The Breakdown - Bank Regulators Say ‘No Operation Choke Point 2.0! Seriously! Believe Us!’

Episode Date: February 25, 2023

Apparently all our angry howling worked. This week, the Office of the Comptroller of the Currency, Federal Deposit Insurance Corporation and the Federal Reserve Board of Governors, while nominally speaking about the liquidity risks of crypto banking, took pains to say they weren’t saying banks weren’t allowed to work with crypto companies. As you might guess, many in the crypto space aren’t buying it. We thinks the Regulator Doth Protest Too Much?    Enjoying this content?   SUBSCRIBE to the Podcast Apple:  https://podcasts.apple.com/podcast/id1438693620?at=1000lSDb Spotify: https://open.spotify.com/show/538vuul1PuorUDwgkC8JWF?si=ddSvD-HST2e_E7wgxcjtfQ Google: https://podcasts.google.com/feed/aHR0cHM6Ly9ubHdjcnlwdG8ubGlic3luLmNvbS9yc3M=   Join the discussion: https://discord.gg/VrKRrfKCz8   Follow on Twitter: NLW: https://twitter.com/nlw Breakdown: https://twitter.com/BreakdownNLW     “The Breakdown” is written, produced and narrated by Nathaniel Whittemore aka NLW, with editing by Michele Musso and research by Scott Hill. Jared Schwartz is our executive producer and our theme music is “Countdown” by Neon Beach. Music behind our sponsor today is “Foothill Blvd” by Sam Barsh. Image credit: Stevanovicigor/ Getty images, modified by CoinDesk.  Join the discussion at discord.gg/VrKRrfKCz8.   Join the most important conversation in crypto and Web3 at Consensus 2023, happening April 26-28 in Austin, Texas. Come and immerse yourself in all that Web3, crypto, blockchain and the metaverse have to offer. Use code BREAKDOWN to get 15% off your pass. Visit consensus.coindesk.com.

Welcome back to The Breakdown with me, NLW. It's a daily podcast on macro, Bitcoin, and the big picture power shifts remaking our world. The breakdown is produced and distributed by CoinDesk. What's going on, guys? It is Saturday, February 25th, and that means it's time for the weekly recap. One quick note before we dive in, there are two ways to listen to The Breakdown. You can hear us on the Coin Desk podcast network, which comes out every afternoon alongside other great CoinDesk shows. Or you can listen on the Breakdown-only feed, which comes out a few. hours later in the evening. Wherever you're listening, if you're enjoying the show, I would so

appreciate it if you would take the time to leave a rating or a review. It makes a huge difference, and I appreciate each and every one. All right, well, happy weekend all. And man, oh man, is there a lot to follow up on for this recap? It seems like every story we've covered this week has some additional nugget to include, so let's dive in and let's start with Coinbase's announcement of base. One of the things that we discussed about this new entrance of Coinbase into the L2 space was how it seemed like their aggressive, no-token approach was at least in part trying to position Coinbase in the regulatory clear. At least that was many people's first reading of it.

However, some have argued subsequently that the move was still problematic from a regulatory perspective. Gabriel Shapiro, the general counsel at Delphi Lab, said many people seeing some kind of regulatory strategy in Coinbase's L2. No idea if that is Coinbase's primary motivation or not, but if so, in my opinion, it is a massive miscalculation. Let me explain. Base is a stage zero optimistic roll-up,

aka essentially a glorified enterprise blockchain that could become decentralized in the future. Coinbase hasn't added a token, instead using ETH, which provides some regulatory cover. SEC could claim any new token as a security, but in my opinion not enough. Keep in mind, Coinbase is the only significant SEC-registered company in crypto.

This very anti-crypto SEC is likely watching every move Coinbase makes looking for vulnerabilities. A centralized layer 2 that trades lots of tokens any number of which could be alleged securities or does lots of defy transactions that arguably might alleged to be regulated, i.e. security swaps, opens the door to the SEC making new kinds of secondary market claims. Consider that the SEC has already proposed to change the definition of securities exchange to cover communication protocols and the fact that this L2 will essentially just be a messaging protocol and you get some rough intuitive sense of the danger.

