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Blockchain Bites: The merge is here; Black market for stolen NFTs; ATO (air)drops new guidance; Gensler urges crypto registration; Coinbase insider pleads guilty; KKR jumps into avalanche for PE offering – Fin Tech



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Michael Bacina, Steven Pettigrove, Sally Fetouh, Luke
Misthos and Jordan Markezic of the Piper Alderman Blockchain Group
bring you the latest legal, regulatory and project updates in
Blockchain and Digital Law.

The Merge is here!

The Ethereum Merge has finally arrived following months of
upgrades, developments, and a first-of-its kind transition on a
blockchain of this size. The Merge is designed to offer a
more-sustainable future for the second largest (by market cap)
cryptocurrency, Ethereum, by substantially reducing the energy it
takes to verify transactions.


The old Ethereum Blockchain
has ‘merged’ with the Beacon
Chain
which was launched in 2020 to test the proof-of-stake
system. This evolution has been in the works since the start of
Ethereum and fits into a broader roadmap of ongoing improvements to
Ethereum.

The old Ethereum Blockchain used a consensus model similar to
Bitcoin, with nodes verifying transactions using a proof-of-work
(PoW) model. Proof of work uses energy intensive
computers to solve complex mathematical problems in order to verify
transactions. Before the Merge, Ethereum was
estimated to be using as much electricity as the
Netherlands
.

In an ambitious move to redevelop the software without ceasing
trading, in a move
said to be similar
to be akin to changing out a petrol engine
for an electric motor while a car is driving, Ethereum is now
running on proof-of-stake (PoS), which requires
validators to hold and stake tokens. Validators are selected at
random to mine the next block and once a designated number of
validators have verified the block is accurate, the next block will
be created.

Validators receive rewards proportionate to their staked tokens,
without having to expend large amounts of energy and makes
participation in the consensus nodes cheaper and easier.

Holders of ETH and ERC-20 tokens do not need to do anything for
their tokens to continue to function as normal, but a raft of scams
are expected to try and trick people into handing over their
private keys or transferring their tokens to scammers.

The Merge has not only revamped thousands of decentralised apps
that rely on the Ethereum Blockchain, but potentially reduced the
overall
energy usage of the entire world by 0.2%
.

Merge parties were held around the world, luckily in Australia
the merge time was about 5pm AEST but many stayed awake to watch
history be made:-

The network will be watched closely for any bugs or unexpected
operations in the coming days but so far the Merge is being
considered one of the greatest open source software successes to
date.

The Black Market for Stolen NFTs: Elliptic
Report

The rise of non-fungible tokens (NFTs) with
secure ownership on the blockchain has been followed swiftly by
scams seeking to steal NFTs and flip them for a profit, leading to
a distinct economy for the stolen goods. Thanks to the traceable
nature of blockchains, however, that economy can be identified and
studied faster than would be the case for a traditional black
market.

A new report from blockchain analytics’ company Elliptic
gives us an update on NFT-based scams, sanctions risks, market
manipulation and money laundering. The risk to marketplaces and
exchanges is presently small but significant and growing. Some
exchanges have been subject to lawsuits over their management of
stolen assets, alleging that marketplace operators have failed in a
duty to flag or freeze onward sales. In particular, marketplace
operators need to be vigilant at all times for scammers within the
NFT community, as it only takes seconds of complacency or
accidental clicks to result in losses which can run into the
millions of dollars.

How are scammers operating?

Scammers often use social media to steal NFTs using phishing
links and impersonate NFT marketplace support staff. Scammers often
then list stolen NFTs at very low prices, taking advantage of bots
deployed by other NFT traders on marketplaces which are designed to
detect and acquire NFTs at cheap prices.

