Blockchain Week in Review - February 2020 #3

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Weekly Focus:

  • ICO Issuer Settles SEC Registration Charges
  • IRS and Cryptocurrency Industry Groups to Meet Amid Agency Enforcement Push
  • Washington Blockchain Work Group Bill Passes State Senate
  • Brazilian Central Bank to Launch Payment System to Compete With Cryptocurrencies
  • Financial Intelligence Units Meet to Discuss Global Issues Surrounding Virtual Assets
  • Bank of Korea to Leverage Blockchain Technology in Bond Market
  • DeFi Project, bZx, Loses $630,000 in Ether in Second “Flash Loan” Exploit in a Week
  • Coinbase Given Principal Status With Visa

U.S. Developments

ICO Issuer Settles SEC Registration Charges

The Securities and Exchange Commission (“SEC”) announced it reached a settlement with Enigma MPC (“Enigma”) for conducting an unregistered offering of securities. Enigma, a data encryption startup located in San Francisco and Israel, raised roughly $45 million through the sale of 75 million “ENG” tokens during the summer of 2017, as part of an Initial Coin Offering (“ICO”).

Enigma and its promoters stated that they would use the funds received in the ICO to develop both a digital asset trade-testing platform and a marketplace to buy and sell information related to virtual currency transactions. Enigma emphasized the long-term scope and viability of the project, stating that “[i]f successful, the Enigma protocol could become the cornerstone of the new decentralized web” and that “[a]chieving this vision is a long term endeavor that will require us to venture far into the frontiers of computer science.” However, once the ENG tokens were delivered to purchasers, they could not yet be used for any of the use cases that Enigma described.

As part of the settlement, Enigma must cease from committing any future violations of the securities laws and pay a civil penalty of $500,000. Enigma must also establish a claims process by which investors can recoup the funds that they invested in ENG and register the ENG tokens as securities with the SEC.

A copy of the press release is available here. A copy of the settlement is available here.

IRS and Cryptocurrency Industry Groups to Meet Amid Agency Enforcement Push

The Internal Revenue Service (“IRS”) has sent out invitations to cryptocurrency companies for an informational “summit” regarding the tax treatment of cryptocurrencies and digital assets. The summit is to include speakers from both the cryptocurrency industry and the IRS.

The IRS’s goal in organizing the summit is to foster communication with the industry, as the agency continues to develop policies and guidance relating to cryptocurrencies and virtual assets. The summit will be broken up into panels. The invited panelists will present on issues such as regulatory enforcement, cryptocurrency exchange technology, and tax return preparation. Audience participation is encouraged, as the invitation notes that panelists are to “share their views and engage with the audience” on these and other topics.

The Bloomberg story regarding the IRS summit may be found here.

Washington Blockchain Work Group Bill Passes State Senate

A bill to establish a blockchain work group in Washington passed the State Senate and has been transmitted to the State House for approval.

Substitute Senate Bill 6065 would authorize a work group to “examine various potential applications for blockchain technology” in industries or activities relating to “computing, banking and other financial services, the real estate transaction process, health care, supply chain management, higher education, and public recordkeeping.” The bill establishes the composition of the work group and the rules by which it will meet and operate. The objective of the work group is to submit a final report on recommended policies “that will facilitate the development of blockchain applications in Washington” by December 1, 2021.

Washington is not alone in its efforts to pass a measure of this type: Kentucky, Wyoming, New Mexico, and Arizona have proposed similar “work group” bills since the beginning of 2020. Congress has also expressed interest in this type of policy. For example, S. 553 directs the Secretary of Commerce to “establish a working group to recommend to Congress a definition of blockchain technology, and for other purposes.” One such purpose is for the working group to recommend “a study to examine a range of potential applications, including nonfinancial applications, for blockchain technology.”

The full text of Washington’s Substitute Senate Bill 6065 is available here.

International Developments

Brazilian Central Bank to Launch Payment System to Compete With Cryptocurrencies

The Central Bank of Brazil will launch a “near-instant” payment system in November, referred to as PIX. Financial and payment institutions licensed by the Central Bank will be required to offer the platform to their customers if they maintain over 500,000 active customer accounts. The platform will be available “24/7/365” for immediate funds transfers, and customers may initiate these transfers using a QR code or submitting other identifying information, such as a cell phone number or an email address.

The creation of PIX appears to be, in part, related to the Central Bank’s need to compete with cryptocurrencies, given their increase in popularity. Roberto Campos Neto, the Central Bank’s President, stated that “if we think about what has happened in terms of the creation of bitcoins, cryptocurrencies and other encrypted assets, [creating the payment system] comes from the need to have an instrument with such characteristics.” The press release announcing PIX goes on to state that “[i]n line with the ongoing technological revolution in the banking industry, PIX will encourage digitization of payments and enhance financial inclusion.”

