Top Stories of the Week - 7/14

This week a district court judge’s ruling in SEC vs. Ripple, a new token design for Polygon, and the launch of Arkham Intelligence’s deanonymization market. Subscribe here and receive Galaxy's Weekly Top Stories, and more, directly to your inbox

Judge Rules XRP Tokens Are Not Securities

In ongoing litigation between the SEC and Ripple, a US federal judge ruled Thursday that Ripple’s token, XRP, does not constitute a security. “XRP, as a digital token, is not in and of itself a “contract, transaction, or scheme” that embodies the Howey requirements of an investment contract,” the ruling said.

The decision marks a partial victory for Ripple in their ongoing battle with the SEC. $728 million in direct sales of XRP to “sophisticated individuals” (i.e. institutional investors) were ruled to be an unregistered security offering for passing all three prongs of the Howey test – a ruling that does leave Ripple with some exposure. However, sales of XRP via “programmatic sales” were not considered an unregistered security offering for failing to pass the third prong of the Howey Test. “Many Programmatic Buyers purchased XRP with an expectation of profit, but they did not derive that expectation from Ripple’s efforts,” the court ruling reads. Because the court identified that the third prong of the Howey Test was not met in these instances, they cannot be considered securities. The court also ruled that Ripple’s use of $609 million in XRP as compensation for employees and other third parties, as well as sales of XRP by Ripple’s CEO and co-founder, failed the first prong of the Howey Test that there be an “investment of money.”

The SEC first sued Ripple and its two founders in December 2020, alleging that they had illegally raised $1.3 billion through an unregistered security offering. Over the past year, under SEC Chairman Gary Gensler, the agency has brought additional charges against major crypto companies, including exchanges Binance and Coinbase, for dealing unregistered securities among other charges. Crypto markets responded favorably to the court’s ruling on Ripple. Within the first three hours after the news broke, the total market cap of crypto increased by nearly 5%. XRP specifically shot up by 30%.

Our take

While this is a significant win for Ripple, the decision’s applicability to other coins is nuanced. This decision does not say that all secondary trading of cryptos are not securities. In fact, the judge specifically demurs on this question in a footnote, writing “The Court does not address whether secondary market sales of XRP constitute offers and sales of investment contracts... whether a secondary market sale constitutes an offer or sale of an investment contract would depend on the totality of circumstances and economic reality of that specific contract, transaction, or scheme.” Whether or not secondary trading of cryptos (i.e., crypto trading on exchanges) are unregistered securities transactions will require a case-by-case analysis, according to the judge. This is a major question left unanswered by the court. Given that the court ruled that the institutional sales of XRP – the offerings themselves, not the underlying token – were securities (and in the case of Ripple they may have been unregistered), it’s logical to wonder what this means for other protocols and teams who sold tokens to early institutional investors, who themselves may since have sold their tokens in secondary markets. It goes back to the old question from Bill Hinman’s 2017 speech – can a token that starts as a security (or in this case is offered in a securities transaction) transform into not a security? In the Ripple decision, the judge says that quesiton would depend on the “totality of circumstances and economic reality.” Said another way, this would have to be analyzed on a case-by-case basis. And that is what makes this ruling so negative for the SEC – rather than pursuing the wholesale approach of pressuring the centralized exchange venues to get at the securities question, the SEC will have to make a specific argument each time that tokens trading on exchanges are securities.

Another notable part of the ruling is the concept that Ripple Labs’ programmatic sales of XRP (their quarterly, scheduled sales) were not securities transactions and the underlying XRP that was emitted in those sales are not securities. While few other crypto protocols conduct programmatic sales like Ripple, many have some form of programmatic emissions, such as miner or validator rewards. If the judge’s analysis on programmatic sales hold, it would be hard to see that any tokens that enter the market by way of programmatic issuance – such as through staking rewards – could be considered securities.

The judge also says that certain “other distributions,” such as XRP given to Ripple employees as compensation, cannot be securities because they fail the first prong of the Howey Test (there is no investment of money). This line of thinking appears to provide cover for airdrops as a token distribution method that doesn’t result in a securities offering.

It’s very possible that the decision will be appealed to the 2nd Circuit, although there are some procedural hurdles. And while there is nuance, and there will be appeals, this ruling as it stands is undeniably positive for Ripple, negative for the SEC, helpful to Coinbase and Binance, and at least slightly beneficial to the other token projects that the SEC has alleged in various venues are unregistered securities.

-Alex Thorn

POL: a New Network Token Design to Unify Polygon 2.0

Polygon Labs unveils new token design for MATIC under latest network upgrade proposal. Polygon Labs introduced a new token design for its native network token to fit the new the Polygon 2.0 vision. The ZK-based protocol architecture aims to turn Polygon into a network of chains unified by a shared interoperability layer, which will use a new 'POL' token designed for coordination and incentivization of the Polygon ecosystem.

According to the whitepaper, POL will be used for validator staking across all Polygon chains, validator rewards, and governance. The initial proposed parameters for the token include: (i) an initial supply of 10bn POL tokens, (ii) a yearly emission rate of 1% of POL supply for validator rewards, fixed for 10 years before it can be adjusted downward-only via governance--i.e., never to exceed 1%, and (iii) a similar 1% yearly emission for a community-governed ecosystem fund subject to the same aforementioned limitations. A new staking layer will coordinate all Polygon chains and validators, which can potentially earn additional yield depending on the arbitrary configurations of any Polygon chain rolling into the staking layer.

