The Breakdown - Is Custodia a ‘Sacrificial Lamb’ to the Fed’s War on Crypto Banking?

Episode Date: February 23, 2023

In a recent tweet, Kraken co-founder Jesse Powell suggested U.S. regulators like it when bad actors beat good actors because it takes down the crypto industry and the bad actors can be jailed later. In this episode, NLW explores the issue in the context of Custodia Bank's battle to join the Federal Reserve system, and its argument that it is being unlawfully used as a “sacrificial lamb” in the wake of the FTX failure.  Join the discussion at discord.gg/VrKRrfKCz8. 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: Godong/Getty Images, modified by CoinDesk.  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 CoinDess. What's going on, guys? It is Wednesday, February 22nd, and today we're talking about why regulators don't go after bad actors, but instead, focus on the good guys. A quick note before we dive in, there are two ways to listen to the breakdown podcast. You can hear us on the Coin Desk Podcast Network feed, which comes out every afternoon and features other great Coin Desk shows alongside the breakdown, or you can listen on the breakdown only feed, which comes out a few hours later in the evening. Wherever you're listening, 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 truly appreciate each and every one.

All right. So yesterday, we closed the show on a fiery statement from Crackens' Jesse Powell. I'm going to reread that tweet now. Jesse writes, I have a theory. Regulators let the bad guys get big and blow up because it serves their agenda. One, destroy capital and resources in the crypto ecosystem. Two, burn people and deter adoption. Three, give air cover to attack good actors. The bad guys are actually on side. Good guys are the enemy. If the bad guys can run long enough without blowing up, they might just kill the good guys for you. Bad guys operate with huge competitive advantages. They suck up users. revenue, and venture capital, that would have otherwise gone to good guys. Bad guys can always be

jailed later. So today I want to dig a little bit more into what prompted this particular statement, and to do that, we need to talk about Custodia Bank. Custodia Bank is a special purpose depository institution or SPDI in Wyoming, and has long had ambition to be a very different type of full reserve bank. The bank was originally called Avanti, and it was started by Caitlin Long a few years ago. Now, for much of its life, it's been going through an onerous process to become part of the Federal Reserve system and get access to a Federal Reserve master account. A master account would give Custodia the ability to access wholesale payment systems from the Fed without needing another bank as an intermediary. This is obviously hugely important to the development of the business model that they ultimately wanted to be in. Well, Custodia was left waiting so long that last June they filed suit against the Federal Reserve, saying that it was unlawfully done.

delaying their application. Custodia claimed that the Fed's own paperwork says that a master account decision ordinarily takes five to seven days. Meanwhile, by making Custodia wait 19 months, the Fed had, quote, clearly violated its one-year statutory deadline. Still, another half year passed before the Fed finally issued his decision. On January 27th of this year, of course, a couple months after the FTX collapse, the Federal Reserve announced their denial of custodias application to become part of the Federal Reserve system. This was, I think, in many ways, the first follow-up to the January 3rd joint statement from the Federal Reserve, the Federal Deposit Insurance Corporation, or FDIC, and the Office of

the Comptroller of the Currency or OCC on the, quote, crypto asset risks to banking organizations. That statement, while not banning banks from interacting with crypto entirely, did represent a pretty chilling warning. The January 3rd statement effectively increased the political costs and the political risk for banks to interact with crypto companies and crypto assets in general. We've covered this extensively here in my previous episodes on Operation Chokepoint 2.0. The comparison is to an Obama era program that used convert political pressure on banks to get them to deny services for out-of-favor industry, industries which were legal, to be clear, but not politically loved. So think porn, guns, etc. During the Brian Brooks era,

the office of the comptroller of the currency put out a rule saying that banks were not allowed to deny companies based on their industry, but that was literally the first thing the Biden-era OCC reversed when that administration came to power. So back to January, the point is that the most important banking regulators in the country put out a joint statement saying that crypto is unlikely to be able to be banked in a safe and sound manner. And that, to me, certainly looks like the same playbook, except much more explicit this time. Bringing it back to using Custodia as their first example, the press release from the Fed on their denial of Custodia's application certainly seems to reinforce that connection. They write, the firm's novel business model and proposed focus on

crypto assets presents significant safety and soundness risks. The board has previously made clear that such crypto activities are highly likely to be inconsistent with safe and sound banking practices. The board also found that Custodia's risk management framework was insufficient to address concerns regarding the heightened risks associated with its proposed crypto activities, including its ability to mitigate money laundering and terrorism financing risks. So that was the state of play as of a couple days ago, but Custodia has come out swinging. On Friday, the company filed an amended complaint in their lawsuit against the Federal Reserve, claiming that the denial of its application was unlawful.

