The Breakdown - Did the Fed Just Institutionalize Operation Choke Point 2.0?

Episode Date: August 9, 2023

On the same day that bitcoin surged more than 3%, the Federal Reserve released some new guidance for banks it regulates around interacting with crypto and stablecoins. Does this clear a path for more active engagement or is it just codifying Operation Choke Point 2.0's pressure on banks to stay away from the sector. Enjoying this content? SUBSCRIBE to the Podcast: https://pod.link/1438693620 Watch on YouTube: https://www.youtube.com/nathanielwhittemorecrypto Subscribeto the newsletter: https://breakdown.beehiiv.com/ Join the discussion: https://discord.gg/VrKRrfKCz8 Follow on Twitter: NLW: https://twitter.com/nlw Breakdown: https://twitter.com/BreakdownNLW

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. What's going on, guys? It is Wednesday, August 9th, and today we are talking about what to make of the Fed's new crypto policies. Before we get into that, however, if you are enjoying the breakdown, please go subscribe to it, give it a rating, give it a review, or if you want to dive deeper into the conversation, come join us on the Breakers Discord. You can find a link of the show notes or go to bit. Well, friends, yesterday was a very interesting day in crypto. As I said, we had some big news from the Fed, which we are going to dig into deeply, but we have to start on the financial side of things. Yesterday was hot fire in the markets. Let's be clear. Bitcoin rose sharply by 3% to briefly

reach over 30,000 before moderating into the evening. Ethereum enjoyed a similar, if slightly smaller bump of 2.4%, peaking at around 1870, and for both major cryptos, this move represented filling in the trough of the previous weeks and regaining levels from last month. This is the highest Bitcoin has been since July 24th. Now, of course, what's even more interesting to ask than what price Bitcoin was, is why it was pumping. Last week, as you know, was a big week for macro, with multiple events causing tailwinds for interest rate-sensitive markets.

Fitch downgraded the U.S. government, implying higher long-term rates for U.S. treasuries, as a new slim but real risk of default gets priced in. Over in Japan, after a confusing policy adjustment, the Bank of Japan settled into its new yield curve control target range. The BOJ allowed 10-year Japanese government bonds to close last week above 0.5% for the first time since 2014. Finally, on Friday, a strong jobs report showed a slightly reduced unemployment rate and robust wage growth despite the headline number of new jobs coming in below expectations.

At the end of last week, the longest term U.S. government bond, the 30-year, was trading at an implied interest rate of 4.3%. This matched its 22-year peak from last October and implied that markets believe high inflation is here to stay. Now, moving into this week. On Monday night, China released a dismal set of trade data. July imports recorded a 12.4% collapse compared to the previous year. Exports fared no better, with a 14.5% year-on-year drop exceeding the already gloomy expectations. Now, that kind of a drop in trade volume hasn't been seen in China since the initial wave of pandemic lockdowns. This implies both a deep recession for China, which has global consequences, as well as eventual

stimulus from Beijing. On that news of a major slowdown in China, global bond yields fell. The yield on the 10-year U.S. Treasury dropped below 4% after rising to almost 4.2% late last week, and European bonds showed even steeper declines with the 10-year German bond trading at a yield of 2.45%. Overall, the macro data is beginning to show signs of a much-anticipated global slow. lowdown. And while it might be too early to know for sure if the money printers will be switched back on, just the drop in long-term interest rates seems to be enough to bolster crypto markets, assuming, of course,

that macro is driving this. But what else might it be? Well, under the macro headlines, trading is picked up recently, with Wales returning to the order books. Crypto Quant CEO Ki-Yong Ju pointed out that derivatives open interest had increased by 616 million across all pairs on Tuesday price action, more than a 5% bump. Wales had positioned. heavily at 29,000 going into the day. According to Coinglass, over 65 million in short liquidations happened on Tuesday, which was the largest day of shortbursting in almost a month. Bitcoin open interest reached a new high for the year. Dan Crypto writes, Bitcoin open interest on Binance is now at its highest point since the FTX collapse. It has seen a 500 million plus increase in the past day

alone. Something is cooking. Now the main narrative driver at the moment is clearly the institutions coming in to take over the industry. Just like, listen to yesterday's episode about PayPal for more evidence of that. Now, of course, on top of that, speculation that BlackRock will be successful in strong-arming the SEC into approving a spot Bitcoin ETF has only been increasing. Over the past two weeks, 14 futures-based Ethereum ETF applications have been filed, with rumors that the SEC had softened its position on the suitability of Ethereum ETFs. Then Monday's Stablecoin announcement from PayPal cemented the idea that large financial firms would not be held back from launching crypto products. Vivian Fang, head of trading products at

