The future of the crypto interest market

In light of the collapse of the crypto interest industry in November 2022, PROHASHING and author Steve Sokolowski are commencing litigation against multiple lenders and individuals discussed in these articles. These posts are outdated and will not be updated due to the ongoing legal actions. You should not rely on the information presented here. PROHASHING and the author are no longer able to respond to comments and support tickets regarding crypto interest companies.

Introduction

Crypto lending platforms appear to be under siege by the Securities and Exchange Commission, which has threatened legal action to stop them from offering interest-bearing accounts. In this post, I'll detail why much of the media reporting about what's going on is incomplete, show that the impact of the BlockFi settlement is likely to be limited, and offer that the SEC actions are likely to result in people choosing riskier platforms to generate interest, such as DeFi contracts.


BlockFi and its interest rates
>
My #1 rule of thumb is that when something doesn't make sense at face value, there is something that you don't know about. It seems that was the case with interest provider BlockFi.

BlockFi has been slowly phasing out its interest accounts for almost a year now. Their accounts offered 6% yields on bitcoins until March 2021, but even before the Interest Account program's cessation to new customers last week, bitcoin rates at BlockFi were 0.1% for greater than just 0.35 bitcoins. While I am legally prohibited from disclosing the exact interest rates of Genesis Capital, the largest borrower and lender of last resort in the industry, they do allow me to state that the rates are at least 10 times higher than what BlockFi is offering for any number of bitcoins.

If BlockFi's business model were borrowing bitcoins and re-lending them to other customers, then any excess bitcoins that BlockFi had left over could simply be loaned to Genesis, which would be happy to take a large customer like BlockFi. BlockFi could set rates slightly lower than Genesis pays them, such as offering 0.9% when Genesis pays them 1%. They pocket 0.1% of all the money earned - and that's exactly what Ledn and legacy banks do. Since BlockFi offered loans to their own customers, the average interest rate they earn would be that paid by the customers and Genesis, allowing them to make even more profit.

It never made sense to me that BlockFi was offering ridiculously low rates when they could have made money by re-lending the money to someone else. Their competitive advantage would have been their user interface and the ease of use with their exchange. While there is no concrete evidence, and I'll be glad to publish proof to the contrary if someone provides it, the most logical explanation is that no large corporation, including Genesis, was willing to borrow lots of money from BlockFi. Since there would have been a lot of money to be made from such borrowing, the reasonable conclusion is that there was likely an open secret among "insiders" in the industry, who discovered something about BlockFi's books or management team that made them stay away from potentially profitable deals with BlockFi.


Whistleblowers

Most SEC investigations start with "whistleblowers," or people who become aware of illegal activities inside companies. Laws in the United States protect such whistleblowers from prosecution, retaliation, and identification if they reveal information to the SEC. While the identities of whistleblowers are never disclosed, many of them are thought to be employees of the companies they are reporting. These people are incentivized by the lure of unbelievably huge rewards. In one year alone, over half a billion dollars (https://www.phillipsandcohen.com/sec-wh ... ster-year/) in bonuses was paid to whistleblowers, and one case paid $114m to a single person!

In this case, someone who worked for BlockFi might have said something to the SEC about their lending practices. An alternate explanation is that someone working for Digital Currency Group, which owns Genesis and the Bitcoin Investment Trust in which BlockFi is heavily invested, reported wrongdoing at BlockFi. Whatever the case, eventually the things people were discovering about BlockFi gave them reason not only to avoid doing business with the company, but also provided the opportunity for a massive payday.


The SEC

Reading the text of BlockFi's settlement with the SEC (https://www.sec.gov/news/press-release/2022-26) yields few insights by itself into what BlockFi was doing wrong. I offer that the only way to figure out what happened is to look at the context of what the SEC has been executing over the past few years. In particular, the SEC began to open investigations into companies that offered ICOs to fund operations, on the grounds that these ICOs had something of value behind them (as compared to a coin like litecoin, which does not have any backing.) The SEC has also focused on stablecoins, again likely because stablecoins have actual value attached to them.

In regards to this settlement, Gary Gensler, chairman of the SEC, was quoted in the BlockFi document as stating:

Today’s settlement makes clear that crypto markets must comply with time-tested securities laws, such as the Securities Act of 1933 and the Investment Company Act of 1940...

The key words in the quote are "1933" and "1940." As time has passed, Gensler has become more and more aggressive with companies involved with cryptocurrencies and smart contracts by using laws that were written before the first digital computer was built. Note that as an agency of the executive branch, the SEC may not create new laws. Like most prosecutors, it decides from the laws already passed which are the most pressing to enforce. Gensler has decided, for whatever reason, that the SEC should devote significant resources towards attempting to apply these laws to cryptocurrencies and cryptocurrency companies, even though there are clear differences between the stocks these laws were originally aimed at and cryptocurrencies. Those differences have resulted in the proliferation of "joke" coins.


