Hi all, a happy (and sober) 2023 to you. This week we look at big boy pain, not just in court but in public spats between major crypto players thus far still going concerns. "How messy is it going to get?" is a question that still doesn't have an answer. We look at the deeper themes of this year, where the likely good news may come from niche pursuits within DeFi and web3. Oh, and it's likely to be a taxing time for anyone who has taken more than a passing glance at crypto as an asset class. Good luck with that.
The usual disclaimer: This newsletter collates the main themes and headlines of the week in DeFi/crypto/metaverse/web3/NFT land and tries to provide unbiased context. It's aimed at anyone who wants to keep an eye on the space. It's put together by a team at YAP and doesn't contain any promotion of our clients (if one is mentioned, we'll flag that).
The team: founder Samantha Yap and Jeremy Wagstaff, formerly of the journalism parish, with Sam O'Donohoe, Becky Corbel, Delon Chan, Ewan Brewster and Tiffany Mac Sherry. Your feedback is as always welcome. Ping us at thecontext@yapglobal.com. Old newsletters can be found here.
[tl;dr]
Bankman-Fried pleads not guilty, trial in October, and the Winklevosses want their money back
As the 'toy financial system' hunts for its big boy pants, attention focuses on security, use cases
2023 is likely to be the first big crypto year for the tax man; what, where and how much are harder questions than you'd expect
[SBF]
The FTX saga rolls on and will do so for the rest of the year, not least because Sam Bankman-Fried's trial won't start until October at the earliest. The FTX founder pled 'not guilty' to fraud and conspiracy charges meaning he will be pitted against his two former colleagues and friends, FTX cofounder Gary Wang, 29, and former Alameda co-CEO Caroline Ellison, 28, who have both pled guilty and are now cooperating witnesses. SBF convinced the judge to protect the identities of those behind his bail. Journalists are still digging: The WSJ reported that troubles at Alameda began well before the crash, sending potential partners like Citibank scurrying for the door. (Stories by Patricia Kowsmann, Vicky Ge Huang, Caitlin Ostroff and Greg Zuckerman of The Wall Street Journal; Chris Dolmetsch of Bloomberg; Tom Warren of BuzzFeed; Nikhilesh De, Cheyenne Ligon and Elizabeth Napolitano of CoinDesk)
Pay attention to an increasingly public spat between the Winklevoss twins' Gemini and Barry Silbert, CEO of Digital Currency Group. Here's a good summary of where we stand. At its heart, it's a story about the entangled nature of DeFi and an indication that FTX's collapse will continue to pull major names down with it. Ryan Browne, author of the CNBC piece, quotes Evgeny Gaevoy, founder and CEO of crypto market maker Wintermute, that industry contagion would be widespread "because anyone in the crypto space and beyond crypto could have been exposed to them one way or another." For its part, DCG's Genesis has asked for more time to find a solution.
And then the big elephant in the corner: Binance, crowned the exchange 2022's winner by capturing 92% of the Bitcoin spot market and 61% of derivatives by market volume, but still under the microscope of US regulators. The SEC on Thursday intervened in bid by Binance's US arm to buy the assets of bankrupt crypto lender Voyager Capital, worth some $1 billion, saying there was insufficient information to show that Binance US would "consummate a transaction of this magnitude". (Stories by Luke Huigsloot of Cointelegraph, Scott Chipolina and Joshua Oliver of the Financial Times)
[Growing out of our toys]
There's a certain sober tone to the beginning of 2023, where the more serious aspects of DeFi come to the fore. More dominoes may fall, but the emphasis is shifting to straightening the rough edges of this sometimes chaotic space and exploring those hidden corners where real work is being done.
Bloomberg's Matt Levine has called crypto a "toy financial system", pointing out that while many described DeFi "as a set of innovations that would have profound effects on the real world" a lot "treated it as a game where they could click some buttons on a computer and get rich with no real-world consequences." His point? Crypto manipulation has consequences, as we're discovering with the Avraham Eisenberg case. The bottom line: those who do things in DeFi that wouldn't be legal in TradFi are likely to find themselves in the crosshairs of increasingly savvy prosecutors. The space will grow up, with or without the involvement of DeFi creators. (Stories by Matt Levine and Robert Burnson of Bloomberg)
Indeed, financial institutions are likely to take a more careful look at crypto, whatever their clients, or the market opportunities, dictate. The Federal Reserve, FDIC and OCC have all warned banks about cryptocurrency risks. The agencies said they are "continuing to assess whether or how" banks can deal with cryptocurrencies in a way that adequately ensures the institutions' safety and soundness, consumer protection and legal compliance, according to the WSJ's Paul Kiernan. Expect more 'guidance', regulation and tougher questions asked by compliance departments of banks that still have a foot in crypto.
