This week in the newsletter, we write about the SEC's speech disclosing a path to banks for SAB 121 relief, prediction markets in the regulatory spotlight, and Bitcoin mining difficulty reaching new all-time highs.

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SEC Appears to Ease on SAB 121

SEC speech discloses path to banks for SAB 121 relief. On Monday, Sep. 9, Chief Accountant at the Security & Exchange Commission (SEC) Paul Munter gave a speech in which he disclosed that the Commission has not objected to a bank's assessment that the SAB 121 balance sheet accounting requirements do not apply to the bank. In the speech, Munter described the circumstances and private dealings with the bank holding company that established a fact pattern sufficient, in the SEC's view, to not require SAB 121 accounting for that bank. In short, this could pave the way for some banks to enter the cryptoasset custody market.

For background, Staff Accounting Bulletin 121 ("SAB 121") was put forth by the SEC in 2022. Under SAB 121 publicly traded companies must account for digital assets held on behalf of clients on their corporate balance sheets. This could have the effect of making custody clients of those companies unsecured creditors if the custodian goes bankrupt. Because many banks are publicly traded companies, and due to separate bank capital rules that require banks to hold cash 1:1 for crypto assets on their balance sheets, SAB 121 has had the effect of deterring any banks from custodying crypto assets on behalf of depositors.

In May 2024, both houses of Congress passed a bill that labeled SAB 121 a formal rule and asserted that the SEC violated the Administrative Procedures Act in issuing it without conducting a formal rulemaking process (such as offering comment period, publishing in the Federal Register, etc.). 21 House Democrats defied a White House veto threat to join Republicans in passing the bill that would effectively overturn SAB 121, and 11 Democrats and 1 Independent joined Republicans in the Senate to pass the bill. President Biden vetoed the bill on May 31, arguing that overturning SAB 121 "would inappropriately constrain the SEC's ability set forth appropriate guardrails and future issues" and "risk undercutting the SEC's broader authorities regarding accounting practices." Biden continued by saying his "administration will not support measures that jeopardize the well-being of consumers and investors."

In his Monday speech, Munter asserted that "the staff's views on SAB 121 remain unchanged" but outlined two separate fact patterns that, if applicable to a company, the company would not have to apply SAB 121.

First, a bank holding company has a path to relief from SAB 121 if they: 1) receive "written approval from its prudential regulator at the state level"; 2) client cryptoassets would be held in a bankruptcy-remote manner, and that remoteness is substantiated with a legal opinion; 3) the bank has clear standards of care negotiated in contracts with its institutional depositors; 4) regulatory, legal, and technology risk is mitigated and assessed on an ongoing basis.

Second, introducing brokers also have a path to relief from SAB 121 if they 1) don't possess the cryptographic keys to client assets; 2) the third party is the agent of the customer, not the introducing broker; 3) and the introducing broker obtains a legal opinion that supports the status of the introducing broker as it relates to the cryptoasset activities.

OUR TAKE:

The short story is that this appears to be good news. Banks that would like to custody cryptoassets and expressly fit the fact pattern described have a clear path to avoid SAB 121 accounting. Myriad types of institutional investors desire the highest form of qualified custody - bank custody. If the world's most trusted custody banks can custody cryptoassets - let alone tokenized assets - that could ease a big barrier to adoption that has loomed for years.

But there are a few weird things about this speech. The private guidance and subsequent speech outlining the fact pattern to achieve relief effectively carves out a giant portion of potential SAB 121 reporting companies. If banks don't need to do it, that just leaves Coinbase and some publicly traded fintech firms. There is perhaps some nuance, though - the fact pattern specifically mentioned a bank "obtained written approval from its prudential regulator at the state level." So, according to this speech, nationally chartered banks (i.e., OCC-regulated) would probably not fit the fact pattern and thus would need to come into the SEC and make their case. Given the current attitude towards crypto from the national banking regulators, it may be hard to obtain such written approval from the OCC given that agency's currently hostile posture to digital assets. If national banks want to get involved, they probably need to spend more time and money to convince the SEC they deserve relief too. (This process reminds us of SEC Commissioner Hester Peirce's eloquent speech about the "secret garden."). But still, there are some very large state-chartered custody banks. The two largest custody banks in the world are both state trusts (BNY Mellon in New York & State Street in Massachusetts).

The speech also makes specific and repeated references to the fact that the bank holding company would hold its client assets in bankruptcy remote manners as being very important to the SEC staff's analysis that allows the bank to avoid SAB 121 accounting. But the effect of the accounting standard for those to who it does apply actually could have the opposite effect. Coinbase themselves disclosed in May 2022 following the issuance of SAB 121 that "customers could be treated as our general unsecured creditors." So, on one hand, to avoid SAB 121 accounting, the unknown bank assured the SEC that the cryptoassets it will custody for clients will be bankruptcy remote, but on the other hand public companies like Coinbase are explicitly warning that SAB 121 could mean their clients' cryptoassets are not bankruptcy remote. That's a real headscratcher.

