DeFi & Financial Services

Binance is the latest major crypto industry player to be sued by a U.S. regulator.  On March 27, 2023, the CFTC announced that it had filed a civil enforcement action against Binance Holdings Limited (and related legal entities) (collectively, “Binance”), its CEO, Changpeng Zhao (“Zhao”), and its former chief compliance officer, Samuel Lim (“Lim”), for violating the Commodity Exchange Act and CFTC regulations. (CFTC v. Zhao, No. 23-01887 (N.D. Ill. Filed Mar. 27, 2023)).  The CFTC, among other things, alleges that Binance allowed U.S. customers to make use of their centralized digital asset trading platform without Binance first properly registering with the CFTC and also allegedly failed to implement an effective anti-money laundering (“AML”) program as required under applicable law. The complaint states that Binance has “never been registered with the CFTC in any capacity.” The CFTC is seeking disgorgement, civil monetary penalties, permanent trading and registration bans, and a permanent injunction against further violations of the Commodity Exchange Act and CFTC regulations.

On September 22, 2022, the CFTC announced an order simultaneously filing and settling charges against bZeroX, LLC (“bZeroX”) and its creators for illegally offering leveraged and margined retail commodity transactions in digital assets, operating as an unregistered futures commission merchant and failing to conduct KYC on its customers. According to the CFTC, a month prior to this settlement announcement, bZeroX transferred control of the bZx Protocol to the bZx DAO, a decentralized autonomous organization (“DAO”), which later renamed itself as the Ooki DAO.  On the same day as the bZeroX settlement was announced, the CFTC filed an enforcement action against the Ooki DAO (successor to bZeroX) for violating those same regulations.  The CFTC stated that bZeroX and its creators engaged in this unlawful activity in connection with their decentralized blockchain-based software protocol that functioned in a manner similar to a trading platform.  The transactions executed on bZeroX, and subsequently on the Ooki DAO, were required to take place on a registered designated contract market.  Additionally, the complaint asserted that bZeroX and Ooki DAO were operating as unregistered futures commission merchants by soliciting and accepting orders from customers, accepting money or property as margin and extending credit.

The structure of Ooki DAO, and the CFTC’s enforcement action against the DAO itself, has garnered a lot of media attention (and industry reaction) and raised novel legal issues.

On October 3, 2022, the Financial Stability Oversight Council (“FSOC”) – a collaborative body formed under the Dodd-Frank Act composed of state and federal regulators and tasked with identifying risks and responding to emerging threats to financial stability – released its 100+-page Report on Digital Asset Financial Stability Risks and Regulation (the “Report”). In the Report – a response to President Biden’s Executive Order 14067 on digital assets, which, among other things, directed various agencies to promote innovation and R&D while calling for measures to mitigate risks – the FSOC reviewed what it deems to be, “specific financial stability risks and regulatory gaps posed by various types of digital assets.”

At the core, the FSOC Report is a call to arms, with the council citing what it sees as a host of regulatory and industry shortfalls that have not kept up with the rapid growth of digital asset activities.  For example:

  • The FSOC report noted that stablecoins and the lending and borrowing on digital asset trading platforms are now an “important emerging vulnerability.”
  • The Report’s basic thesis is that crypto-asset activities “could pose risks to the stability of the U.S. financial system if their interconnections with the traditional financial system or their overall scale were to grow without being paired with appropriate regulation, including enforcement of the existing regulatory structure.” This point was reiterated in the Federal Reserve’s November 2022 “Financial Stability Report,” which presents the Federal Reserve Board’s current assessment of the stability of the U.S. financial system.
  • The FSOC Report also expresses the position that federal comprehensive digital asset legislation is needed to address complex, systemic economic risks, as, in its opinion, “many crypto-asset platforms are not registered or chartered under regulatory frameworks that would address these risks.”

Back in 2013, the first cryptocurrency matter hit our desks. That was the beginning of the exponential growth of our digital assets practice. Recognizing the importance of the area, we launched this blog, Blockchain and the Law. In our first cluster of posts, we covered topics such as cryptocurrency taxation, blockchain and privacy, and issues surrounding initial coin offerings (or ICOs), one of the hottest issues at that time and a practice that still garners SEC scrutiny in 2022 (interestingly, there is still no consensus around when a digital asset, outside of Bitcoin, which is considered a commodity, is a “security”).