It's one thing for the SEC to let optimism at all sit on the back burner, while the SEC waits to see how big they get and racks up wins against token, quote-unquote, issuers. It's quite another matter for the SEC to let Coinbase an SEC registrant do the same. In my opinion, this will accelerate the SEC's secondary market agenda regarding blockchain securities issues because they can't let an SEC registrant get away with, quote-unquote, potential violations, and build up a legal arbitrage strategy right under the SEC's nose. Many L2s have centralized aspects, and the team's running core infrastructure will have a hard time defending allegations that they are functioning in broker-dealer or facilitation roles regarding market transactions that may involve securities. Overall, if indeed Coinbase's motives are regulatory in nature, it's not only a bad step for them, but could threaten dangerous collateral damage to the rest of the ecosystem.

If their moves are regulatory, they should have waited till all the infrastructure can be really decentralized. I thought this was a super interesting take about how this isn't just a risk to Coinbase potentially, but a risk to the industry as well. And staying on the regulatory theme, another big point of discussion, really all year, has been the banking system closing in around crypto, something that many of us have called Operation Chokepoint 2.0. Part of the evidence for that was the early January advisory note from the key U.S. bank regulators, including the FDIC, the OCC, and the Federal Reserve, effectively saying that it was unlikely

that banks would be able to engage with crypto assets in a, quote, safe and sound manner. As a total aside, one thing that basically gives me an aneurysm is the way in which regulators pick up on these memes of specific phrases that have no implicit meaning in just sound good and press releases, and then they beat them to death. Safeness and soundness is the big one now with everyone talking about whether crypto can be engaged in a safe and sound manner. WTF does that even mean? It doesn't matter because the point of all of this political engagement isn't really

getting crypto to engage in a safe and sound manner. It's to sound smart for constituents in your next election. So anyways, we got another statement, and this one was honed in on liquidity risks. So the statement again came from the Federal Reserve Board of Governors, the Federal Deposit Insurance Corporation, and the Office of the Comptroller of the currency. This time it focused on the risks posed by rapid withdrawals at crypto firms that impact the deposit base of the banks that serve them.

The statement identified that both holding deposits related to crypto firms' customer holdings, as well as holding stable coin reserve balances could open a bank up to liquidity risks. The regulator's risk management suggestion is that banks dealing with crypto firms should be more aware of the industry-specific factors that could drive a wave of withdrawals, as well as stress testing their liquidity needs

under such a scenario. Now, there are two big things to note here for me. The first is that a key part of the liquidity risk that comes with crypto banking is actually driven by the fact that the advice of regulators, like the FDIC and the OCC and the Federal Reserve, has been not to bank crypto companies.

That means that only a few have been willing to do it, which means naturally that those firms get a huge amount of business from the industry, which means, of course, that they're hyper-concentrated in the crypto sector and thus much more at risk when the crypto is going through some painfully leveraging event. Putting it more crisply, if Silvergate is the only bank that will bank crypto companies, of course they're going to get a ton of business from that, and it's probably going to represent a huge part of their overall deposit base, And so when those companies are dealing with some big cataclysmic crypto event, a relatively

bigger portion of Silvergate's deposits are going to flow out, then would be the case if the crypto industry's banking was distributed across, I don't know, a dozen banks instead. This is exactly the sort of catch-22 gotcha that makes people so infuriated about the entire crypto banking situation. The second thing that it brings up is whether there should be different rules for crypto asset deposits as opposed to general deposits as related to fractional reserve banking. Certainly, I think that we're going to see regulation eventually. at some point, saying that things like Stablecoin Reserve balances have to be one-to-one,

no matter what, which obviously cuts down a lot of this liquidity risk because the liquidity just sits there. Anyway, I could rant all day on that, but let's move to another really interesting piece of this statement. Maybe the most intriguing part was multiple references that appeared to address industry concerns of a bank in crackdown. The regulators kind of tried to walk back or at least clarify their previous statements about this idea that cryptoactivity was unlikely to be in line with, quote, soundness

and stability principles. In this statement, they wrote, quote, the statement reminds banking organizations to apply existing risk management principles. It does not create new risk management principles. Banking organizations are neither prohibited nor discouraged from providing banking services to customers of any specific class or type, as permitted by law or regulation. Now, this clarification was considered so important that it was duplicated in the press release about the brief as well. The industry definitely picked up on this clarification. Dante DeSparte, who's the chief strategy officer at Circle writes, Today, the Fed, the FDIC, and the OCC issued another joint statement to U.S. regulated banks.

