The Breakdown - Operation Chokepoint 2.0 (2.0)

Episode Date: April 30, 2024

Is the US government coordinated crackdown back? This time it seems focused on self-custody. Today's Show Brought To You By Ledger - 5% to Bitcoin Developers When You Buy https://shop.ledger.com/pages/bitcoin-hardware-wallet Consensus 2024 is happening May 29-31 in Austin, Texas. This year marks the tenth annual Consensus, making it the largest and longest-running event dedicated to all sides of crypto, blockchain and Web3. Use code BREAKDOWN to get 15% off your pass at https://go.coindesk.com/3PWW96A. Superintelligent - Learn AI fast. Get 50% off your first month with code "breakdown" https://besuper.ai/ Enjoying this content? SUBSCRIBE to the Podcast: https://pod.link/1438693620 Watch on YouTube: https://www.youtube.com/nathanielwhittemorecrypto Subscribe to 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 Monday, April 29th, and today we are talking about Operation Choke Point 2.0. 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 in the show notes or go to bit.ly slash breakdown pod. So last week, we saw a ton of action from three-letter agencies. The sense that started to emerge was that the crypto industry was perhaps facing another

wave of crackdowns. There was the IRS releasing forms that would require reporting from self-hosted wallets and dexes. There were multiple lawsuits filed against the SEC, pushing back on regulatory overreach. Things really came to a head with the arrest of samurai wallet developers on Wednesday. The charges were conspiracy to commit money laundering and conspiracy to operate an unlicensed money transmission business. And while one conclusion might have been that this was just the next step in the crackdown on crypto mixers, some were worried that it would go much farther. Those fears were stoked on Thursday, with the FBI publishing a warning to crypto users. The agency said they were investigating money transmitting services that,

quote, purposefully break the law or knowingly facilitate illegal transactions. They warned that users risked losing access to funds. The problem is that Samurai was a non-custodial wallet, leaving many to wonder, if that could be targeted, was the FBI making a much bigger warning than it might at first seem? On Friday's show with Scott Melker, I said that this is beginning to look like the next stage of Operation Chokepoint 2.0. You'll recall that at the beginning of last year, a series of government agencies leaned on the financial industry to debank crypto firms. Policies weren't overt. Instead, they used the implied threat of regulatory scrutiny to achieve this goal. This latest wave of government actions has a very similar tone. And it seems like this time around, the target is self-custody and privacy tools.

The overarching message seems to be that any firm offering a way to use crypto without an intermediary could be the next target. So that is the broader framework for what we're going to talk about today, and we're going to start with the Tornado Cash case. The criminal case against Tornado Cash co-founder Roman Storm is quickly shaping up to be one of the most important crypto lawsuits of the year. While other cases deal with big-picture regulatory issues, this one deals with criminal liability and has the potential to have a chilling effect on DFI developers. The court is currently dealing with a motion to dismiss filed by Storm. He argues that Tornado Cash doesn't take custody of customer funds, so should not be subject to the licensing

and compliance standards imposed on financial institutions. The DOJ response has caused waves in the crypto-legal community. They filed a 111-page motion, disputing the core arguments being made about the decentralized protocols more broadly. The DOJ rejects the idea that Tornado Cash developers were merely writing code, arguing the Tornado Cash Service was a commercial enterprise carried on for-profit or financial gain, and that the defendant himself profited from its operation through his control with others of key components of the integrated Tornado Cash service. Regarding whether Tornado Cash operated as a money transmitter, the DOJ pointed to the infrastructure surrounding the smart contracts,

such as the front end at the Relayer Network, arguing, quote, the Tornado Cash Service caused all of these actions to take place behind the scenes and without any further action by the customer. Under the ordinary meaning of the term, the Tornado Cash Service was transferring funds when it executed customer deposits and withdrawals in this way. This section of the brief is especially obtuse, with the DOJ cracking open the dictionary to provide

the definition of the word transfer. An analogy they used was a frying pan transferring heat from a stove top without needing control of what's being transferred, which honestly feels like a stretch to me, but what do I know? The point being made was that the relevant legislation doesn't require control for a service to be considered a money transmitter. The DOJ also references the 2019 FinCEN guidance on money transmitters in the crypto industry. This guidance has been widely relied upon in designing defy systems that do not control user funds in an effort to avoid the need for licensing. The DOJ notes that the section dealing with anonymizing software doesn't reference the idea of control. Instead, it's much more focused on receiving a fee for the service.