Why can't the SEC simply revise or reverse SAB 121? Why can't the SEC adopt something formal through a normal process on a topic that both houses of the U.S. Congress said was a rule in violation of the Administrative Procedures Act? In a way, the SEC has painted itself into a corner on this issue - the Commission denies that SAB 121 is a formal rule (even though both houses of Congress disagree), but if it's not a formal rule they can't offer formal relief from it (say, through a No-Action Letter). They can't provide clarity via a formal rulemaking process because they have spent the last 2 years being obstinate to the point where they needed the President to bail them out with a veto after being shunned by both parties in Congress. Given this conundrum, it appears the best this SEC can offer is guidance that carves out entities from applicability. The crypto industry has been loudly and repeatedly calling for formal rulemaking and guidance from the SEC, but apparently, everyone is left with backroom conversations with staff members that allow the backdoor dilution of the rule.

The chief accountant at the SEC says that "the views of the staff on SAB 121 haven't changed," but he's just announced a loophole that would allow tons of the firms to which it applies to ignore it. The convoluted nature of that logic makes it hard to believe that politics aren't at the center of this issue. If I'm being honest, it looks like the SEC never thought banks would want to play in crypto, intended this rule to apply only to crypto-native companies (perhaps punitively), and has now crafted a way to let traditional banks off the hook in a way that saves face by not reversing their posture of the last 2 years. - Alex Thorn

Prediction Markets Get Interesting

Prediction markets are in the spotlight as election season heats up. The largest crypto native prediction market, Polymarket, has seen significant growth in 2024, driven largely by bets on the outcome of the U.S. presidential election.

At the time of writing, $900m is currently betting on either a Harris (50%) or Trump (49%) victory, and another $200m is betting on the winner of the popular vote (Harris 74%, Trump 25%). The next biggest market by volume has a $45m bet on the 2025 Super Bowl champion; followed by a $34m bet on the electoral college margin of victory for the presidential election; and then a $26m bet on the outcome of next week's FOMC rates decision.

Last week, a Federal Court ruled against the CFTC in a suit brought by prediction market Kalshi, arguing that the CFTC overstepped its statutory authority by blocking the firm's election markets. Core to the ruling from D.C. District Court Judge Jia Cobb (who was appointed by Pres. Biden) is the recent overturning of Chevron deference by the U.S. Supreme Court.

Essentially, the Court argues that the CFTC's claimed jurisdiction is well broader than intended by Congress in the Commodity Exchange Act and prediction markets generally speaking cannot be sufficiently defined as "gaming" or "unlawful activity" to result in CFTC jurisdiction. The CFTC filed an emergency motion to make Kalshi wait 2 more weeks before launching election markets, though the Court has yet to rule on the motion. Separately, the CFTC is considering a proposed rule that would ban election markets at all the exchanges it oversees.

Kalshi succeeded in launching its election markets yesterday afternoon (Thursday), but they were halted at 11:30 pm after the judge granted a temporary stay as the CFTC appeals.

OUR TAKE:

The use of prediction markets has expanded significantly, with more than 5000 daily users often betting more than $15m in volume daily volume. July and August saw $386m and $472m respectively, and September is on track to see $500m traded. Before January 2024, Polymarket had never seen more than $35m in trading volume in a month. Prediction markets were one of the first application types crypto builders sought to bring to the blockchain. One of the most storied, but ultimately unsuccessful projects, in crypto was the prediction market Augur. But not until the 2024 election have crypto-native prediction markets begun to hit their stride.

The CFTC regulates prediction markets ("event contracts") as they are essentially types of futures markets, but Polymarket was fined by the CFTC in 2022 for not obtaining a designated contract market (DCM) or registering as a swap execution facility (SEF) and has essentially been operating offshore since. PredictIt is another major prediction market that describes itself as "an experimental project operated for academic purposes under permission from the CFTC" and is operated by the Victoria University of Wellington. PredictIt received a No Action Letter from the CFTC in 2014, allowing it to operate so long as each question allowed only 5000 traders and individual investments per question were capped at $850, but that No Action Letter was rescinded by the CFTC in 2022 and PredictIt has been locked in a suit with the CFTC since. Kalshi received a DCM registration from the CFTC in 2020 but the CFTC has refused to allow the company to launch prediction markets relating to U.S. elections, resulting in Kalshi's suit against the agency which it just won.