Today, blockchain-based innovations continue apace, continuously offering new opportunities (and raising challenges). In the push toward Web3 – with its decentralized, permissionless, tokenized core – there are a variety of new technologies and innovations, from DeFi to DAOs to NFTs to fan tokens to the Merge to the metaverse.  We have been privileged to work with many of the most dynamic clients in helping them build businesses around these advances.

We were thrilled to host a three-day symposium from September 19-21, 2022 to highlight some of the hottest legal and business issues affecting digital assets, featuring a full slate of discussions among our attorneys and guests from the industry.  At the symposium, we programmed virtual panels across a range of topics: SEC enforcement and securities regulation of digital assets, asset manager considerations surrounding digital assets, employee compensation and benefits issues, cryptocurrency AML considerations, digital assets in bankruptcy, decentralized autonomous organizations (DAOs), and sports and media trends and issues in Web3.  The final day of the event culminated in an in-person reception and a “Voices from the Industry” panel featuring an eclectic group of executives from across the digital asset space talking about issues that are top of mind.  In the span of a few days, we learned a lot.

On July 5, 2022, cryptocurrency brokerage Voyager Digital filed for chapter 11 in the Southern District of New York Bankruptcy Court, citing a short-term “run on the bank” due to the “crypto winter” in the cryptocurrency industry generally and the default of a significant loan made to a third party as the reasons for its filing.  At Voyager’s first day hearing on July 8, 2022, the Bankruptcy Court asked the critical question of whether the crypto assets on Voyager’s platform were property of the estate or its customers.  Voyager asserted the crypto assets were assets of the estate pursuant to the terms of its customer agreements, but the question of ownership was more problematic in the context of a liquidation.  In that context, Voyager’s plan of reorganization proposes to resolve any mystery of ownership by delivering the reorganized company to its customers.

On July 13, 2022, cryptocurrency lender Celsius Network filed for chapter 11 in the Southern District of New York Bankruptcy Court.  Celsius had frozen customer withdrawals on June 12, 2022 and, at the time of its chapter 11 filing, indicated that it would not be requesting court authority to allow customer withdrawals.  Celsius noted in a press release that customer claims would be addressed through the chapter 11 process.

Voyager’s and Celsius’ chapter 11 bankruptcy filings highlight the question of whether crypto assets held by an exchange, or similar platform, may be considered property of a bankruptcy estate and, therefore, not recoverable by the customer, who would then likely be an unsecured claimholder of the debtor.

While some commentators have suggested that crypto assets might be considered property of the exchange’s bankruptcy estate, existing common law, existing provisions of Uniform Commercial Code (UCC) Article 8, and proposed amendments to the UCC recognize that if the arrangement and relationship between the exchange and its customers is one that is characterized as “custodial,” the crypto assets held by the exchange should remain property of the customer and, hence, not subject to dilution by general unsecured claimholders.

There have been a number of developments swirling around stablecoins in the past month, including, earlier this week, the recent introduction in the U.S. Senate of a bill (the “Responsible Financial Innovation Act”) that would put in place a regulatory framework for digital assets and enact certain requirements and consumer protections surrounding stablecoins. The topic of stablecoins’ utility and risk has been in the headlines and on the minds of both legislators and state and federal financial regulators. In a timely move, the New York Department of Financial Services (NYDFS), released its “Guidance on the Issuance of U.S. Dollar-Backed Stablecoins” meant to set foundational criteria for USD-backed stablecoins issued by DFS-regulated entities on the issues of redeemability, assets reserves and attestations about such reserves. The NYDFS is the first state regulator to release such guidance. With the fate of Congressional action on stablecoins this year uncertain (and equally uncertain whether federal agencies or banking regulators will step in to offer certain guardrails), it will likely be left to the states (and the industry itself) to establish certain baselines that offer consumer protection and stability without harming innovation. Given NYDFS’s experience in the virtual currency space and its prominence, its latest guidance may be influential to other regulators around the country.