In February 2022, a phishing attack occurred where over 200 NFTs
worth USD$5.1 million were stolen and represented the single
largest NFT phishing heist on record. The scammer ended up
returning two thirds of the stolen NFTs back to their owners but
kept the higher-value NFTs. The scammer sold the remaining assets
across 3 NFT marketplaces. Of those, 45 were purchased and sold by
their buyers within 5 days of the attack. The scammer gained
USD$1.42 million from the 45 stolen NFTs, for around 8% lower than
their total floor price at the time (USD$1.54 million). All but 10
of these were flipped for a profit by the subsequent buyers who
grossed USD$1.77 million from their sales, meaning that 13% of the
monetary gains were made by the initial buyers rather than the
scammer. This demonstrates the attractiveness of this emerging
black market of stolen NFTs. Additionally, one user minted an NFT
and sent it to the scammer with a note saying:

Hello, I am interested in buying the NFTs you have on you
[right now]. I can buy them in bulk at 50% of floor price.

Nevertheless, buyers often purchase stolen NFTs without
realising their stolen nature, and on becoming aware of the theft,
these buyers prefer to sell them at a loss rather than flip them
for a profit. The reasons for this include avoiding negative
publicity in the NFT community or disposing of stolen assets as
quickly as possible to mitigate the risk of complicity. The
community actively calls out users interacting with stolen NFTs and
openly urges the return of the NFTs or sale back to the victims, as
is what happened to the 3 stolen Mutant Apes which were subject of
a phishing scam on 20 February of this year. Two of the stolen Apes
were sold by their initial buyers at a loss as a result.

What can marketplaces and exchanges do to combat
this?

Some ways in which marketplaces and exchanges can fight these
types of scams:

  • Have procedures in place to flag, freeze or delist stolen
    assets once a credible theft report has been made.

  • Scammers risk being banned from major marketplaces and
    potentially be left with unsellable assets if a report is made.
    Therefore, encouraging scam victims to report and lock NFTs during
    negotiations with scammers, even offering to buy back their assets
    at reduced prices is a successful strategy for that reason.

  • Highly public campaigns through the use of social media and
    other channels frequented by the NFT community can be a huge
    success in being able to block sales on major NFT marketplaces at
    once. An example is the
    Calvin Becerra campaign
    on Twitter in regards to stolen
    BoredApeYC NFTs. Successful campaigns such as this leave scammers
    and potential onward buyers with no avenue to sell stolen assets,
    with the only viable option being the return of the stolen NFTs at
    a negotiated ransom.

NFT marketplaces and exchanges need to be proactive in reporting
and responding to theft reports and detecting malicious activity
through their services, including using wallet screening and
transaction monitoring tools like Elliptic, Chainalysis or TRM
Labs.

Red flags for exchanges to consider include:-

  • where an NFT has been sold in quick succession over several
    marketplaces and swap services;

  • where an NFT has been sold at well below the floor price;

  • where NFTs that have been quickly sold have been bought by the
    same set of users who may be running bots;

  • if funds have gone into Tornado Cash or other mixers shortly
    after NFTs have been exchanged;

  • the transaction wallet has numerous comments on its blockchain
    explorer page about being involved in prior hacks or scams;
    and

  • a search of the associated wallet address on a search engine or
    social media reveals that it has been implicated in prior hacks or
    scams.

The key for exchanges is to act swiftly, be vigilant and on
alert with action plans in place and ready to be implemented as
soon as potential scam activity is detected. Scam reports may
originate from numerous sources so NFT marketplaces and crypto
exchanges alerted can act swiftly to block suspect addresses
identified through different platforms. The more marketplaces which
do this, the more scammers can be prevented from easily cashing out
the stolen assets, decreasing incentives for NFT theft overall.

Australian Tax Office (air)drops new airdrop
guidance

The Australian Taxation Office (ATO) has issued

new guidelines on how Australia’s tax regime applies to
cryptocurrency rewards
and new tokens earned from staking
crypto assets.

There is a wide variety of what constitutes staking in the
crypto market, but the ATO has provided the following high-level
definition
:

Staking involves locking your existing crypto asset tokens
to validate transactions on the blockchain and create new blocks.
The users who create new blocks in this system are known as
forgers.

The ATO views ‘forgers’ who create new blocks should
treat the tokens they receive as ordinary income and to declare
that on their tax return.

