Blockchain Week in Review - April 2019 #3

Perkins Coie

Perkins Coie

U.S. Developments

Regulatory Updates

Arca Investment Management Files With SEC to Issue Stablecoin

Arca Investment Management, a California-based investment management firm specializing in digital assets, filed an amended preliminary prospectus with the SEC seeking to make available its Arca UST Coins to investors. The Arca U.S. Treasury Fund (“Fund”) would issue its shares as “Arca UST Coins,” which are digitized securities that would be ERC-20 compatible tokens and utilize the Ethereum blockchain.

In compliance with the “Names Rule” under the Investment Company Act of 1940, the Fund will invest at least 80% of its assets in U.S. Treasury Securities, which could include bills, bonds, and notes issued by the U.S. Treasury; the remaining assets would be held in cash, cash equivalents, or investment-grade bonds. The Fund is designed to function as a stablecoin, because it is structured to have little volatility between the “net asset value” per share and the coin’s value for purposes of trading in a secondary market. The Fund’s shares will be issued as a digitized security token, and all transactions, including issuance and transfer, will be recorded on the Ethereum blockchain, with ownership and transfer of the Arca UST Coin authenticated through cryptography. Arca Investment Management seeks to raise $25 million with its offering.

In order for an investor to own Arca UST Coins, the investor has to establish a wallet on the Ethereum blockchain through the Arca application and be accepted by Arca’s affiliated transfer agent (for Anti-Money Laundering/Know Your Customer purposes). After the investor’s wallet address is approved and “whitelisted,” the investor can then use the Arca application to transfer funds from a bank account directly to the Fund and receive the Arca UST Coins directly into his or her wallet. According to the preliminary prospectus, the private keys with respect to issuance transactions are maintained by the Fund’s transfer agent, which also must confirm any transactions (such as on a decentralized exchange). The Fund’s custodian is also an affiliated party.

The Form N-2, which is a registered investment company registration statement, is not effective until the SEC declares the filing to be effective. This would be the first registered investment company to use a blockchain for share registration, issuance, and redemption transactions.

FinCEN Penalizes Individual as a Peer-to-Peer Virtual Currency Exchanger

On April 18, 2019, the Financial Crimes Enforcement Network (FinCEN) assessed a civil money penalty against an individual for “willfully violating the Bank Secrecy Act’s (BSA) registration, program, and reporting requirements.”

Among other things, FinCEN determined that the individual operated as a money transmitter by conducting transactions as a “peer-to-peer exchanger.” Per a footnote in the assessment, FinCEN defined “peer-to-peer exchanger” as “a natural person engaged in the business of buying and selling convertible virtual currency, who typically advertises and markets his or her services through classified ads, specifically designed web platform websites, online forums, other social media, and word of mouth.”

The full FinCEN Assessment of Civil Monetary Penalty is available here.

Presidential Candidate Andrew Yang Calls to Implement Federal Crypto/Digital Asset Regulation

This week Democratic presidential candidate Andrew Yang called for federal regulation of cryptocurrencies and digital assets. Yang noted the current regulatory uncertainty and conflicting state regulations and said that investors, companies, and individuals would all benefit from clarity in the treatment of crypto/digital assets. Yang calls for legislation to define what a token is and when it is a security, while recognizing utility tokens; confirm which federal agencies have regulatory power over digital assets; clarify the tax implications; and preempt state regulations when possible. For more information, see Andrew Yang’s policy here.

Industry Updates

Decentralized Exchanges May Be Subject to Arbitrage and Frontrunning Used on Wall Street

According to a new research paper from scholars at Cornell Tech, decentralized exchanges (“DEXes”) are susceptible to the same exploits that high-frequency traders use on Wall Street. In the paper, Flash Boys 2.0: Frontrunning, Transaction Reordering, and Consensus Instability in Decentralized Exchanges, researchers claim that arbitrage bots “exploit inefficiencies in DEXes, paying high transaction fees and optimizing network latency to frontrun, i.e., anticipate and exploit, ordinary users’ DEX trades.” Similar to how Michael Lewis’ book Flash Boys: A Wall Street Revolt shined light on high-frequency trading is used to gain an advantage over traditional trading, the authors of Flash Boys 2.0 highlight risks in current smart contracts and decentralized exchanges.

Arbitrage bots leverage “pure revenue opportunities” and “priority gas auctions,” two specific kinds of transactions on the blockchain, to ensure profits over a series of transactions. The researchers created a fork in the Go-Ethereum client to enable a tool created by the researchers to capture unconfirmed transactions to identify priority gas auction arbitrage bots. The researchers collected over 708 million unique observations of arbitrage bots during the nine months of gathering data. As the arbitrage bot market matured, revenues dropped from around 10-100 ETH per day in late 2017 down to 1-10 ETH per day for bots making over 1,000 daily trades.