There are, of course, a ton more details. It's 111 pages. But suffice it to say that the crypto legal community was fairly unimpressed with the tactics on show from the DOJ. Amanda Tuminelli, the chief legal officer of the Defy Education Fund wrote, The DOJ's opposition to Roman Storm's motion to dismiss and suppress evidence in the tornado cash case is filled with technical inaccuracies, obvious disdain for privacy and emerging technology, and misapplication of the law. The TLDR of the opposition is, look at our really long speaking indictment. It has so many details. You have to take these facts

alleged as true judge, even if they don't make sense. Please don't think too hard about it until a jury weighs in. One of the things that was least impressive to Tuminelli was the way in which the DOJ handled the amicus briefs that have been filed by industry legal experts. This type of brief is, of course, intended to assist the court in understanding the legal and technical issues of the case. They're considered to be neutral in this effort, even when their legal arguments support one side or the other. Throughout the brief, the DOJ referred to them as, quote, the defendants, implying a direct interest in defending storm and tornado cash. Tuminelli wrote, I have never seen this before and must be meant to categorically

dismiss the well-founded arguments raised by the briefs. Law professor and financial privacy advocate J.W. Verrett was more direct with his summary tweeting, TLDR, ha-ha, FinCend guidance on money services businesses doesn't mean we can't prosecute you anyway. The reason this case matters so much is the threat of widespread prosecution for defy developers, even if they design their protocols in line with guidance. Crypto lawyer Gabriel Shapiro, thinks this threat might be overblown, writing, I'm not yet worried that Torn Cash makes DTI Web App operators into money transmitters. In Torn Cash, it's going to come down to the relayers and the Torn token.

Relayers did Ethereum transactions for users, including paying gas. Torn provided an economic interest in the relaying enterprise. On most DFI web apps, it's still the user ultimately directly transacting on Ethereum, paying their own gas, etc. Or if indirect, the RPC node is owned by the wallet operator, not the DeFi Web App operator. I do view it as an abhorrent case for the government to bring regardless, especially to seek a prison sentence over it.

Consensus lawyer Bill Hughes made the broader point that we're getting further and further away from legal clarity, tweeting, the chaos of having trial attorneys set policy. They are inclined to make basically any argument they can colorably make to win the case before them. Supervisors just need the case to be important enough and they grant a lot of leeway, even breaking with well-established jurisprudence. This is why the SEC strategy of letting enforcement litigation dictate policy has been actually

bad for the country. Litigators will literally make up new rules and standards to win and claim it's always been like this. If this tornado cash prosecution suggests DOJ is on the same path, then it would mark a decidedly bad turn. Hello, breakers. Today's episode is sponsored by Ledger. As another cycle ramps up, it's another chance to think about your Bitcoin custody best practices, and of course, to help all the new folks do the same. Ledger is the global platform for securing Bitcoin and other crypto. Ledger combines both hardware wallets and the Ledger Live app to offer the best way to buy, sell, swap, and

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breakdown. That is 15% on registration with the code breakdown. What's more, there is a real sense that this prosecution is just the tip of the spear. The DOJ is rejecting the industry's understanding of the 2019 FinCID guidance, which has been relied upon in building decentralized infrastructure ever since. The issue then is that a successful prosecution would leave the industry in no man's land, with even more unclear guidelines if founders want to stay on the right side of the law. The nightmare scenario is that neutral infrastructure like wallets, nodes, and validators are required to register and perform compliance, something that would be simply impossible

with the way these services currently function. Ultimately, without solid guidance that can be relied upon to keep founders out of prison, the risk of developing on-chain protocols will increase dramatically. And this is the way that the on-chain economy gets shut down, by an act of Congress, but through a series of prosecutions by unelected agencies. Indeed, after Thursday's FBI warning that unlicensed crypto money transmitting services are being investigated, there was a sense that more arrests could be coming. The crackdown had begun with Samurai wallet, a non-custodial Bitcoin mixer that was not shy about courting criminal users. However, there was a feeling that

anyone could be next. The FBI had been extremely unclear about which elements of Samurai had made it a target and how other projects could avoid arrest. It wasn't obvious whether prosecutors would draw the line at purposefully facilitating illicit transactions, or if simply providing on-chain privacy could make the wallet a target. Over the weekend, multiple projects decided that they weren't willing to take that chance and announced they would be closing their doors to U.S. users. Both Phoenix wallet and Wasabi wallet have firewalled their products from U.S.-based IP addresses and removed their App Store listings. Wasabi's publisher wrote, in light of the recent announcement from U.S. authorities, uncertainty lies on whether self-custodial