The
guidance
also looks at the proof-of-stake consensus mechanism
– where forgers hold units of a crypto asset to validate
transactions to create new blocks. Upon the verification of a
transaction on the network as valid, there is a consensus.

The ATO then takes the opportunity to look at other
consensus mechanisms
that reward existing token holders for
their role in maintaining the network and which also have the same
tax outcome. Rewards received through: i) proof of authority and
proof of credit mechanisms by validators; ii) agent nodes and
guardian nodes; and iii) premium stakers and other entities
performing comparable roles, will also be treated as reportable
ordinary income.

A forger or miner will also receive
ordinary income
equal to the monetary value of the tokens they
receive as a reward for participating in proxy-staking or voting
with their tokens in a consensus mechanism. The key is that the
staker has received something with a known market value.

Importantly, when a token holder disposes of a crypto asset
earned through any of the above staking processes, they will also
need to work out whether they have made a capital gain or loss for
the purposes of
CGT
.

In relation to
‘airdrops’
– a tool used to distribute crypto
assets to a group of people (whether they want it or not) to try
and increase the adoption of a token, the ATO has now said the
monetary value of an established token received in an airdop is
also reportable ordinary income at the time of receipt.

Thankfully, where a
crypto project has made an initial airdrop
of tokens that is
the very first distribution of its tokens, and where there has been
no trading in the project’s tokens prior to the airdrop, that
is there is no market value, the ATO will consider that the token
holder does not derive ordinary income or make a capital gain at
the time of receipt, but if the tokens are free (which is usually
the case under an airdrop), they have a cost base of zero and the
whole of any subsequent sale or swap for any amount above zero will
trigger a
CGT event
, but the tokens will be eligible for a normal 50% CGT
discount if the assets are held for longer than 12 months.

This guidance follows the repeated requests from the industry
for clearer guideance from regulators in the absence of legislative
reform. In June this year, federal Treasurer Jim Chalmers issued a
statement confirming that the Labor government planned to introduce
legislation clarifying the tax treatment of digital currencies.

Last week,
Treasury released an exposure draft
of the legislation which
seeks to clarify that digital currencies will not be taxed as
foreign currency under Australian law, in line with the
Administrative Appeals Tribunal’s decision in
Seribu v Federal Commissioner of Taxation
. That
submission process continues and with the Board of Taxation
continuing their review, we expect to see more clarification of the
Australian tax position regarding crypto in coming months.

Square peg round hole: Gensler urges registration of
crypto-assets despite regulatory mismatch

The Chairman of the United States Securities and Exchange
Commission (SEC), Gary Gensler, has reiterated his
reductive approach to the regulation of cryptocurrency and digital
assets in a speech titled ‘Kennedy and
Crypto
‘.

Presented
as part of ‘SEC Speaks’
, Gensler opened by recognising
past leaders of the US and its landmark investor protection
legislation: The Securities Act of 1933, the Investment Company Act
of 1940 and the Securities Exchanges Act of 1934. Gensler repeated
his previous views that he considers that almost all crypto-asset
tokens are ‘securities’ (noting the speech does not purport
to be official SEC policy) and that:

Nothing about the crypto markets is incompatible with the
securities law. Investor protection is as relevant, regardless of
underlying technologies.

Few could disagree with the second sentence, but the first
sentence raises serious concerns. Despite instructing his SEC staff
to encourage entrepreneurs to have their tokens registered and
regulated under existing securities law, only a tiny
‘handful’ of crypto tokens have managed to be registered as
securities, which suggests some incompatibility must exist. Indeed,
in many cases, the nature of and rights attaching to crypto-assets
are quite different from traditional securities. In the years since
the SEC’s Munchee
Order
, the DAO
Report
and other ‘regulation by enforcement’ actions
have hit US crypto projects, standing in stark contrast to
Gensler’s invitation to projects to ‘come in’ and
register.