The scholars highlight the differences between blockchain payment protocols and smart contract systems. Blockchain payment protocols, such as bitcoin, are secure simple payments and are executed atomically, so they are generally unprofitable to manipulate. Smart contract systems, such as Ethereum, use a second-layer system added on top of the bitcoin miners and adds a layer of dependence vulnerable to exploitation. The researchers warn that arbitrage bots may drive up order optimization fees and transaction fees beyond the block reward for the miner. If the optimization fees and transaction fees greatly exceed the block reward, the researchers argue that a miner might attempt to undercut a high-fee block and fork the block to hold back fees to attract other miners to build on the new fork. Additionally, the researchers caution that time-bandit attacks, wherein a miner utilizes a 51% attack to fork and recapture optimization fees and transaction fees, may already be profitable on certain blocks with high fees or arbitrage opportunities.

EY Will Make Its Zero-Knowledge Proof Private Transaction Protocol Publicly Available

Following up on EY’s initial unveiling in October 2018, EY announced it will release its zero-knowledge proof (“ZKP”) private transaction protocol into the public domain. The protocol is designed to allow “secure, private transfers and payments on the public Ethereum network.” The transactions using the ZKP technology will be kept private so that blockchain users who are outside of the transaction or not authorized to view the information will not have access. The transaction information will be available to auditors and regulators. The protocol will support ERC-20 standard fungible token payments and unique asset transfers compatible with the ERC-721 standard. EY expects the software code to be released into the public domain in the next four to six weeks.

Enterprise Ethereum Alliance Launches Blockchain-Neutral Token Taxonomy Initiative to Accelerate a Token-Powered Blockchain Future

The Enterprise Ethereum Alliance (“EEA”) announced the launching of the Token Taxonomy Initiative to help jumpstart token-powered blockchain platforms. The Token Taxonomy Initiative seeks to clearly define a token in layman’s terms and establish a common nomenclature for use by businesses and technical participants. Additionally, the Token Taxonomy Initiative strives to create a simple and easy-to-understand Token Taxonomy Framework and collaborate with structured Token Definition Workshops to define new or existing tokens, and it aims to define metadata using the Token Taxonomy Framework to help enable generation of visual representations and mappings of token solutions, implementations, or source code for any platform. The Enterprise Ethereum Alliance consists of over 300 member companies across 19 technical, industry, and legal groups. For an overview of the Token Taxonomy Initiative, review the EEA Token Taxonomy Initiative flier.

International Updates

Japan May Require Cryptocurrency Exchanges to Increase Internal Oversight of “Cold Wallets”

According to a Reuters report, Japan’s Financial Services Agency (“FSA”) may require additional internal oversight of “cold wallets” in light of virtual exchanges’ shift from internet-connected “hot wallets” to cold wallets. Cold wallets are devices disconnected from the internet and have been utilized more by virtual exchanges following a series of security lapses by Japanese exchanges last year. It is not yet known when the FSA will formally issue the order.

French Finance Minister Bruno Le Maire Asks for European Union to Regulate Cryptocurrency

At Paris Blockchain Week, French Finance Minister Bruno Le Maire called upon the European Union to enact a regulatory framework for cryptocurrencies that mirrors the French regime enacted earlier this April. In a speech, Le Maire highlighted the construction industry, the agriculture and food industry, and the energy industry as the three industrial sectors that will engage in developing and utilizing blockchain technology with France’s support. Le Maire believes that the French regulatory proposals create “a unique worldwide framework for ICOs” (translated) and encourage working on regulating cryptocurrency at the G20 level. Le Maire offered an overview of his statements on his Twitter account.

Japanese e-Commerce Company Rakuten Launches Applications for Cryptocurrency Exchange

Japanese e-commerce giant Rakuten began accepting applications this week for a new cryptocurrency exchange, Rakuten Wallet. In 2018 Rakuten purchased the exchange, which was formerly named Everybody’s Bitcoin. Under Japan’s Payment Services Act, cryptocurrency is regulated by the FSA and requires, among other things, that currency exchanges register with the FSA and manage customers’ money separately from their proprietary funds. Initial applicants must already have an existing Rakuten Bank account. For more information, see the official Rakuten (Japanese) press release.

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DISCLAIMER: Because of the generality of this update, the information provided herein may not be applicable in all situations and should not be acted upon without specific legal advice based on particular situations.

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