Bybit said, our attention is on catalyst towards year end, potentially linked to ETF narratives or industry transforming events. The alignment between speculative strategies and these kind of pivotal events could combine to form significant tailwinds for the crypto market. Now, one person who's getting more convinced of the spot Bitcoin ETF is Galaxy Digital CEO Mike Novogratz. During an earnings call on Tuesday, he said, it's a big deal because both our contracts from the Investco side and from the BlackRock side gets you to think that this is a question of when, not if, until you're kind of thinking four to six months. Novogratz also said that Galaxy would, quote,

fight like cats and dogs if an ETF wins approval. Subbing up his feelings yesterday, Novagratz tweeted, eight weeks ago, I was praying for four things that could help crypto prices. One, Fed pausing, two, ripple winning lawsuit, three, Bitcoin ETF, four, Binance slash Z settles with the feds. I didn't expect so much progress on at least three of my four wishes. Fed will hike once more and then pause. Ripple victory should push Biden and Gensler to the table

with Republicans to get legislation done. ETF is when, not if. No insight on finance yet, but still praying. Now, one person who is a little skeptical of an ETF approval in the very short term is Arx's Kathy Wood. Her firm is at the front of the line due to be considered for approval on Sunday, but she said, quote, I think the SEC, if it's going to approve a Bitcoin ETF, will approve more than one at once.

Remember, the SEC has the option to delay most applications until March of next year. However, we'll need to make a final decision about ARC's ETF by January. Now one more on this institutional theme, private equity heavy hitter David Rubinstein said on Tuesday that Bitcoin isn't going away and he wishes he'd bought in earlier. The co-founder of the Carlisle group said, quote, there's enormous interest around the world and to be able to have something you can transfer without having the governments knowing about it and keep it private. You can say people shouldn't do that, but that's not going to stop people from doing it. During his appearance on Bloomberg TV, he noted that institutional interest is turning heads on Wall Street. He said,

what's happened is people made fun of Bitcoin and other cryptocurrencies, but now the establishment, Larry Finkett BlackRock, is now saying they're going to have an ETF if approved by the government in Bitcoin. So you're saying, wait a second, if the mighty BlackRock is willing to have an ETF in Bitcoin, maybe Bitcoin is going to be around for a while. Now, one other possible cause for some amount of excitement yesterday, at least from a narrative perspective, comes with this Federal Reserve announcement. Odin Free tweeted, the Federal Reserve is giving banks a clear path on how to handle crypto. By legitimizing the tech, more traditional financial institutions will explore and adopt it. So with that, let's transition to this Fed news and see whether it's as bullish

as Odin seems to think. The Federal Reserve has created a new program to oversee crypto activity at the banks under its supervision. The initiative is called the novel activity supervision program. The Fed says the program will, quote, ensure that the risks associated with innovation are appropriately addressed. The program will focus on enhancing supervision of a number of novel activities for banks. within crypto that includes custody, crypto-collateralized lending, facilitating trading, and engaging in stable coin issuance or distribution. Alongside crypto, the program will also look at other novel activities like complex fintech partnerships, including providing automated banking through APIs, broader uses of distributed ledgers, and tokenized assets. The program will also look into

concentration risk of banks that provide traditional banking services to crypto and fintech firms. The Fed says that supervision will be risk-based in that, quote, the level and intensity of supervision will vary based on the level of engagement in novel activities by each supervised banking organization. Now, banking entities engaged in novel activities will not be moved to a separate supervisory portfolio. Instead, the program will work alongside existing supervision teams. The Fed claims the aim of keeping this continuity and oversight is to, quote, maximize efficiency and minimize burden.

Overall, the stated objective of the initiative is to, quote, allow for innovations that improve access to and the delivery of financial services, while also safeguarding bank customers, banking organizations, and financial stability. In their note on the launch of the program, the Fed reiterated their existing position that, quote, 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, alongside the announcement of the novel activity supervision program, the Fed also published a non-objection process for stablecoin use at state member banks.

State banks must seek pre-approval from the Fed prior to dealing with stablecoins and must demonstrate that they have appropriate measures in place to mitigate risks. The Fed highlighted liquidity, cybersecurity, and illicit finance risks as examples. This policy brings state banks back in line with national banks who are authorized to use stable coins by the OCC in January 2021. Now, overall, the Fed has characterized this program as a, quote, enhancement of banking supervision for crypto activities. However, it's steered clear of using stronger language.

