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"Reading the Merkle Leaves" - QuadrigaCX, Kik, & Bitcoin ETFs

Phil Liu, Esq
Feb 5, 2019

I am a co-founder of Arca, a financial services company designing institutional-grade digital asset investment products. This is the first of many thoughts on blockchain and regulation. As a securities lawyer and accountant for 21+ years, designing innovative financial products, I have a unique perspective on blockchain and crypto regulation.

Recent events predict that regulators will continue to press enforcement of existing securities laws.

Last week, Canadian exchange QuadrigaCX admitted in an insolvency filingthat they had lost (or can’t locate) the private keys to the cold storage wallets of their customers. Now, more than $190 million worth of their customers’ crypto is potentially lost. In a “palm on face moment”, the company revealed, after the sudden death of QuadrigaCX’s owner while traveling in India, that he was apparently the only person with access to the private keys.

QuadrigaCX was one of the largest exchanges in Canada and had approximately 115,000 customer accounts. It is unbelievable that any legitimate company could allow this to happen especially after the Mt.Gox fiasco where it was revealed that Mark Karpeles was running the site with, metaphorically speaking, servers in his home closet. Had the exchange been an SEC-registered broker/dealer, it would have been required to comply with business continuity, asset segregation and regulatory capital rules that may have protected its investors. Instead, it looks like QuadrigaCX’s customers are left holding the bag.

Next up, Kik Interactive and their Kin ICO filed a response to a Wells Notice for their September 2017 Kin ICO. Kik Interactive makes a Telegram-like messenger app that promotes message privacy. They created a cryptocurrency called “Kin” which would be used by advertisers in its messenger app to pay for interacting with Kik’s users. Additionally, Kin could be integrated by third parties as a payment currency. The Kin ICO (which they called a “token distribution event”) was conducted in two parts — one to private investors via private placement (which seems to be ok) and another public distribution (which the SEC took issue with). I read the Wells Response and found it completely unconvincing. It’s incredulous that their lawyers could not convince their client to not publish it. Since it is out in the public domain, I think it is fair game to look closely at some of their arguments.Kin Distribution Event

In July 2017, the SEC issued its findings of an investigation into DAO tokens (the “DAO Report”) that goes into depth about why the DAO token offering was, in their view, a securities offering. This was a real “shot across the bow” moment for everyone else considering offering securities. Rather than take a step back, Kik decided to go ahead with its ICO in September 2017. Consequently, they raised a lot of money and apparently, it is reported by The Block, promoted the tokens as appreciating in value as a reason for people to turn over their money — a hallmark of the definition of a security. The company presses the usefulness and utility of the Kin tokens, yet just because a token may have some (or a lot of) utility does not preclude a finding that a distribution event is a securities offering. The Wells Response is ripe with superficial arguments and, to this seasoned Wall Street-trained lawyer, seems like desperation on the part of the company’s outside lawyers to mount some sort of defense. Reminds me when Bush 43’s Secretary of Defense Donald Rumsfeld once said, “You go with the Army you Have, not the Army you want.”

Kik is backed by a who’s who of big name venture capitalists so I’m surprised no one in that stable stood up and vetoed the ICO. There are also big names in crypto telling their followers on Twitter and Medium to “stand with the company” in the face of unfair regulation. But, if there was a clear cut case of enforcement, Kik might be it — they raised a lot of money; their Kin tokens lost a lot of value (peak to trough); small investors got screwed; it was done after the DAO Report warning; the media blitz, etc., etc.

The contradiction of a Bitcoin ETF

VanEck and CBOE resubmitted their Bitcoin ETF proposals and there are a bunch of similar ones on the SEC’s docket. Does anyone else find it ironic that many decentralist crypto-promoters are demanding the approval of a Bitcoin ETF? Anyone promoting crypto as a decentralized store of value or medium of exchange not subject to any (corrupt) government’s control on the one hand and then vigorously pounding their figurative chest demanding a Bitcoin ETF be approved on the other hand just lays bare their skewed world view. The point of a Bitcoin ETF is to allow the masses ensconced in the existing (corrupt) financial system to participate in the decentralized vision of Bitcoin. But wrapping a decentralized product in a centralized vehicle just destroys the purpose of decentralization. Don’t get me wrong, I’m not a die-hard decentralist — I’m a pragmatist and supporter of anything that accomplishes to get greater adoption of crypto among mainstream investors is a win for the industry. However, the cynic in me would say that these decentralist crypto promoters have an agenda — it’s less about decentralization and more about increasing their own wealth for the crypto they hold. Kinda reminds me of a book by George Orwell — Animal Farm…

Building financial products on the blockchain is a finance-first proposition

My experience thus far in this space is that everyone wants to be in charge. Especially when it comes to building financial products at the intersection of technology like blockchain. For example, the question of whether a stablecoin is more a financial product or a technology product. Ask a finance guy like me and I’ll tell you that finance and structuring are what drives the technology. Ask a tech developer and he or she will tell you that the product is technology and it’s up to the finance guys and lawyers to keep them out of trouble. But my take is that there are other, non-tech, variables at stake when it comes to designing a financial technology product. You can’t build the tech and then figure out how to make it work in the financial system. First, you have to figure out what’s missing in the financial system then build the solution. While things may seem convoluted and inefficient, they are like that for a reason. Every financial crisis has resulted in a change in the law. Every change in law has resulted in a complication to the financial system. You can’t start from scratch and throw away the existing financial structure just because the technology allows you to do that. Blockchain technology can make existing financial structures more efficient but you still have to respect the regulatory foundations upholding the existing financial structures. If you don’t understand that, you shouldn’t be leading the build out.

Final thought: letting non-accredited investors participate in private offerings

There are a lot of complaints about how rigged the U.S. financial system is when it comes to restricting retail, non-accredited investors from participating in private deals. I call b.s. on that; most everyone doing the complaining are the companies trying to push their company and looking for capital. How many retail investors are complaining they can’t participate? True, there are some. But they are also the first to complain when they lose their shirts. For every Uber and other unicorns, there are a thousand Theranoses. Rather than focus on allowing more retail investors to participate in private deals, think about qualifying a retail-accessible investment when the company is finally ready to accept retail investors and provide the necessary regulatory disclosures.

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©2018 by Arca Funds Past performance is not indicative of future results. Investors should carefully consider the investment objectives, risks, charges and expenses of Arca "(The "Funds"). This ad other important information about the Funds are in the respective Fund's offering documents which can be obtained by entering Arca Private Investor Portal. All of the offering documents should be read carefully before investing. Disclaimer: This commentary is provided as general information only and is in no way intended as investment advice, investment research, a research report or a recommendation. Any decision to invest or take any other action with respect to the securities discussed in this commentary may involve risks not discussed herein and such decisions should not be based solely on the information contained in this document.