Interestingly, Mr Gensler’s approach is also at odds with a
number of significant bipartisan reform proposals currently making
their way through the US Congress, including the
draft Responsible Innovation Act
and the
draft Digital Commodities Consumer Protection Act
.

Despite the reality of crypto-asset regulation not being fit for
purpose in the US becoming increasingly clear, Gensler remains
steadfast in his view that:

Not liking the message is not the same as not receiving it

It appears that Mr Gensler, unlike other Commissioners, wants
innovation in digital assets only to occur in the narrow ways that
laws designed for a centralised financial system will permit.
Commissioner Pierce has been praised for calling out the lack of
regulatory fit in the US, and pressing for sensible reforms and
Commissioner Uyeda in a
recent speech
also said:

Rulemaking can be challenging and time-consuming. It may be
tempting to develop “new” interpretations of existing
statutes and rules and apply them through enforcement action. This
temptation should be avoided.

He continued in noting the two key issues are:

does the crypto asset constitute a security and, if so,
how do market participants comply with the federal
securities laws and the Commission’s rules
. To date,
the Commission’s views in this space have been more often
expressed through enforcement action. This is an example of a
situation where regulation through enforcement does not yield the
outcomes achievable through a process that involves public comment.
(emphasis added)

Many jurisdictions face similar problems, with a substantial
education gap meaning that often the suggestion is made that
cryptocurrencies should be simply regulated like a
“normal” financial product. The fundamental differences
between centrally issued and controlled financial products with
walled markets permitting trading only under strict rules with
carefully admitted participants, and the freeflowing nature of
global permissionless blockchains prevent an easy fit.

Few major regulators have set out for crypto projects a path by
which they can comply with securities laws and overcome
requirements which are entirely sensible for a centralised system
but become illogical when applied to a decentralised system. The
current approach of some is to suggest that there is only
decentralised theatre at work, and in truth small groups of
centralised individuals operate crypto projects. While that may be
true for some projects (a great number in the early stages of a
crypto project as they journey towards fully decentralised
decision-making), it is not the case for many more established
projects.

The SEC has a history of crypto ‘regulation by
enforcement’, launching a range of investigations and lawsuits
against crypto projects such as Coinbase
and Uniswap
Labs
. This is despite concerns voiced by the industry as to the
lack of clear guidance as to what features the SEC will or will not
regard as indicative of whether a crypto-asset is a security and
examples of how a crypto project can register under existing US
securities laws. Coinbase’s General Counsel recently
called out
the regulatory mismatch and suggested a proper fit
for purpose regime be developed.

To date, there is no example provided by the SEC as to how a
decentralised crypto project could comply with US securities laws,
and projects are left with a choice to try and register their
tokens as securities (and accept the significant costs, delays,
practical limitations and uncertainty as to how or whether they can
in fact comply), avoid the US market entirely, or risk being the
next target of the SEC.

At some point, the “technologically neutral” approach
taken by regulators in relation to crypto-assets may need to be
revisited. Laws have had to address specific technologies of cars,
radio, mobile phones, tv and the internet, and it seems
increasingly likely that the activity based regulation of financial
services will need to evolve to accommodate both investor and
consumer protection and the technological innovations brought by
decentralised technologies.

Coinbase Insider Trader Pleads Guilty

Earlier this week, Nikhil Wahi, the brother of a former Coinbase
product manager, has
pleaded guilty
to one count of conspiracy to commit wire fraud
in connection with a scheme to commit insider trading in crypto
assets. The charge carries a maximum sentence of 20 years.

Nikhil Wahi was
arrested
in July this year,
after being alleged to have used confidential Coinbase information
about which crypto assets were about to be listed on Coinbase
.
Nikhil Wahi had transferred funds, crypto assets and proceeds
through multiple anonymous Ethereum blockchain wallets.

Damian Williams, the United States Attorney for the Southern
District of New York,
said
:

Less than two months after he was charged, Nikhil Wahi
admitted in court today that he traded in crypto assets based on
Coinbase’s confidential business information to which he was
not entitled.

For the first time ever, a defendant has admitted his guilt
in an insider trading case involving the cryptocurrency
markets.