According to the press release announcing the payment system, Brazilian taxpayers will be able to use PIX to pay federal taxes at the November launch, with plans to expand the capabilities of the system in the future so as to enable customers to collect other government payments, such as income tax refunds, social benefits, and grants.

A story by Coindesk discussing the implications of the PIX platform in Brazil is available here.

The press release announcing the platform is available here.

Financial Intelligence Units Meet to Discuss Global Issues Surrounding Virtual Assets

On Sunday, February 16, fifty senior officials and experts of government Financial Intelligence Units (“FIUs”) met to discuss the challenges virtual currencies pose to the international FIU community. Officials from France’s International Affairs Department, the United States Treasury Financial Crimes Enforcement Network, and Germany’s Financial Intelligence Unit co-chaired the meeting. Officials representing the United States, France, and Israel presented to the body on topics related to cryptocurrency business models, anti-money laundering and terrorist finance risks, and the role of FIUs in tracing digital assets. Attendees commented on the importance of FIUs in combating money laundering and terrorism financing around the globe and stressed the importance of cooperation amongst FIUs and the global community of regulators.

The press release for the meeting is available here.

Bank of Korea to Leverage Blockchain Technology in Bond Market

The Bank of Korea (“BOK”) is exploring blockchain as a mechanism to record bond transactions. BOK is searching for a company that can assist it with developing a blockchain based system to improve the bond market’s record-keeping capabilities. BOK notes that any system developed as part of the request should also improve the process of sharing financial information between BOK and Korea’s Fair Trade Commission. A local official stated that the platform may one day lead to a “real-time simultaneous payment trading system.”

A story by Coindesk providing an overview of the proposal is available here.

Industry Developments

DeFi Project, bZx, Loses $630,000 in Ether in Second “Flash Loan” Exploit in a Week

For the second time in less than a week, an Ethereum transaction took place that appeared to exploit a flaw in the implementation of the smart contract of bZx, a DeFi project. The person or persons that performed the exploit, who remain unknown, used an opportunistic strategy to combine “flash loans” and margined transactions to net a gain of Ether. The exploit took place in the span of a minute within a single Ethereum transaction.

In summary, the bZx smart contract used certain decentralized exchange protocols as sources of information on the price of a synthetic stablecoin, which the smart contract accepted as collateral for flash loans. The bZx smart contract required up-to-date price information of the synthetic stablecoin to ensure that the value of collateral matches the value of the digital asset lent. Using the Ether lent in a flash loan, the exploiter was able to purchase large amounts of the synthetic stablecoin and raise its price using margined transactions on the decentralized exchange protocols that bZx relies on for calculating its reference value of the synthetic stablecoin. The exploiters then used the higher-priced synthetic stablecoin as collateral for a second flash loan of Ether. The lent Ether was used to satisfy the initial loan and net the exploiters a profit of Ether, valued at roughly $630,000. The exploiters defaulted on the second flash loan, leaving the counterparty with the synthetic stablecoin collateral. However, the synthetic stablecoin collateral was not nearly as valuable as the Ether lent because the synthetic stablecoin collateral had materially reverted back to the prior price.

To prevent future attacks, bZx is planning to use Chainlink’s more reliable decentralized oracle network to source price information for its smart contracts. This will enable bZx to write smart contracts that use multiple Chainlinks to evaluate the same data before it becomes a trigger, as a way of helping to minimize the risk of manipulation of any one data source.

A story from Coindesk on the matter is available here.

Coinbase Given Principal Status With Visa

In an announcement on Wednesday, Coinbase shared that it had been approved as a Visa principal member, noting that it would be the first “pure-play crypto company” approved in such capacity. Coinbase launched the “Coinbase Card” with Visa in 2019, allowing holders of the card to spend cryptocurrency in a manner similar to spending money in a bank account.

Visa has three types of membership: principal, associate, and participant members. Per the Federal Financial Institutions Examination Council’s (“FFIEC”) website, principal status gives a member the power to “solicit cardholders and issue cards, solicit and sign merchants, and sponsor other financial institutions for membership in the company.” These are generally the same responsibilities that an issuing bank would have under the card rules.

Through sponsorship, a principal member can authorize an entity as an associate member. Visa provides its principal members with a Bank Identifying Number (“BIN”) and an Acquiring Identifier, to use and engage with the service. While a principal member receives both on its own, an associate member does not. An associate member can only access the service by either licensing both a BIN and an Acquiring Identifier, with a principal member as a sponsor, or using the BIN and Acquiring Identifier of the principal member sponsoring it.

The Visa Core Rules are available here.

The Coinbase announcement is available here.

A Forbes article discussing this development, and its implications, is available here.

[View source.]

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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