"Joke" coins

PROHASHING considered at one time the creation of a mineable coin or smart contract, where each unit would represent the indefinite right to be paid a proportion of PROHASHING's excess reserve at the end of every month. If implemented in Ethereum Classic, as was one possibility, ETC would have been automatically sent to the addresses which contained the tokens when profits were made; the amounts could have been verified by the published profit reports (https://prohashing.com/tools/profit-report). Periodically, some of the tokens would have been exchanged for ETC, and then exchanged for BTC, to allow PROHASHING to engage in pay-per-share bitcoin mining. This plan was never implemented, because the legal and accounting fees to file the immense amount of SEC paperwork required were likely to exceed the amount of ETC that would ever be received through this plan - estimated to likely be 2000 ETC or fewer.

On the other hand, Shibu Inu tokens have received billions of dollars of inflows. The only major difference between Shibu Inu and the above proposed plan is that Shibu Inu's proponents claim from the beginning that the coin isn't really worth anything. Therefore, commentators on CNBC and bitcoin "maximalists" criticize the creators of coins like Shibu Inu for being "jokes," which is completely true. However, it is also true that Gensler directly caused this current state where cryptocurrency is known for "joke" coins by initiating enforcement action against any coin that had something giving it actual value.

The SEC's attempting to apply laws from the 1930s to cryptocurrencies resulted directly in this situation. Many investors have lost a lot of money on Shibu Inu, which has far off its all-time-high, whereas few investors have lost money in stablecoins and coins that represent shares of profits like BNB.

The joke coin situation is relevant to the BlockFi case because it demonstrates that Shibu Inu and a proposed ERC-20 token that would have almost exactly the same code would have vastly different SEC outcomes solely because of what a person said about them.


How bad is it for BlockFi?

Even though the text of the document doesn't state all that much, a few facts can be inferred - again - from things that didn't happen:

• No BlockFi depositors lost money at any time
• BlockFi was investigated for a year by New Jersey, the SEC, and several states without any arrests and without being forced to immediately shut down
• Existing customers continue to earn interest without any changes even today
• The SEC offered to settle the case, rather than take it to a trial

While it could just be improbable good luck, the fact that BlockFi depositors didn't lose money implies that whatever BlockFi was doing, it was not ridiculously risky. If the investigation had yielded evidence of criminal activity or fraud, someone would have been arrested immediately, which again implies that BlockFi's business model was at least reasonably sound. And obviously, the settlement wouldn't have allowed for the program to continue for all existing customers if the program itself were illegal.

The most interesting part, however, is that the SEC was willing to offer a settlement to BlockFi. Any party in a lawsuit will not offer a settlement if the case is so obviously tilted in his or her favor, and the opposing party so wealthy, that an even larger judgment could be obtained. While the SEC's official statement (https://www.sec.gov/news/press-release/2022-26) states that the settlement should serve as a "warning" to other interest platforms, what happened is no such thing. Since it wasn't decided in court, no precedent has been set, and if the SEC believed that the case was a slam dunk against egregious behavior, then the agency would certainly have instead allowed a judge to impose a punishing penalty. Except for Nexo, which is hiding a lot, companies are not rushing to the exit as a result of this settlement.


A problem with wording?

Given all the above, I'll propose that this entire situation simply comes down to wording. The major point of consistency in the SEC's actions thus far is that the agency more frequently sanctions words or statements, rather than the usefulness or legitimacy of a product. Here, they are again focusing on wording and advertising, while allowing the (perhaps more important) concept of whether a product, token, or company should provide actual value to go unaddressed.

reddit is an easily manipulated forum, but sometimes some interesting information comes out of verified posters. At https://reddit.com/r/blockfi and in E-Mails sent to customers, a BlockFi representative stated that the current BlockFi Interest Accounts will be replaced with "BlockFi Yield." While the E-Mails provide little more information except for a "promise" that Yield will be available when approval is granted (false, because no application to the SEC for Yield has yet been submitted), the representative on reddit stated that from the customer's perspective, there will be little difference between the "Interest Accounts" and the "Yield" program. And if there is no customer difference, then the economics of providing the service on the backend must be roughly similar.

So what happened in the end? I think it's all simply a matter of word choices in marketing. The SEC announcement explicitly accuses BlockFi of having made a "false and misleading statement" on their website for two years. The implication of BlockFi Yield being almost the same program as the current BlockFi Interest Account is that the name of the program was one of the problems. Perhaps the SEC believed that the word "interest" implied that the payouts were being generated in a similar way to the way legacy banks generate "interest," whereas "Yield" implies that the payouts are being generated similar to the way corporate and Treasury bonds are referred to as having a yield. If so, bringing the issue to court would have been a battle over the definition of those terms, which would have been interesting and would have clarified regulations in multiple areas of the law.

