Crypto Custody Services Expand; CFTC Enforcement Targets DeFi, SEC Targets NFTs; FinCEN Warns of Crypto Scams; Major Hacks Steal $41M and $55M | BakerHostetler
Financial Services Firms Expand Cryptocurrency Custody Services
According to recent reports, the cryptocurrency custody arm of a major international bank has launched its institutional cryptocurrency custody services in Singapore, making it “the first entity that is owned by and partnered with banks to provide digital asset custody services for financial institutions in Singapore.” The cryptocurrency custody provider reportedly will offer its services to clients ranging from hedge funds and high-frequency traders to prime brokers, exchanges and asset managers. According to other recent reports, a German multinational investment bank and financial services company has partnered with a Swiss crypto firm to provide custody services to institutional clients’ cryptocurrencies and tokenized assets. This partnership will reportedly allow the multinational investment bank to hold a limited number of cryptocurrencies for its clients, as well as tokenized versions of traditional financial assets.
In a recent press release, Ripple announced that it has agreed to acquire Fortress Trust, “a financial institution that provides licensed Web3 financial, regulatory, and technology infrastructure for blockchain innovators,” including “critical infrastructure to address the growing enterprise crypto market.” According to the press release, “[w]ith this acquisition, Ripple’s growing portfolio of regulatory licenses expands, as Fortress Trust holds a Nevada Trust license” and adds to Ripple’s “more than 30 Money Transmitter Licenses across the U.S.” A few days prior to the acquisition, reports indicate, Fortress Trust incurred a security incident involving a third-party analytics vendor that resulted in the loss of approximately $12 million in bitcoin and other cryptocurrencies.
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IOSCO, BIS and CFTC Address DeFi and Digital Asset Markets
Various regulatory bodies recently addressed the decentralized finance (DeFi) market in new publications, as the DeFi market continues to expand. According to one recent report, spot trading volume on the leading decentralized exchange surpassed that of the largest U.S. cryptocurrency exchange by trading volume for the first time in Q1 of 2023.
In one new publication, the Board of the International Organization of Securities Commissions (IOSCO) issued a report titled Policy Recommendations for Decentralized Finance (DeFi) Consultation Report. The 128-page report “proposes nine policy recommendations that IOSCO plans to finalize by the end of 2023 to address market integrity and investor protection concerns arising from DeFi by supporting greater consistency of regulatory frameworks and oversight in member jurisdictions.” The recommendations are to (1) analyze DeFi products, services, arrangements and activities to assess regulatory responses; (2) identify responsible persons; (3) achieve common standards of regulatory outcomes; (4) require the identification and addressing conflicts of interest; (5) require the identification and addressing of material risks, including operational and technology risks; (6) require clear, accurate and comprehensive disclosures; (7) enforce applicable laws; (8) promote cross-border cooperation and information sharing; and (9) understand and assess interconnections among the DeFi market, the broader crypto-asset market and traditional financial markets.
In another publication, the Bank for International Settlements (BIS) recently issued a report titled The oracle problem and the future of DeFi that addresses DeFi’s use of “oracles” to “import real-world data into blockchain environments for use in smart contracts.” Among other things, the report explores “[w]hether oracles can truly adhere to the complete decentralisation ethos of crypto” when “striving for … decentralisation leads to complex consensus protocols that further erode blockchain efficiency.” The report finds that while “centralisation in oracles might boost efficiency, it also means adding trusted parties to a system designed to be trustless”; the report concludes that “[a]s a result, crypto-based DeFi is likely to remain the preserve of cryptoassets only, rather than being used for real-world assets.”
In a final related item, in a recent speech, a commissioner at the U.S. Commodity Futures Trading Commission (CFTC) proposed that the CFTC launch the first-ever U.S. pilot program for digital asset markets. Among other things, the commissioner recommended the CFTC “help the U.S. stay ahead of the curve by commencing a pilot initiative for digital asset markets … to test, gather data, and develop a pragmatic approach to digital assets and tokenization.”
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CFTC Brings Wave of Enforcement Actions Against DeFi Market Actors
The U.S. Commodity Futures Trading Commission (CFTC) recently brought a wave of new enforcement actions in the decentralized finance (DeFi) and digital assets space. In a recent press release, the CFTC announced that it had issued orders simultaneously filing and settling charges against three DeFi market actors: Opyn, ZeroEx and Deridex. According to the press release, all three companies were “charged with illegally offering leveraged and margined retail commodity transactions in digital assets.” In addition, Deridex and Opyn were “charged with failing to register as a swap execution facility (SEF) or designated contract market (DCM), failing to register as a futures commission merchant (FCM), and failing to adopt a customer identification program as part of a Bank Secrecy Act compliance program, as required of FCMs.” The press release further notes that each company “engaged in these activities in connection with blockchain-based software protocols and smart contracts, commonly referred to as DeFi, that functioned similarly to trading platforms, and which purported to offer users the ability to engage in transactions in a decentralized environment.”
In a quote from the press release, the CFTC director of enforcement said, “The DeFi space may be novel, complex, and evolving, but the Division of Enforcement will continue to evolve with it and aggressively pursue those who operate unregistered platforms that allow U.S. persons to trade digital asset derivatives.” In a separate statement, CFTC Commissioner Summer K. Mersinger criticized the enforcement actions, stating in part that the CFTC “in these cases is taking another step down the path of bringing enforcement actions when we should be engaging with the public” and that the cases “are especially concerning in that they represent a significant shift in position on the merits of engagement with DeFi market participants.”