Custodia is alleging that the Federal Reserve Board colluded with the Biden administration to release a series of public statements to accompany the rejection of Custodia's application, and that the Federal Reserve Board rather than the Kansas City Fed, who actually issued the denial of the master services account was, quote, pulling the strings. The filing said, quote, defendants had a non-discretionary duty to grant custodia's master account application and not to discriminate against custodia in its ability to access all bank services using that account. Any other outcome eviscerates the dual banking system that has served our nation since its founding. The amended complaint goes on, quote, confronted with discovery requests to the Kansas City Fed

and a looming deadline for the board to produce an administrative record that would have revealed the board's control over the Kansas City Fed's decision-making process, defendants tried to moot the litigation. On January 27, 2023, in a coordinated maneuver orchestrated by the board in consultation with the White House and leaked to reporters by board officials the day before it occurred, the Kansas City Fed reported the denial of Custodia's master account application immediately after the board denied Custodias membership application. Now, the cornerstone of Custodia's argument is that the Fed cannot reject their application, noting that the legislation states that Fed services, quote, shall be available

to non-member depository institutions of which custodia is one. In a statement, a custodia spokesperson said, Custodia Bank today continued its ongoing lawsuit against the Federal Reserve Board of Governors and the Kansas City Federal Reserve Bank by filing an amended complaint that zeroes in on the core legal issue, whether Congress even granted the Fed discretion to decide master accounts at all. Complimenting this announcement was a long and intriguing thread from Caitlin Long. On Friday, she wrote, it's time for me to reveal a few things. I've just published a post, shame on Washington, D.C. for

shooting a messenger who warned of crypto debacle. First, the revelations. Today I'm publicly disclosing for the first time that, A, I handed over evidence to law enforcement of probable crimes committed by a big crypto fraud, starting months before that company imploded and stuck its millions of customers with losses. And B, I warned bank regulators of mounting bankrun risk inside banks serving the crypto industry before the bank runs ultimately hit. How many correctly foresaw the crypto lender implosion, warned regulators of impending bank runs, and tried to help law enforcement stop a big fraud? And in return, what happened to Custodia Bank? Custodia tried to become federally regulated the very result bipartisan policymakers claim to want. Yet Custodia has been denied and now

disparaged for daring to come through the front door. Fixing corruption in crypto is not a partisan issue, yet partisans in D.C. are nonetheless trying to pull in politics. I reject that. It is not partisan to clean up crypto fraud. It's the right thing to do. In the new post, I describe how two descendants of Paul Cabot recently contacted me to analogize my work today to Cabot's work in the 1930s. I'm humbled that they would make such a connection and can only aspire to a fraction of Cabot's achievements. Here's what State Street founder Cabot achieved. He cleaned up rampant corruption in the nascent mutual fund industry of the 1930s. He called out the industry's bad actors. In the 1930s, then-President FDR wanted to crush the mutual fund industry. Cabot succeeded in

convincing FDR not to do that. How? He had credibility because he had called out the bad behavior of his peers, and he was able to get an audience with FDR. Together, they cleaned up the industry and enacted the Investment Company Act of 1940. The rest, as they say, is history. But while FDR invited Paul Cabot to the Oval Office to work out how to fix the problem in the 1930s, most of today's DC policymakers seem intent on killing the high-integrity innovators. Few people truly understand how to separate the wheat from the chaff in crypto, and even fewer at the table with regulators, as I am, though as of yet, I've not been at the table with the decision makers and wonder whether my warnings were buried in the bowels of bureaucracy. I'll end with this. Internet-native money exists. It won't be

uninvented. Today, U.S. dollars can move across the internet without banks and without permission, settling as fast as the speed of light and at a fraction of the cost of incumbent payment systems. This tech will steadily disintermediate banks because anyone with an internet connection can run the code and use U.S. dollars without banks. D.C.'s misguided crackdown will only push risks into shadows, leaving regulators to play whackamol as risks continually pop up in unexpected places. Despite recent attacks, I remain optimistic regulators will realize that antidotes exist to the crypto scams seeping into the system.

Now, crypto Twitter is unsurprisingly on Caitlin's side. Dave Weisberger, the CEO at Coinrout, said, political nonsense. The regulators and legislators know that almost all the systemic risk is from leverage. whether crypto, fractional reserve loans, debt, or equities. Custodia does not allow leverage, so as Caitlin points out, their risk is lower than traditional banks. Of all the people in crypto, Caitlin has been the most vocal about the dangers of leverage. Punishing her firm for the massive leverage-fuel-fueled fraud of FTX is logically backwards. Jesse Powell retweeted her thread and said, I can't tell you how infuriating it is to have pointed out massive red flags and obviously

illegal activity to regulators, only to have them ignore the issues for years. They're offshore, it's complicated, we're looking at everybody. for years, and then to be used as their example. Ram Al-Alawalia says the U.S. has a choice to make. Enable regulated on-ramps and custody from high-integrity leaders or push activity to unlicense overseas players with zero oversight, and get another FTX. Now, one person who took issue with the offshore-onshor dialectic was CZ,

who tweeted the term offshore appears overly narrow-minded, self-centered, misses the broader picture, and unhelpful to the development of our industry. Taking an on-shore perspective, the issue discussed. FtX U.S. is an onshore exchange. SBF and FTCX key execs are Americans. They spent a considerable amount of their time and efforts lobbying in the U.S. This did not stop fraud from being committed. Drawing a distinction between onshore and everyone else is self-centered and somewhat arrogant.

