFTC action. While she supported the charge and settlement against bZeroX and its founders, and even supported the CFTC seeking an injunction against the activities of the Ooki DAO, she took issue specifically with the CFTC setting monetary penalties against members of the DAO who are associated merely by their participation in the DAO governance. She was also very clear that she opposed the CFTC revealing its policies through “enforcement actions” and urged the CFTC to “communicate to, and engage with, the public in a transparent manner and seek out the input of those with expertise to share.” It is worth noting that SEC Commissioner Hester Peirce has also been a vocal opponent of federal regulators leading with enforcement actions and expressed as much as recently as this May on Twitter.
What should we make of these couple of SEC and CFTC activities over September? On one hand, we have to recognize that regulators have tough job enacting new policy and laws to regulate new financial instruments and business activities built on new technologies. They’re damned if they do (overreach!) and damned if they don’t (asleep at the wheel!). SEC Chairman Gary Gensler has articulated the mission of the SEC is “to protect investors, maintain fair, orderly, and efficient markets, and facilitate capital formation.” He has stated this in various venues and as recently as this mid-September in his testimony before the United States Senate Committee on Banking, Housing, and Urban Affairs. This seems like a reasonable mission for a federal securities regulator. Who can quibble with this?
While we can’t quip about the mission, we also have to recognize that successful adoption of new policy and regulations lies in the implementations details. Sharp eyes and sensationalism will grab the headlines, but we ought to relegate those to the roles that they deserve – to raise awareness and be sure that we ask the right questions.
In the SEC’s complaint against Balina, what constitutes a US transaction on a blockchain that is globally shared? In what situations can a federal regulator claim jurisdiction?
Regarding the Ooki DAO, and more generally other similarly unincorporated associations, who ought to be liable, for example, in the event of a scam? Certainly, the idea of scammers going unpunished does not seem to be fair, just because a platform has the appearance of being decentralized.
Transactions are public on the blockchain. Is answering these questions a matter of developing a new set of appropriate tools?
As pointed out by CFTC Commissioner Mersinger, revealing policy by enforcement action is not a good practice and leads to distrust by the public, a disincentive to innovate, and potential capital flight to friendlier jurisdictions. How should regulators work with the crypto-community, with which advocacy groups, and in what venues?
Whilst the case of the Ooki DAO appears to be an attempt to set some kind of precedent and its handling appears to be less than perfect – careful and well thought out rules for regulation of DAOs are urgently needed. In the coming years we expect DAOs to play an even bigger role in shaping public discourse around crypto in general. And although cypherpunks may celebrate the ability of DAOs to leverage their decentralized nature and exploit regulatory and legal arbitrages, the potential dystopian downsides of having extremely well-funded and unaccountable organizations operating in the financial, political arenas and beyond is a topic worthy of further considered discussion and debate.
The Shiny New Merge
Despite the macro and regulatory uncertainty, September saw one of the most momentous events in crypto finally come to pass. Ethereum achieved one of the major milestones of the original Ethereum visions, as laid out by Vitalik Buterin in 2013, by switching its consensus mechanism from Proof of Work (used by bitcoin) to Proof of Stake. In doing so some estimates put the energy saving at 0.2% of all electricity usage for the planet, or the equivalent of “turning off” Chile. Buffeted by larger macro events, the impact on price appeared to have been a non-event or perhaps even slightly negative feeding into the “sell the news” narrative. However, there are a number of facts which work against the narrative that the Ethereum merge was already priced in. Firstly, the Merge was a very significant engineering achievement, one that is often compared to changing the engine of a plane in mid-flight – that is, a plane with millions of people and billions of dollars aboard. That they pulled it off flawlessly and the price barely moved is testament to the faith the market has in the Ethereum core developers. But beyond the technical achievement, post-Merge, there is a huge drop in the daily issuance of new ether – as of the time of writing since the merge, $330,000,000 worth of sell pressure from Ethereum miners no longer exists. Every day, the sudden removal of miner sell pressure is compounding. Yet despite this the ether to bitcoin price ratio remains essentially flat on a 1-year basis. Sooner or later, something has got to give, and we expect it will be towards the upside.