DeFi protocols announce updates; FSB Addresses DeFi Risks; Museum to arrange NFT exhibition; Encryption enforcement continues; Crypto Crime Reports Published | Baker Hostetler

DeFi Protocols Announce Updates, US Bank Introduces Deposit Token Concept

Of Christopher Lamb

According to recent reports, Rocket Pool, a decentralized finance (DeFi) protocol used as an Ethereum (ETH) staking service, has reached $1 billion in total value locked (TVL) less than two years after the protocol’s mainnet launch in 2021. Rocket Pool allows users to run their own ETH node with only 16 ETH – half of what is normally required. The other 16 ETH comes from a decentralized node operator that only requires users to deposit 0.01 ETH to participate.

In a recent press release, MakerDAO, the DeFi lending protocol and creator of DAI (a decentralized stablecoin), announced that it has successfully implemented Chainlink Automation as part of the Keeper Network. The Keeper Network provides price and debt cap updates through an automated system to promote DAI’s stability using a network of automated bots. According to the press release, the integration of Chainlink will further decentralize MakerDAO and increase the number of third-party actors tasked with performing important tasks.

A report recently published by a major US bank introduced the concept of “deposit tokens”, which the report defines as “transferable tokens issued on a blockchain by a licensed depository institution that evidence a deposit claim against the issuer.” Among other things, the report argues that bank-issued deposit tokens “are much safer than stablecoins for large institutions looking to transfer value across chains”, and increased interest in blockchain emphasizes the need to have “cash equivalents” on the blockchain. According to the report, deposit tokens are different from central banks’ digital currencies and work in the same way as traditional deposits at licensed institutions such as commercial banks. These deposit tokens will be “supported by the issuer’s regulatory framework, capital and liquidity requirements, access to contingency funding as well as ‘robust’ consumer protection policies.”

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Financial Stability Board addresses DeFi risks in new report

Of Joanna F. Wasick

This week, the Financial Stability Board (FSB), an international body that monitors and makes recommendations on the global financial system, published a report on the financial stability risks of decentralized finance (DeFi). The FSB defines DeFi as “an umbrella term commonly used to describe a range of services in cryptoasset markets that aim to replicate some functions of the traditional financial system, while ostensibly disintermediating their offerings and decentralizing their governance.”

The report discusses a number of vulnerabilities in DeFi, the “most concerning” of which it identifies as “different liquidity and maturity profile of liabilities and assets of relevant entities.” Other identified “operational fragilities” in DeFi include “easy-to-manipulate DeFi governance frameworks”, reliance on congested or unreliable blockchains, oracles and cross-chain bridges that can expose users to disruption and theft, and coding errors in smart contracts. The report concludes that, in light of its findings, the FSB should (1) analyze financial vulnerabilities in the DeFi ecosystem as part of its regular monitoring of the broader cryptoasset markets, (2) explore approaches to fill certain data gaps regarding DeFi and ( 3) study how proposed policy recommendations for international crypto regulation may need to be improved in light of DeFi-specific risks.

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French museum to host NFT exhibition, new report provides 2022 NFT market data

Of Amos Kim

A leading French modern art museum recently announced “an upcoming permanent exhibition aimed at the intersection of art and the blockchain represented by non-fungible tokens (NFTs).” The exhibit will feature NFTs from many different artists, including “the next installment of Punk’s Legacy Project” by Yuga Labs, a blockchain technology company that is a contributor to ApeCoin. Yuga Labs simultaneously announced that CryptoPunk #110 will join the museum’s permanent collection in Paris as “Yuga Labs’ Punks Legacy Project aims to raise awareness of the origins and cultural relevance of Cryptopunks, one of the first NFT projects….” The CryptoPunk #110 donation is the second donation from Yuga Labs. CryptoPunk #110 will be unveiled and installed at the Paris museum “this spring as part of an exhibition dedicated to celebrating digital art.”

In other recent news, DappRadar, a global app store for decentralized applications, reported a 59.6 percent “loss in market capitalization in 2022” in NFT collections on the Ethereum blockchain. According to DappRadar, the NFT market began to fall from its February 2022 peak a few months later in May, when the “Terra Collapse” occurred, reaching a low of $2.2 billion in November. From the November low, “the market ended the year up 68%.” The report notes that “this withdrawal of the NFT market was not a reflection of NFT’s utility, but rather the result of bad actors and market manipulation.” Other key takeaways from the DappRadar report include the following: (1) The market value of the 81 collections analyzed by DappRadar showed a 59.60 percent decline in USD value; (2) Yuga Labs has established itself as a leading player in the NFT industry, although most collections faced year-end declines; (3) only three NFT collections (Azuki, Pudgy Penguins, and Degen Toonz) that launched in 2021 or early 2022 experienced significant market growth; and (4) NFT collections launched after the Terra Luna collapse managed to appreciate in market value by the end of 2022.

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The SEC proposes to expand the scope of the custody rule to cover all crypto assets

Of Robert A. Musiala Jr.