Everyone is onshore from their own perspective. We are better than everyone else is not a panacea towards building a better industry. There are good and bad people everywhere. Embracing diversity and openness will lead to a better outcome. Any over-generalization, especially against others, is counterproductive and negative. Let's guard against that. Now, CZ also made sure to say that he wasn't signaling out Jesse specifically, and he's not wrong when he talks about FTX's lobbying efforts.

He's also right to say that onshore or offshore doesn't necessarily come with some sort of moral value judgment. However, the point that the folks using that terminology are trying to make is a U.S. centric point for U.S. regulators. And their argument is simple. Crypto companies want access to U.S. capital markets and are willing to abide by even slightly onerous regulations as long as they're clear. When the rules aren't clear, however, the incentives to stay in the U.S.,

no matter how big the user and capital base goes away. That means companies move operations to jurisdictions with looser regulations, which means the U.S. loses out on all the benefits that come with having big frontier technology platforms built in the U.S. And what's more, those regulators lose much of their ability to play cop on the beach as some of them are so fond of calling themselves due to the natural properties of the internet that allow citizens from anywhere to skirt around pesky things like national jurisdictions. Now, bringing it back to Custodia, in short, Caitlin is arguing that they were chosen to make an example of. She writes, why was Custodia Bank chosen as the sacrificial lamp, the so-called

shooting of the stallion to scatter the herd? On unchained with Laura Shin, Coinbase Chief Legal Officer Paul Grewell definitely gave some breath to this argument that there is a coordinated effort against crypto-related banking. He said, I think at some point these actions line up in a way that you have to wonder. Is it all just a coincidence? You have to ask why we are confronting restrictions of withdrawals to banking of legal, recognized, highly regulated companies in this country. The notion that somehow the right way to constrain activities that give rise to concern is to cut off their oxygen, I think that's something that as much as anything explains the strong reaction we're seeing not just inside of the crypto community, but in the broader financial services community as well.

That's a dangerous precedent. And maybe that crypto is currently the object of that particular approach, but if the government gets away with that with crypto, what's to stop them from getting away with it as to a whole host of other legal, safe, regulated industries that happen to be out of favor with policymakers. Join CoinDesk's Consensus 20203, the most important conversation in crypto and Web3, happening April 26th 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, founders, entrepreneurs, and more. Use code Breakdown to get 15% off your paths. Visit Consensus. coin desk.com or check the link in the show notes. Meanwhile, somewhat related over in SEC world, an update on the Paxos situation. Paxos is in talks with the SEC after having received notification of potential enforcement actions surrounding its finance-branded stablecoin BUSD last week. According to Reuters reporting, Paxos CEO Charles Cascarilla sent an email to staff over the weekend stating, quote, we are engaged in constructive discussions with the SEC and we look forward

to continuing that dialogue in private. He added that Paxos would defend its position that BUSD is not a security in litigation if necessary. He also gave an update on other in-progress applications. Quote, we are working with the SEC towards the publication of our clearing agency application. We are working with the OCC to move our conditional approval into an operationalized and launched national trust. We are also working to expand our Singapore products and consultation with the MAS following our payment service provider approval last year. We continue to pursue each of these plus any other opportunities for productive collaboration with regulators. James Murphy at Met a Lawman on Twitter really summed up the SEC Paxos debacle, I think, in a way that's

instructive for the rest of the industry. He writes, life in Gary Gensler's world, a case study. In April of 2021, Paxos went in to register with the SEC at securities clearing service. Paxos said that it expected the SEC registration would become effective by the end of the year, 2021. Well, it's two years later, and surprise, Paxos still has no securities clearing license from the SEC. But the SEC didn't leave Paxos totally empty hands. candid, the SEC did deliver a Wells notice to Paxos, threatening to sue them for issuing a stable coin BUSD, which the SEC now claims is a security. Paxos says they're still working with the SEC on their securities clearing application from 2021. So it's fair to say that Gary Gensler

has a bit of leverage over Paxos to compel a settlement on the BUSD stable coin. Welcome to Life in Gary's World. Listen, if you really want a sense of where the narrative is right now, look no farther than the comments from the head of the Bank for International Settlements August and Carson's this morning on Bloomberg. He said that the last year had fully settled the question of whether crypto could be a replacement for fiat money. The battle has been one, he said. A technology doesn't make for trusted money. Only the legal historical infrastructure behind central banks can give great credibility to money. He added that he anticipates a, quote, strong statement from the G20 nations for strength and regulation of the digital

asset sector. I go in depth on all of this today because this is the fight that is at our doorstep. To understand it, we need to understand both the explicit and implicit levels we're fighting on, the behind the scenes, and the in front of the cameras. I'm glad Custodia is taking the fight legal and keeping the fight legal. I think we need a lot of that. But we also need to find ways to exert political pressure and to fight back against these techniques that are moving around the traditional lawmaking system. Anyways, there will be a lot more to talk about this in the weeks to come. So for now, I appreciate you listening. And until tomorrow, be safe and take care of each other. Peace.