Today’s guilty plea should serve as a reminder to those
who participate in the cryptocurrency markets that the Southern
District of New York will continue to steadfastly police frauds of
all stripes and will adapt as technology evolves. Nikhil Wahi now
awaits sentencing for his crime and must also forfeit his illicit
profits.

Coinbase employees were frequently exposed to confidential and
privileged information prior to the public being informed about
tokens to be listed on the exchange. For almost a year, Nikhil Wahi
used unanimous Ethereum blockchain wallets to buy up crypto-assets
after being tipped by his brother Ishan Wahi before they were
publicly listed on Coinbase. The crypto assets were then sold for a
profit.

Coinbase had a strict internal process that prohibited its
employees from sharing any confidential information with others, as
this could impact the market price. Nikhil Wahi’s charge was
one of three that were the first ever crypto insider trading
tipping scheme prosecuted in the US. Ishan Wahi, a former Coinbase
product manager and Nikhil’s brother, was charged for allegedly
tipping off Nikhil Wahi and Sameer Ramani (who was a friend of
Ishan Wahi) about upcoming token sales,
making profits of USD$1.1M
by front running listings in over 25
tokens.

As part of the prosecution, the SEC had made allegations that
the tokens involved in the insider trading scam were securities
under US law. At the time Coinbase was
critical of the SEC investigation
, citing the lack of clear
guidance and rules for defining cryptocurrencies as securities
under US law.

Coinbase’s Chief Legal Officer, Paul Grewal
said
to Coindesk:

We are confident that our rigorous diligence process –
a process the SEC has already reviewed – keeps securities off
our platform, and we look forward to engaging with the SEC on the
matter.

Nikhil Wahi is scheduled to be sentenced in December for his
crimes and the prosecution of the others continues. The question of
whether the tokens involved in the trading scandal are securities
or not will not be decided by the guilty plea, but will have to
wait for another case as the SEC continues “regulation by
enforcement”.

KKR jumps into Avalanche for PE offering

On Tuesday, global investment firm, KKR & Co,
announced
a partnership with digital asset management firm, Securitize, to tokenise its
private equity fund “Health Care Strategic Growth Fund
II” on Avalanche, a public blockchain network. KKR offers
alternative asset management, capital markets and insurance
solutions to its clients. Securitize manages and tokenises
institutional-grade products, leveraging blockchain based capital
markets and financial solutions.

Commenting on the development Securitize CEO, Carlos Domingo,
said
:

‘This new fund is an important step toward democratizing
access to private equity investments by delivering more efficient
access to institutional-quality products…Tokenization has the
potential to address many of the biggest challenges for individual
investors seeking to participate in private market investing by
enabling technological and product innovations that were not
possible before’.

The Health Care Strategic Growth Fund II is a
$4 billion fund
and invests in growing healthcare companies in
North America and Europe. The development is facilitated by
Avalanche, an eco-friendly smart contract platform based on proof
of stake technology. Investors in the new fund will have to hold
the security for
at least a year
prior to selling it to other qualitied
purchasers on a secondary market managed by Securitize. Tokenising
private equity investments should allow individuals to access
investments in smaller amounts, enhance operational efficiency and
facilitate greater liquidity.

Managing Director and Co-Head of KKR, Dan Parant,
commented
on the partnership:

‘With its ability to digitize operational inefficiencies
and increase ease of use for individual investors, blockchain
technology has the potential to play an important role in the
future of private markets… We’re excited to be working with
Securitize to be an early adopter of this technology and look
forward to opening our investments up to a new audience of
investors’.

KKR’s new partnership follows a string of recent
announcements by institutional players who are looking to leverage
the benefits of blockchain technology for clients and enhance their
digital assets offerings, such as
State Street
,
Blackrock
and
Barclays
. Despite the onset of crypto-winter, institutional
interest in blockchain technology continues to grow unabated.

The content of this article is intended to provide a general
guide to the subject matter. Specialist advice should be sought
about your specific circumstances.





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