In another recent press release, the CFTC announced the entry of a consent order against Mirror Trading International Proprietary Limited (MTI) related to “an international multi-level marketing scheme by which they solicited and accepted nearly 30,000 bitcoin from at least 23,000 people located in the U.S. for participation in a commodity pool that purportedly traded retail foreign currency” but instead “misappropriated virtually all of the money.” And in yet another recent action, the CFTC announced that it had settled charges against a defendant, Jacob R. Orvidas, who allegedly “fraudulently solicited at least four pool participants to trade leveraged Bitcoin in a commodity pool” and failed to register as a commodity pool operator. The U.S. Securities and Exchange Commission (SEC) also settled a parallel enforcement action against Orvidas.
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SEC Brings Second Enforcement Case Alleging NFTs Are Securities
On Sept. 13, the U.S. Securities and Exchange Commission (SEC) settled charges against a company for allegedly selling non-fungible tokens (NFTs) that the SEC deems are securities in violation of the federal securities law registration requirements. The settlement order alleges that the company sold the NFTs for approximately $8.2 million to fund the production of an animated web series, touted the sales of NFTs in the secondary market, and tied success of the show to the value of the NFTs, which led investors to believe they would profit from the company’s efforts. The company agreed to pay a $1 million civil penalty, along with other undertakings, including destruction of the NFTs. Commissioners Hester Peirce and Mark Uyeda published a dissent, stating that “[t]he application of the Howey investment contract analysis in this matter lacks any meaningful limiting principle.” The dissent further analogized the NFT project as a digital update of the Star Wars collectibles, chastising the SEC that “[u]sing the analysis of today’s enforcement action, the SEC should have parachuted in to save those kids from Star Wars mania.” The dissent concluded by stating that the “application of the securities laws here makes little sense and discourages content creators from exploring ways to harness social networks to create and distribute content . . . [and] contributes to the legal ambiguity facing artists, writers, musicians, filmmakers, and others seeking to build a loyal, engaged following.”
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FinCEN Issues Alert on ‘Pig Butchering’ Scams Involving Virtual Currencies
The U.S. Financial Crimes Enforcement Network (FinCEN) recently published a FinCEN Alert (Alert) titled Prevalent Virtual Currency Investment Scam Commonly Known as “Pig Butchering” (FIN-2023-Alert0005). According to the Alert, “The victims in this situation are referred to as ‘pigs’ by the scammers who leverage fictitious identities, the guise of potential relationships, and elaborate storylines to ‘fatten up’ the victim into believing they are in trusted partnerships … then refer to ‘butchering’ or ‘slaughtering’ the victim after victim assets are stolen, causing the victims financial and emotional harm.”
The Alert notes that the “butchering” phase often involves convincing the victims to invest in virtual currency. According to the Alert, pig butchering scams “are largely perpetrated by criminal organizations based in Southeast Asia who use victims of labor trafficking to conduct outreach to millions of unsuspecting individuals around the world,” resulting in billions of dollars in losses to U.S. victims.
The Alert explains the pig butchering scam methodology and provides a list of 15 red flag indicators to assist in identifying and reporting related suspicious activity. The Alert instructs financial institutions to report suspicious activity involving pig butchering scams by filing suspicious activity reports (SARs) that reference the Alert. Specifically, financial institutions should “reference this alert in SAR field 2 (Filing Institution Note to FinCEN) and the narrative by including the key term ‘FIN-2023PIGBUTCHERING’ and selecting ‘Fraud-Other’ under SAR field 34(z) with the description ‘Pig Butchering.’”
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Lazarus Group Hacks Crypto for $41M and $55M; Wash Trading Data Published
The U.S. Federal Bureau of Investigation (FBI) recently published a press release “to warn the public regarding the theft of approximately $41 million in virtual currency from Stake.com, an online casino and betting platform.” According to the press release, the FBI “confirmed that this theft took place on or about September 4, 2023, and attributes it to the Lazarus Group,” a criminal organization associated with the government of North Korea. The FBI press release includes a list of cryptocurrency public keys that received the hacked funds. In a separate development, a cybersecurity firm recently reported that the Lazarus Group was responsible for the theft of approximately $55 million in cryptocurrencies stolen in a recent hack of the CoinEx cryptocurrency exchange.
According to another recent report, the social media profile of Ethereum co-founder Vitalik Buterin was hacked and subsequently used to promote a non-fungible token (NFT) scam that resulted in losses to victims of approximately $691,000. The scam was reportedly facilitated through a fraudulent social media post containing a malicious link. Victims who followed the link were prompted to connect their crypto wallets to receive an NFT, but instead the hackers gained access to and stole crypto from the wallets.
In a final notable item, a recent report from a decentralized finance (DeFi) trade surveillance and risk monitoring software firm provided findings on wash trading in the DeFi market. According to the report, “liquidity providers (LPs) on Ethereum-based decentralized exchanges (DEXs) have wash-traded at least $2 billion worth of cryptocurrency, manipulating the prices and volumes of more than 20,000 tokens.” The report also found that of the almost 30,000 DEX liquidity pools sampled, LPs have executed wash trades in 67% of the pools and wash trading has constituted 13% of the total trading volumes.
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