A major thing to note about the ruling in Kalshi's favor, as noted above, is the Court's reliance on the Lopper Bright Supreme Court ruling, which sharply limited the power of federal agencies to interpret the statutory authority granted to them by Congress. The Chevron case, which allowed federal agencies broader power to interpret vague federal laws, was cited at least 18,000 times by federal courts over the last 40 years (according to SCOTUS Blog). Federal agencies will likely continue to see their authority curtailed as a result of the Lopper Bright ruling and in the absence of new, clearer legislation from Congress. This could have wide implications for the crypto industry and the SEC's jurisdiction over it, which has been alleged by industry participants to be based on unclear statutory authority. - Alex Thorn

Bitcoin Difficulty Soars to New ATH

Bitcoin mining difficulty increased to 92.67 terrahashes at block height 860,832 on September 10, 2024. The recent spike in mining difficulty marks a new all-time high for the mining sector. For background, Bitcoin mining difficulty programmatically adjusts every 2,016 blocks, approximately every two weeks, to ensure that a new block is found every 10 minutes. Mining difficulty typically increases as more hashrate comes online from miners turning on machines (ASICs). The increase in mining difficulty requires miners to perform more computation to mine the next block. As a result, spikes in mining difficulty reduce the profitability of individual miners as their existing computation effectively produces less bitcoin.

OUR TAKE:

The increase in Bitcoin mining difficulty while the BTC price remains stagnant and fee revenue is low creates a challenging environment for miners. Despite the current unfavorable market conditions, miners are expanding their operations to increase future hashrate targets. In June 2024, CleanSpark acquired GRIID for $155m, and in August 2024, BitFarms acquired Stronghold Digital Mining. Although the acquisition of live mining sites does not directly increase overall hashrate, these acquisitions may increase the future hosting capacity for miners. With increased energy and storage capacity, miners who are acquiring other sites can scale their operations more efficiently.

Galaxy Mining's Mid-Year Report expects public miners to ramp up hashrate significantly in the second half of the year. The report underscores that historically during the summer, mining sites showcase marginal hashrate growth due to high energy grid demand, especially in warm regions like Texas. Consequently, hashrate accelerates after the summer when energy grid demand is lower. Galaxy Mining estimates that the increase in miners turning on machines (ASICs) will lead to global hashrate reaching 725-775 Exahash (EH) by the end of 2024, up from 665 EH on September 12, 2024.

The expected hashrate increase in Q4 2024 coupled with more efficient ASICs coming online could lead to higher difficulty adjustments later this year. The continued increase in bitcoin mining difficulty may position merged mining as a viable alternative revenue stream for miners. Earlier this week, Fractal, a Bitcoin Sidechain, launched and already has 37% of Bitcoin's hashrate merged mining the chain. Merge mining involves PoW miners mining both Bitcoin and another PoW blockchain at the same time. Miners who successfully merge mine Fractal blocks earn roughly $1,700 per block at 30-second block intervals. Although the long-term viability of new Bitcoin sidechains remains to be seen, if fee revenue on Bitcoin stays flat from the lack of Ordinals/Runes activity, miners will continue to seek new revenue streams, including from partnering or leasing their energy and data center assets to AI firms. - Gabe Parker

Charts of the Week

Onchain stablecoin supply yields are trending below what is achievable offchain through traditional dollar-denominated yield channels. These yields are achieved by lending stablecoins out to other users and are the closest purely onchain comparable to offchain yields like the Effective Fed Funds Rate and short-term bond yields.

As of September 11, 2024, the Effective Fed Funds Rate (EFFR) is 5.33% while the weighted average supply rate by amount borrowed of USDC, USDT, and DAI on Ethereum Mainnet is 3.75%. August 5, 2024, marked the first time onchain stablecoin yields in the largest and most liquid markets crossed below what is achievable offchain since June 2022. The move signals greater risk off sentiment in the market as onchain activity compresses, dragging yields down with it.

Rate cuts from the Fed anticipated to take place this month will bring offchain yields more in line with onchain stablecoin yields. It is also noteworthy to highlight that the upcoming cutting cycle will be the first where large and widely used onchain stablecoin markets exist. Onchain stablecoin markets, and DeFi as a whole, were highly nascent through the last cutting cycle that took place in 2020.

The spread between onchain stablecoin supply yields and the Effective Fed Funds Rate (onchain yield - EFFR) is the lowest it has been since October 2023. As of September 11, 2024, the spread stands at -158 basis points. Despite sluggish yields, and in turn, incentive to hold stablecoins onchain over dollars offchain, the onchain stablecoin supply continues to grow. There are $170.19 billion worth of stablecoins as of September 11, 2024. The supply has grown by $6.4 billion (a 3.9% increase) since the spread turned negative on August 5, 2024.

Other News

• Trump-backed DeFi project World Liberty Financial to launch Sep. 16

• Paypal and Venmo Now Support Ethereum Name Service for Sending Crypto Payments

• Friend.tech Creators Walk Off With $4m as Project Shuts Down

• EToro Reaches $1.5m SEC Settlement, Agrees to Stop Trading Most Cryptocurrencies

• Bitcoin Miner Solves Block Alone, Grabs $180,000 Reward

• Standard Chartered Launches Bitcoin and Ethereum Custody in UAE

• VanEck to Shutter Ethereum Futures ETF

• Worldcoin Says it isn't Under Investigation in Singapore

• From the Desk of Galaxy Digital Research

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