This week, the US Securities and Exchange Commission (SEC) published a proposed rule under the Investment Advisor’s Act of 1940 to address how investment advisors safeguard client assets. According to an SEC fact sheet, the proposed rule would, among other things, “expand the scope of the current custody rule beyond client funds and securities to include all client funds of which an adviser has custody.” The SEC fact sheet notes that the proposed rule would define “assets” as “funds, securities or other positions in a client’s account” and would include any assets that investment advisers deposit for their clients. Accordingly, with limited exceptions, advisers will be required to maintain client funds with a qualified custodian, such as a federally or state-chartered bank or savings association, certain trust companies, a registered broker-dealer, a registered futures commission dealer or certain foreign financial institutions.

The proposed rule discusses “crypto-assets” at length. According to the proposed rule, “most cryptoassets are likely to be funds or cryptoasset securities covered by the current rule,” and therefore investment advisers are already required to maintain such “cryptoassets” with a qualified custodian. The proposed rule goes on to say that the proposed new definition of “asset” would include “all crypto assets, even in cases where such assets are neither funds nor securities.” Accordingly, “to comply with the proposed rule, an adviser with custody of client crypto assets would generally need to ensure that those assets are maintained with a qualified custodian who has possession or control of the assets at all times in the adviser’s custody.” As a result, under the new proposed rule, an investment adviser with custody of its client’s cryptoassets that trades the assets on a cryptoasset trading platform that is not a qualified custodian would be in violation of the rule. According to a statement from SEC Chairman Gary Gensler, “[b]based on how crypto platforms generally operate, investment advisors cannot rely on them as qualified custodians.” The proposed rule seeks comments, which should be received on or before the end of the 60-day period from the date the proposed rule is published in the Federal Register.

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DFS orders end to BUSD; US, UK agencies launch crypto enforcement

Of Robert A. Musiala Jr.

This week, the New York State Department of Financial Services (DFS) published a consumer alert to advise that “DFS has ordered Paxos to cease minting Paxos-issued BUSD as a result of several unresolved issues related to Paxos’ oversight of its relationship with Binance vs. Paxos-issued BUSD.” According to the consumer alert and a blog post by Paxos, “[i]n response, on February 13, 2023, Paxos notified customers of its intention to terminate its relationship with Binance for BUSD.” The DFS consumer alert noted that “Paxos is required to redeem its Paxos-issued BUSD tokens for US dollars through Paxos at a 1:1 exchange rate in accordance with compliance protocols for customers in good standing” and stated that DFS is “closely monitoring Paxos to verify that the company can facilitate redemptions in an orderly manner subject to enhanced, risk-based compliance protocols.”

In other news, the federal agency that oversees federal bank deposit insurance this week published a press release saying it had issued two letters to crypto industry firms demanding that the firms “cease and desist from making false and misleading statements about … deposit insurance and take immediate corrective action.” In addition, the agency instructed two crypto industry websites “to remove similar false and misleading statements.” The agency published the four letters as part of the press release.

In the UK, the Financial Conduct Authority (FCA) this week published a press release announcing that it had taken enforcement action against unregistered crypto-ATMs that the FCA claims were operating illegally in the country. The FCA’s operation was carried out with assistance from West Yorkshire Police’s Digital Intelligence and Investigation Unit.

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Reports provide data and analysis on illegal cryptocurrency activities in 2022

Of Robert A. Musiala Jr.

This week, blockchain analytics firm Chainalysis published its 2023 Crypto Crime Report. The report provides detailed analysis of illegal cryptocurrency activities in the areas of sanctions, ransom, money laundering, stolen funds, Oracle manipulation attacks, Darknet markets, fraud, and pump and dump tokens. Among its many findings, the report notes the following: (1) Illegal cryptocurrency transaction volume “rose for the second consecutive year, reaching a record high of $20.6 billion”; (2) “43% of 2022’s illicit transaction volume came from activity related to sanctioned entities”; (3) “[t]raid volumes fell across all other, more conventional categories of cryptocurrency-related crime, with the exception of stolen funds, which rose 7% year-on-year”; (4) “[o]overall, the proportion of all cryptocurrency activity linked to illegal activity has increased for the first time since 2019, from 0.12% in 2021 to 0.24% in 2022”; and (5) “[o]overall, illegal activity in cryptocurrency remains a small proportion of total volume at less than 1%” while “crime as a share of all crypto activity continues to decline.”

Another recent report published by CoinGecko provides additional 2022 data on illegal activity involving cryptocurrencies. Among other findings, the report notes the following: (1) “Cryptocurrency hacking and exploitation caused $2.8 billion in losses [in 2022], the highest since 2013”; (2) “47% of these funds were stolen using a variety of hacking and exploitation methods”, including “bypassing verification processes, market manipulation, “crowd looting”, [and] take advantage of smart contract flaws or loopholes”; and (3) the biggest hacks in 2022 were the Ronin bridge hack ($625 million), the Wormhole hack ($326 million), the Nomad Bridge hack ($190 million), and the Mango Markets hack ($116 million). In a related development, a report this week noted that the Wormhole hacker recently moved $46 million of stolen crypto funds, according to blockchain transaction data.

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