Banking regulators, of course, came under fire from the crypto space in January, after issuing a joint statement which inform banks that they, quote, have significant safety and soundness concerns with business models that are concentrated in crypto-asset-related activities, and that issuing or holding crypto as principle was, quote, highly likely to be inconsistent with safe and sound banking practices. While that statement obviously did not explicitly ban crypto activities within banks, many across the crypto industry, including this humble podcaster, viewed the statement as intended to have a chilling effect.

This statement led to the suspicion that banks were being informally told by their regulators not to deal with the crypto industry, or even if they weren't, that the intention to raise the political cost of doing so would have the same sort of freezing effect. This is, of course, what we have referred to as Operation Chokepoint 2.0. That term itself was a reference to the original Operation Chokepoint, which was an official government program during the Obama administration, that saw the debanking of politically unsavory but legal businesses like firearms dealers, payday lenders, and pornography websites through the subtle regulatory implication that they were high risk. Now, perhaps no one has been as fierce an observer around Operation

Chokepoint 2.0 as Nick Carter, who was the first person to identify it as such. So what did Nick think about this release from the Fed? Yesterday, he tweeted, quick thread reacting to the Fed's novel activities press release. TLDR, it looks neutral to negative for me. Let's start with the novel activities supervision program. First of all, this looks like an attempt to codify the informal pressure they've been applying to banks, which I've been calling OCP 2.0. Everyone who's been paying attention knows that banks servicing crypto clients have been subjected to extra special scrutiny and compliance overhead. But it has been largely informal. So now it's written down the Fed can claim its explicit policy and nothing unusual. Regulation by blog posts, we call this.

Second, this is an acknowledgement that the Fed is targeting embedded finance and banking as a service. We already knew they were targeting partner banks of these fintechs, but now it's explicit. They want to discourage innovation and risk-taking, suppress fintechs that are gaining market share by banking riskier clients and create barriers to entry to consolidate the industry. Next on the non-objection process for dollar tokens, I am not seeing any material shift in tone from the infamous January guidance, which de facto ban bank issuance of stable coins on public blockchains. Banks can receive a non-objection letter from the Fed if they want to issue a stable, but the due diligence and identity verification language seems to effectively prohibit banks

from satisfying this if they are issuing on a public blockchain, as you can never truly know who is holding your stable coin if you are operating under the blacklist model, whereby the token can circulate freely on chain on a p-to-pe basis. So it still looks like a de facto ban of public blockchain stable issuance for banks. It's a bit like saying, banks can issue cash via ATMs, but they need to be able to report the identities of the holders of those bills to the Fed on an ongoing basis. Impossible to satisfy, of course. The Fed wants banks to comply with its Sisyphysian demands for disclosure in a way that isn't compatible with how Stablecoins actually work. So I don't see any positive change in their stance between January and now. Stablecoins will continue

to be issued by non-banks until we get some kind of federal legislation permitting banks to do this. Under the status quo, banks won't touch this stuff with a 10-foot pole, hoping my pessimism is proven wrong, but not holding my breath. Now, Jacob Franik from Alliance Dow summed it up even more simply saying Fed confirms Operation Jokepoint 2.0. Stablecoin expert and associate professor at Columbia University, Austin Campbell, added a smidge of nuance, saying, the proof will be in the pudding for those watching from the peanut gallery. If this creates an expedited path to banks actually tokenizing things and using blockchains, great. If nothing gets approved for years, chokepoint 2.0 confirmed. Now on the flip side, Avi Feldman wrote, good step towards stable coin issuance and crypto

rails becoming more prevalent in our banking system. Clear shift in tone from the powers that be about crypto should be bullish for Bitcoin short term as we get greater confidence in ETF, but clearly bullish ETH as well given stable coin guidance. So I think the real damnable thing here is that there are two big different divergent possibilities around this. One is, as Nick suspects, that it could represent simply a codification of the political pressure on banks to not really touch crypto at all. The flip side is that nominally it does create some amount of paths forward and guidance around how banks can interact with crypto. The question in many ways is behind the scenes. Are regulators actually saying, yes, we do want people to be able to interact with this industry,

come in and talk to us and let's figure it out? Or are they just leaving this guidance pinned to the wall with a dagger, sending a clear message that they don't want to hear anything else about it? Now, the third possibility is that they don't really know which of those two paths they want it to be, and so they wrote something which could go in either direction. Keep up the pressure on the one hand, create paths forward to the extent that they decide that they want to do that. It's hard to say from here, but I will say from just a broad narrative perspective, and particularly if one is interested in this institutional narrative that's growing,

having guidance, even if somewhat problematic, is better than just the sort of warning that we got back in January. But as everyone agrees, the proof is in the pudding, and we're just going to have to wait and see what happens. That's going to do it for today's breakdown. Thanks as always for listening, and until tomorrow, be safe and take care of each other. Peace.