It makes a salient point that it is not unlawful to bank a novel sector, even if its deposit base might prove flighty as we saw with crypto in 2022. Critically, it goes on to put the onus on banks to demonstrate adequate risk management in exposing their balance sheet to crypto-related deposits. It's worth restating that crypto, like banking, is not monolithic. And while bankers often protest too much about fintech and crypto, responsible innovation in this space is an all-ship's rising proposition

benefiting U.S. banks and the economy. So obviously this means we're all cool and there's no Operation chokepoint 2.0, right? Absolutely not, according to Nick Carter. Nick writes, it's not confirmed until they deny it. It's patently obvious that banks are discouraged both formally and informally from banking crypto clients.

We have abundant evidence of that. Glad they felt compelled to put out a statement means we got to them. Austin Campbell and adjunct professor at Columbia Business School also points out that, of course you can bank crypto companies, but that, quote, they'll just subject you to constant examination and sane capital requirements and level of scrutiny orders of magnitude higher than safe things like checks notes, subprime, MBS. It's not illegal, it's uneconomic. That's the game. Now, to the extent that you're looking for something optimistic here,

I don't think that there's some big about-face in how banks and bank regulators feel about the crypto industry. I think what's happening is that the political pressure exerted by just how God-de-a-loud this industry can be is actually working. The fact that we have congressmen and senators who are actively talking about in Operation Chokepoint 2.0 is an example of political pushback at work. It doesn't mean that this battle is nearly over, but when you're dealing with a type of operation that is sort of sub-legal, or legally gray, which any sort of pressure to have the banking system deny a lawful industry is, then making it loud and pointing a light on it can do actual work. Still, at this point, one could be forgiven for quoting that famous old trope.

Watch what they do, not what they say. And for that, we have to come back to Caitlin Long and Custodia. Join CoinDesk's Consensus 2023, the most important conversation in crypto and Web3, happening April 26 through 28th in Austin, Texas. Consensus is the industry's only event bringing together all sides of crypto, Web3, and the Metaverse. Immerse yourself in all that blockchain technology has to offer creators, builders, founders, brand leaders, entrepreneurs, and more.

Use code breakdown to get 15% off your pass. Visit consensus.coindex.com or check the link in the show notes. On Thursday, the Federal Reserve Board announced that it had rejected Custodia Banks' bid for Fed supervision for a second time after denying the application last month. The Fed Board voted against reconsidering the application. According to an anonymous list of votes, the decision was unanimous in line with the prior decision. Thursday's brief press release said, quote, the board previously concluded that the firm's application as submitted was inconsistent

with the required factors under the law. The board's rules permit an applicant to request that the board reconsider its application decision. In its original rejection, the Fed board cited significant safety and soundness risks, there it is again, by the way, and claim that custodia had insufficient risk management frameworks in place. They also noted that, quote, the firm proposed to engage in novel and untested crypto activities. Caitlin Long tweeted, this is just nuts. The Fed issues guidance today saying banks shouldn't lend out deposits made by their crypto customers

due to the liquidity risk and should hold cash to back the deposits instead, while simultaneously skewering Custodia Bank for proposing to do just that. Still, Custodia is not tapping out in its fight to gain access to the Fed system and continues to pursue legal action. Earlier this week, Custodia amended its complaint against the Fed, which claims that the central bank missed mandatory deadlines to decide Custodia's application. The federal court judge overseeing the case has now denied the Fed's motion to dismiss, setting the stage for the lawsuit to proceed to trial.

And staying on this fun theme of people being frustrated at the government, James Murphy at Meta Lawman tweeted, The SEC has stepped in to block the Binance U.S. bid for Voyager assets. The proposal has 97% support from creditors. The SEC argues that the plan would violate securities laws because Voyager would sell digital assets to fund distributions to customers. Incredible. So what's going on?