If the issue is solely or mostly a marketing error, that would also make logical sense in how the settlement prevents marketing the Interest Account to new customers while allowing existing customers to continue to be served. The product itself is safe enough for investors, but BlockFi's sole error was in marketing.

Finally, the idea of a wording error explains why BlockFi might have agreed to such an expensive settlement when the SEC was obviously not 100% confident in a trial's result. If all BlockFi needs to do to continue offering its existing product is to change its name, make different ads, remove a statement on its website, and submit some paperwork, they can spend money to get rid of the SEC, pay some lawyers to file all the forms, and get back to business as usual. Had there been an actual problem with what they were doing, then one would have expected BlockFi either to close up shop, or to fight in an attempt to win and set a precedent in court that allows them to continue operating what would have otherwise been an illegal business.


Implications

The most notable part of the SEC settlement is what it does not state: there is nobody claiming that BlockFi performed any illegal activities with customers' money. Therefore, I would not expect this settlement to have far-reaching implications, despite the dire "warning" Gensler makes.

Shortly after the settlement was posted, Nexo sent an E-Mail discontinuing new service to US customers, similarly to how BlockFi settled its claim. However, for Nexo specifically, few people should be surprised - as I pointed out at https://prohashing.com/guides/earning-i ... -on-crypto, Nexo never bothered to respond to my questions about state level money transmission licenses, and was unwilling to share specific details about their business model with me. Nexo likely has many unrelated issues to deal with involving the SEC, IRS, and other agencies, and it's surprising they survived this long.

If the issue is indeed this distinction between "interest" and "yield," then it's difficult to know what to make of Celsius. Celsius already refers to earning "yield" on their homepage. Celsius may have a different problem, in that they offer their CEL tokens as payouts. As I pointed out above, CEL is a token that actually has something giving it value, and Gensler has clearly taken the view that the above mentioned laws prohibit coins that have a separate valuable thing associated with them. Personally, I hope that the SEC does go after Celsius over its CEL tokens, and that Celsius does force a trial. Then a judge can either rule that these 1930s laws are not applicable to cryptocurrencies, or (most likely) create some sort of middle ground that carves out exceptions and makes it difficult and expensive for the SEC to continue to push Ethereum towards a collection of "joke" coins.

For Ledn, Gemini, and Genesis (again, assuming the issue actually is word choice and marketing,) there will probably be minimal impact. Ledn and Gemini have always been very clear that they solely lend money to Genesis, and Genesis makes clear in their contracts with lenders that Genesis is providing uncollateralized loans to its borrowers.


Conclusion

In conclusion, while alarming for many, the SEC action against BlockFi may simply be an issue of word choice and advertising. Had BlockFi been insolvent, or doing illegal activities with customer funds, the company would not have been allowed to continue operating for so long. The fact that BlockFi settled the case and is creating a new program with essentially the same features implies that things will be back to business as usual for them in a year or two. Perhaps they will even be able to pay reasonable interest rates again. Because BlockFi was allowed to continue operating, I don't think they are in danger of insolvency.

Instead of shutting down interest providers, I expect that the most significant outcome is that Gensler has - yet again - created unintended consequences. With two of the largest providers ceasing to offer service to US customers, some of that money will flow out from Nexo and BlockFi. The money will go to less reputable companies that operate overseas, which don't perform KYC verification, and which do far worse things with customer money than BlockFi could possibly have been accused of doing. Some people will be fooled into providing money to these companies, but others will understand that giving money to them is risky and will do it anyway in the absence of safer options at reasonable rates.

With ETH rates down to around 1% now, after taxes of 0.5% you're basically betting that the odds are less than 1 in 200 that a reputable company like Gemini is going to fail in a given year, which is absurd because Bank of America's credit default swaps have traded higher than that. For a single individual, a company taking 5 times as much risk as a 1% payer but which pays 6% interest (before taxes,) is a good deal. Population-wide, the higher risk means that it's likely that there will be more high-profile failures of one of these firms.

A big winner will be DeFi, which in the eyes of the SEC and IRS, runs exactly the opposite of how they want the world to operate. Not only are ransomware payments and drug money allowed to flow unchecked, huge hacks and bugs make the news every day, and many DeFi contracts have suicide functions that allow them to be "upgraded" by a group of coders. Some of these contracts are even "upgradeable" exclusively by anonymous authors. Again, people who don't have enough money to lend to Genesis will be tempted to pour assets into these contracts, many of which have not been professionally audited.

While the purpose of this enforcement action may have been to "warn" companies essentially to file paperwork, the end result may simply be more uncertainty caused by the lack of specifics and no court action, and an exodus of US customer funds into significantly riskier platforms.