Signals: Binance's $4.3B settlement

Hey fintech friends,

The debate about how to regulate crypto rages on in courts across the US. As of this June, Coinbase has been fighting SEC allegations that it operates an unregistered securities exchange, Grayscale's successful petition for a GBTC review has sparked speculation that spot Bitcoin ETFs will soon be approved for trading, Circle's planned IPO is drawing close attention from observers after the SEC reportedly blocked its proposed SPAC last year…

... and then there’s the Binance settlement. On Tuesday it was announced that Binance, the world's largest cryptocurrency exchange, is pleading guilty to violations of Anti-Money Laundering, money transmitter, and sanctions regulations in a $4.3 billion deal with the Department of Justice that constitutes one of the biggest corporate settlements in US history. Separately, Binance is disputing a suit brought by the SEC alleging that it operates as an unlicensed trading platform, and that Binance commingled customers' funds with those of its own trading entity– allegations similar to those made against Kraken in an SEC suit filed Monday.

Much like FTX and Three Arrows, Binance's settlement isn't so much an indictment of crypto as it is another case of one company’s good old-fashioned misconduct. Financial regulations are imperfect– especially in their application to crypto companies– but this week was another refresher on why these rules exist in the first place. It also highlights the need for regulators to (reasonably) define how crypto fits into existing regulatory frameworks, and underscores how crypto exchanges’ moves towards decentralization can drive greater transparency across the industry (with caveats, but we’ll get to these).

Crypto is a resilient industry that’s no stranger to events like this week’s. Let's dive into the Binance settlement and what it means for crypto governance going forward.

The DOJ's settlement announcement outlines Binance's track record of illegally serving customers in the US as it generated $1.35 billion in trading fees from US-based customers. Specifically, violations include:

Compliance folks reading this, take a breath.

It seems implausible that Binance made it this far without getting dinged by authorities, but these violations follow a pattern of behavior observed since Binance's founding in 2017. Binance employees have been caught helping users in China onboard by coaching them to evade controls in Binance-hosted chatrooms. The SEC's case that Binance operates an unlicensed exchange further alleges that Binance engaged in wash trading (artificially inflating its trading volumes to drive up prices) and that Binance diverted customer funds to a trading entity owned by its founder and now-former-CEO, CZ. I'm no expert on what constitutes an unlicensed regulatory exchange in the USA, but an internal message from Binance's Chief Compliance Officer saying “[w]e are operating as a fking unlicensed securities exchange in the USA bro” probably isn't a great look.

As part of its settlement Binance has agreed to exit the US, will continue to operate internationally with independent monitoring, and CZ is stepping down as CEO, but regulatory questions still loom across the broader industry. The SEC's cases against Binance, Coinbase, and Kraken will seek to define how cryptoassets on these platforms are subject to oversight by the SEC, CFTC, and/or Treasury. Ideally, regulators would also offer a path for exchanges to register for licenses in correspondence with those decisions, but this seems unlikely given the tenor of conversations so far; just in August, Bittrex was forced to shutter its US business over similar SEC complaints that it operated as an unregistered securities exchange, broker and clearinghouse.

For his part, Coinbase’s CEO Brian Armstrong is still pushing for regulators to find solutions that allow crypto to operate safely within the confines of existing US regulation (i.e. not force exchanges to less-regulated offshore jurisdictions):

Crypto exchanges are also taking steps to decentralize offerings in line with this ethos of greater transparency. Coinbase has made concerted efforts to move payments on-chain through its self-custodial Coinbase Wallet and Onchain Payment Protocol. Binance’s Web3 Wallet would similarly offer users and regulators better traceability on transactions.

3 takeaways that crypto companies, regulators, and observers can draw from Binance’s settlement:

1) Compliance issues showcase failures on the part of crypto companies AND their regulators. Opportunities for misconduct abound in every industry. Binance’s story is only the latest example of malfeasance in the crypto industry, but financial regulators also suppressed their own ability to step in by not giving Binance a reasonable framework to operate within in the US. In absence of clear regulatory guardrails (e.g. licensing requirements for various cryptoassets, a less cumbersome process for obtaining state-by-state MTLs), compliance failures are only poised to recur.

2) Decentralization efforts are largely compatible with regulators’ goals. Most crypto transactions still take place on centralized exchanges which is ironic because, you know, it’s “DeFi,” but the tide has steadily been turning towards on-chain transactions:

Regulators should embrace this; if all of these crypto transactions are taking place on a transparent ledger between KYC’d wallets, it becomes WAY easier to monitor for financial crime than it is in today’s world of fragmented financial databases and banks self-reporting suspicious activity. Some of the largest crypto exchanges are moving towards user-custodied wallets and on-chain payments, which could also play a crucial role in supporting the rollout of Central Bank Digital Currencies (CBDCs).

3) Some aspects of decentralization are very INcompatible with regulators’ goals. Regulators will never approve of a crypto schema that enables true “privacy”. A core tenet of AML is that for payments of a certain size (say, $10,000), every institution in the payments chain should be able to identify A. Where a payment came from, and B. Where the payment went. Obviously most crypto transactions on a decentralized ledger can be traced this way, but how do you ensure that counterparties are KYC’d (and therefore identifiable to regulators)? Even if all wallets are KYC’d, how do you address obfuscation through Layer 2 mechanisms like zero-knowledge protocols? Even if you manage to break ZK protocols through, say, quantum computing (now we’re starting to put a lot of faith in the US government’s capabilities, but do it for the plot), how do you overcome crypto-laundering privacy coins like Monero and Zcash? Regulators are still a long ways away from answering these questions, but won't get any closer by beating down every exchange that attempts to offer crypto compliantly in the US.