Well, the billion dollar deal by Binance U.S. to acquire the assets of bankrupt crypto lender Voyager is being delayed again, this time by fresh objections lodged by the SEC, the New York Department of Financial Services, and the New York Attorney General, Leticia James. The filing lodged on Thursday claimed that the deal could be discriminatory and unlawful. The core of the SEC's objection is that it considers some of the tokens held by the Voyager estate to be securities, so the sale of those tokens to fund the distribution could be in violation of securities law. This is despite the lack of any legal case or rulemaking from the SEC defining those tokens as securities. The SEC claims that Voyager,

quote, have yet to demonstrate they would be able to conduct such sales in compliance with the federal securities laws. Now, New York regulators are objecting on the basis that Voyager may have operated in New York without the correct licensing. They claim that Voyager, quote, onboarded New York customers and thus illegally operated a virtual currency business within the state without a license. The NYDFS claims that this would make the plan discriminatory as New Yorkers wouldn't be able to reclaim their crypto for at least six months, while Binance U.S. gains approval

in the state. Voyager, for their part, has argued that the actions of regulators are, quote, hypocritical, as they claim the finance deal represents the best possible outcome for creditors, and that regulators themselves are limiting the ability to move forward with the plan. As Murphy pointed out, Voyager creditors have now voted on the deal with over 97% of them giving the plan the go-ahead, and one could reasonably question at this point how the blocking of an agreed-upon bankruptcy resolution could possibly be in line with regulators' mandates for investor protection. To get a sense of how people are feeling, here are Scott Melker, i.e., the Wolf of All Streets, comments.

DFS, the Attorney General of New York. They're using Voyager creditors as pawns. Not only are they failing to protect anyone, they're actively working against the interests of people who are financially hurting already. There is no Voyager. Funds held by the company belong to creditors. Any suit against the company will require lawyers the creditors will pay for. They had ample opportunity to punish Voyager when it was operating. Now, it is simply raiding the coffers of creditors. Now at this point, there is still so much that we haven't had a chance to cover this week. We got FOMC meeting notes. We had a hotter than expected inflation print on Friday, but I think I'm going to do a full macro workup early next week instead of tacking it on here. Instead, I'm going to

close with something that is actually exciting. On Thursday, the Montana State Senate passed a bill seeking to enshrine a range of protections for Bitcoin miners into law. The bill, which passed by an overwhelming 37 to 13 majority in the Senate, would protect at-home mining, prevent discriminatory utility rates for miners, and stipulates that crypto used in payments. will not be subject to additional taxes. The bill will now be passed to a House vote before becoming law. The bill, dubbed the Right to Mine Bill, was partly conceived as a response to local zoning ordinances in Missoula County passed in 2020, which required all Bitcoin miners to build renewable energy assets equivalent to their energy consumption. This new bill would

strip local governments of their ability to use zoning laws against active Bitcoin mining operations or to effectively prohibit at-home mining. The bill is one of the first major pieces of legislation passed as a result of advocacy efforts from the Satoshi Action Fund, which has been touring the country speaking with local and state governments to assist with drafting rational Bitcoin mining policy. The fund's founder, Dennis Porter, said, quote, Satoshi Action Fund is pleased with the result in Montana. It is critical to provide regulatory certainty for the mining industry. We've been working diligently to ensure that Bitcoin miners have the right to mine across the USA. There is still more work to be

done in Montana, but as a new organization, we feel confident about the progress we have made. State Senator Daniel Zolnakov, the primary sponsor of the bill, said, quote, This is common-sense legislation that protects digital asset mining businesses from discrimination, not face from other industries. These protections will plant a flag in Montana that we are open to embracing the digital asset mining industry. Alex Brammer, the director of strategy and asset optimization at Talon Energy, said, state by state, that dominoes are falling and the lines are being drawn. Bitcoin mines employ hundreds of people directly and indirectly at one mine, and we provide valuable skilled IT jobs to local communities that otherwise don't.

have them. States that see this and incentivize it are going to win. Big congrats to Dennis and the Satoshi Action Fund. It's exciting to have a positive note to end these shows on when so much it's just regulatory BS. For now, guys, I hope you are having a wonderful weekend. I appreciate you listening as always. And until tomorrow, be safe and take care of each other. Peace.