Inevitably standards will be raised across the spectrum, both on the side of investors' requirements and the quality of services offered. Already those who help the latter are getting more attention, such as a piece on the computer scientist who hunts for costly bugs in crypto code. Ronghui Gu and his CertiK audit smart contracts, and his clients include some of DeFi's biggest players, but often they come knocking only after they've lost hundreds of millions of dollars. A positive sign: his more recent clients include banks and "a major search engine". All launching their own blockchain products. Good for business, but Gu warns it will also attract more and better hackers. (Story by Clive Thompson for the MIT Technology Review)
It also highlights the reality that security is a process, not a product. Take, for example, looking after your crypto stash. The demise of centralised exchanges has prompted many to argue looking after your own -- self-custody, in the argot -- is the only way to do it. But this is cumbersome, and, it turns out, not foolproof. One of the earliest Bitcoin core developers has claimed to have lost more than 200 of his Bitcoin in a hack after hackers apparently gained access to his encryption key. If an old hand can allow that to happen, one BTC influencer asked, "I don't know how other people are expected to do it safely." (Story by Stephen Katte of Cointelegraph)
And what about those dark corners, where good work is being done? We mentioned CertiK above, among a number of smart contract auditors. Other companies, like Goldfinch, are looking to connect crypto investors (in stablecoins like USDC) with off-chain credit funds and fintechs (aka the real world.) Goldfinch raised $25 million in a round led by a16z a year ago.
Finally, possibly the most immediate beneficiary of crypto's focus on true decentralisation and interoperability are other areas, which champion the principles if not the technology of web3. Matrix, an open standards-based communication protocol, appeals to both those who want to stay away from centralised control and censorship, and those who want to self-host messaging systems to better comply with data sovereignty laws. There's no blockchain in sight or talk of web3, but "the pendulum has been clearly swinging toward decentralisation for quite a while," co-creator Matthew Hodgson was quoted by TechCrunch's Paul Sawers as saying.
[The taxman cometh]
The taxman's pursuit of crypto is gathering pace, with some inevitable consequences. Those countries that wanted to be DeFi-friendly mostly remain so, but caution, and a desire to increase tax revenue, are pushing those hoping to see the space corralled into existing or revised tax regimes.
The current fiscal year, which ends in March 2023, means Indians will be taxed for their trades as a trader, miner or yield farmer. As a result, the tax is pushing traders to foreign exchanges, who hope they can better mask their activities from local authorities. The share of foreign exchanges has risen from 50% in November 2021 to 67.6% in October 2022, according to a report from New Delhi-based think-tank Esya. Esya called on the government to reevaluate its taxation policy for fear that India loses competitiveness and emerging technologies to other countries, as have local crypto associations. (Stories by Arun Srivastav of CryptoPotato, Manish Singh of TechCrunch and Saudamini Chandarana Bhat of EastMojo)
In Europe, Italy has imposed a 26% crypto tax on trading above 2,000 euros, which goes into effect this year. Even Portugal, one of the few countries in Europe where cryptocurrency transactions (for example, capital gains) were not subject to personal income taxation, may have closed a loophole allowing this to happen in its 2023 state budget. (Story by Sandali Handagama of CoinDesk)
In South Africa, crypto assets have been treated as financial products since last October. (Story by Loni Prinsloo and Adelaide Changole of Bloomberg)
For many, the rules are opaque, or unclear. In the UK investments can trigger capital gains tax liabilities by selling, lending, staking or even just transferring crypto between sites and portfolios, according to Gary Ashford, chair of the CIOT/ATT Crypto Assets Working Group. Others argue the rules are clear enough: the tax would apply when a user receives crypto airdrops, mining income, or receives any crypto assets for services, so long as any income is more than £12,570. This will likely change, however: the government announced last month that it would extend a crypto tax break for investment managers as part of a package of reforms, including a tax exemption for foreign investors purchasing crypto through local brokers. (Stories by Jack Schickler and Camomile Shumba of CoinDesk and Rachel Woods of Cryptopolitan)
Japan, too, is trying to ease requirements, especially a 30% crypto corporate tax on paper profits for token issuers. The softer crypto tax rules are expected to be submitted to parliament in January and go into effect for Japan's next financial year starting on April 1, but it's possibly too late to attract back those companies that have moved overseas because of the tax. (Stories by Brian Quarmby and Zhiyuan Sun of Cointelegraph)
In the US, services have emerged helping collectors of NFTs to sell their once-valuable digital collectables as tax losses to offset their income tax bills. (Story by Edward Helmore of The Guardian)
[Events]
World Crypto Conference | January 13th - 15th 2023 | Zurich, Switzerland
Blockchain Economy 2023: London Summit | February 27th - 28th 2023 | London, England
[DeFi Definitions]
An occasional segment exploring one particular aspect of DeFi.
This week "Cross-chain bridges" by Tiffany Mac Sherry
One of blockchain's many benefits is that it is a secure, self-contained ledger. However, this means that the networks do not typically interact with each other. Cross-chain bridges create a much broader blockchain ecosystem by allowing cryptocurrency owners to exchange digital assets across the different blockchains. For example, if a user only has bitcoin but wants to buy an NFT on the Ethereum network they would use a cross-chain bridge to complete the transaction.
In this example, the user may use 'Wrapped Bitcoin' (WBTC) to send bitcoin to an Ethereum wallet. Wrapped Bitcoin is a cross-chain bridge that creates a new WBTC token on the Ethereum network and holds a bitcoin in a smart contract on the Bitcoin network. The number of WBTC is always equal to the number of bitcoin in the WBTC cross-chain bridge smart contract. After this conversion, the user has Bitcoin-backed ERC-20 tokens to buy the NFT on the Ethereum network. This is an example of a lock and mint cross-chain bridge, others include burn and mint and lock and unlock.
While cross-chain bridges help to promote blockchain interoperability, they also pose security risks. These apps have played a part in multiple hacks in the past, as we have seen with Nomad, Wormhole and Ronin, the latter of which was hacked for 650 million dollars. Therefore, it is best practice, as with most things crypto and DeFi, to do your research before using cross-chain bridges.