Overall, the initial parameters presented aim to drive sufficient ecosystem security (target minimum staking ratio of 30-40%), sufficient validator incentives (minimum satisfactory return of 4-5%), and sufficient ecosystem support (minimum inflow of $50-100m). Assumptions behind the growth scenario include a 10-15 year period for Polygon and Web3 to reach the maturity phase based on historical tech adoption cycles, an average price of $5 for POL over the 10-year period, with an average of 19-38 txs / sec for multiple public chains and Supernets with an average transaction fee of $0.01 and lower, and an average of 100 validators per public chain and 15 validators per Supernet. If the proposal passes, the token migration would be a straightforward 1:1 exchange of MATIC to POL with a lengthy grace period of at least four years for token holders.

Our take

The new network token design is needed to fit the reimagined protocol architecture of Polygon 2.0. The 2.0 approach follows a similar “network of networks” trend across other platforms that aim to provide builders with more programmability to deploy other chains that share some level of security via the underlying infrastructure - e.g. Avalanche with subnets, Arbitrum Orbit, Optimism's Superchain, zkSync Hyperchains, or even EigenLayer. However, Polygon stands out among this group as the longest operating chain on Mainnet with the longest token history. This also means that Polygon has more technical debt compared to the other projects, so an overhaul of the existing network architecture and token design would be a greater challenge for Polygon compared to the other chains.

Operating protocols need to be able to iterate quickly and adapt to changes given the volatility and infancy of the industry. As mentioned in the whitepaper, the Polygon team assumes the broader Web3 industry reaches the maturity phase after 10-15 years. That said, this information seems to contrast with the proposed 10-year fixed emission schedules for validator rewards and the community treasury. While the 1% cap encourages a more disciplined growth spending strategy for Polygon, keeping it fixed for 10 years would prevent the network from adapting to the inevitable changes in the competitive landscape, and would also be a problem if the Polygon network and POL token doesn't meet the key assumptions laid out in the growth scenario (e.g., the target average price of POL and level of network adoption). Other implications of the POL token design would remove the 10bn max supply seen with the MATIC token (subject to 2% annual inflation) and would allow other tokens to be used to pay for gas on other Polygon networks. The POL token design is subject to changes. Still, if the proposals for the POL token and the broader 2.0 vision are eventually approved and implemented, it would certainly be an impressive achievement for Polygon.

- Charles Yu

Arkham Releases Intelligence Marketplace

Arkham, a blockchain analytics firm, faced significant criticism from the crypto community after announcing the launch of the “World’s First On-Chain Intelligence Exchange.” The new platform will match “on-chain sleuths” with buyers to “incentivize the production of intelligence as a public good.” The platform’s native token ARKM will be released on Binance Launchpad on July 18.

Buyers of intelligence will have sole access for 90 days prior to it being released to the public and both buyers and sellers are required to stake ARKM to better align incentives. Intelligence will initially be verified directly by the Arkham team. Over time, however, the project aims to decentralize the verification process, even soliciting proposals from the community. The platform also features an AI element called “DATA” where on-chain sleuths can provide data to train Arkham’s AI product.

Following the announcement, Arkham became the subject of even further pushback when a Twitter user revealed that a vulnerability in Arkham’s referral program had inadvertently doxxed user emails. According to one tweet, Arkham may have been notified of the vulnerability going as far back as January.

Arkham issued a formal response to the criticism of their new platform, highlighting the exchange is specifically built to “level the playing field” and provide “transparency [that] is missing in TradFi.” Arkham’s founder, Miguel Morel, also tweeted a apology for the referral link vulnerability, acknowledging the mistake and fix going forward.

Our take

Arkham’s new “Intel to Earn” concept was mocked by Twitter users as “Dox/Snitch to Earn” and “Doxxing as a Service.” The strong pushback is not surprising. Anonymity and privacy are core cypherpunk values and carry forth into the ethos of crypto, while Arkham’s proposed solution incentivizes users to reveal other’s identities. Although Arkham stated that personal information like addresses and phone numbers cannot be requested, others could replicate the platform without these constraints. Moreover, the “intelligence verification” process is highly centralized, relying on Arkham to confirm data accuracy.

While the Intel Exchange model is unique, the motives behind its creation are not. On-chain data analytics companies like Chainalysis and Nansen offer various types of on-chain attribution services in a centralized manner and have been in demand for years. Arkham’s new platform does not alter the fundamental reality that users still need to adopt stringent measures to maintain privacy when operating on-chain. If they can be doxed on the Arkham Intel Exchange, they can be doxed another way as well. The marketplace also offers use cases that are likely to immediately gain traction, such as assisting victims of hacks and scams in recovering their funds.

The incident highlights an ongoing debate in the crypto community over the tradeoffs between on-chain transparency and privacy. Crypto proponents often point to the public nature of blockchains as a key value proposition - especially when coupled with the opaque nature of the existing financial system. But that same transparency also exposes uninformed users to hacks and scams and raises concerns about the viability of using public blockchains for everyday use. Newer protocols leveraging zero knowledge EVMs (zkEVM) present one possible means of balancing these tradeoffs. For more information on zkEVMS, please refer to Christine Kim’s report zkEVMs: The Future of Ethereum Scalability.

- Lucas Tcheyan

Other News

• Coinbase will re-enable trading for XRP

• Coinbase Wallet has added encrypted messaging in-app using XMTP

• Coinbase's Base launches mainnet for developers, plans public rollout in August

• SEC files lawsuit against Celsius and ex-CEO Alex Mashinsky

• Circle cuts 'marginal' amount of staff to strengthen balance sheet

• Google Play allows users to earn crypto assets in apps and games

• Starknet deploys ‘Quantum Leap’ upgrade boosting network’s speed

• FTX claims portal goes live, allowing creditors to submit their claims

• CBOE reaches surveillance agreement with Coinbase for spot bitcoin ETFs

• Consensys launches Linea Layer 2 on mainnet

• Aave set to vote on launching GHO stablecoin on Ethereum mainnet