wallet, such as Wasabi Wallet, could be considered money transmitters. Although we believe that Wasabi Wallet is complying with current legislations and regulations, we are taking a conservative approach and decided not to be exposed to the regulatory uncertainty of the U.S. Now, to some, this one might not come as a big surprise, given that Wasabi was the major rival to Samurai as a Bitcoin privacy tool. Perhaps more surprising was Phoenix Wallet, which is simply a non-custodial Lightning Wallet that doesn't have a particular focus on privacy. The publisher of Phoenix Wallet wrote, recent announcements from U.S. authorities cast a doubt on whether self-custodial wallet providers, lightning service providers, or even Lightning Nodes could be

considered money service businesses and regulated as such. And this, my friends, is of course the problem with all of what's happening right now. Without clear guidance and a bright line rule, self-custody wallets have to assume they are at risk and act accordingly. And this is, of course, the idea of an operation chokepoint. The government doesn't have to take the outrageous step of banning self-custody. They just need to make the U.S. jurisdiction too hostile and risky for self-hosted wallets to operate within. Now, some weren't happy with Phoenix and thought that this was an overreaction. Block CEO Jack Dorsey tweeted, completely unnecessary. Strike's CEO, Jack Mullers, asked whether regulators had asked Phoenix to shut down

or whether they had done so on their own but received no response. Zeus wallet founder Evan Kalludas put out a statement which read, We believe that Zeus is following the letter of the law right now. If the law changes or any judgments are made, we will make adjustments accordingly. If Zeus fails, all other Lightning Node operators are next. If lightning node operators fail, self-custody is next. This is the hill to die on, self-custody. If you don't agree, you were never in Bitcoin for the right reasons. So get behind us or go home. Future generations are watching and depending on us. Now, with the industry on high alert, an announcement from the Depository Trust and Clearing Corporation on Friday night sent Bitcoin Twitter into a full-blown freakout. The DTCC handles clearing

and settlement for financial markets serving as the monopoly provider for most U.S. stock trading. The organization announced that as of Tuesday, Bitcoin ETFs would not be accepted as collateral within their system. Early takes were breathless, warning that this limitation could reduce liquidity and suppress Bitcoin's price. However, others with more experience, financial finance, pointed out that on the spectrum from Nothingburger to catastrophe, this is a lot closer to the Nothingburger side. Kikintoshi, the CIO of Combine Capital, wrote, this is in regards to acceptable collateral for using a line of credit to settle trades with the DTCC. Many other securities have 100% haircut for this particular LLC facility, including any stock

price below $5, and the vast majority of trades settle without using an LLC. The ability to use crypto ETFs for lending and collateral with brokerages is unaffected by this, and remains dependent on the broker's risk tolerance. TLDR, nothing to see here but uninformed doom posting. So with another crackdown on Bitcoin seemingly underway, many analysts have turned to asking, why now? Dylan LeClair wrote, they're going to go after self-custody because they need capital controls to properly execute financial repression. Capital is sufficiently captured in Waldgarten ETFs, widely adopted self-custodial Bitcoin used as a medium of exchange with privacy tools presents an existential threat. Some have turned to analysis of the macro landscape and a series of

cracks that are beginning to show. The Japanese yen fell by 3% against the dollar on Friday and struggled to find its feet during Monday trading. The yen has been weakening for more than a year, but this recent price action was triggered by the Bank of Japan meeting on Friday. The central bank announced no change to monetary policy, including their large quantitative easing program. Many had assumed the BOJ would begin to structurally support the currency after multiple interventions over recent months, but nothing was announced. The yen is a critical funding currency for the global economy, making the wild volatility dangerous and a potential sign of breakages within the system. Perhaps more But crucially, Japan has been comfort to other global policymakers as a demonstration that high

government debt isn't necessarily a problem. Robin Brooks, a senior fellow at the Brookings Institute, wrote, Japan has always been a favorite talking point for the MMT crowd, who claimed Japan's huge debt load is totally fine. It isn't. Japan is in a currency crisis because its debt forces the BOJ to keep interest rates pinned, a huge warning sign for debt aficionados. The problems are also closer to home. On Friday, Republic First Bank was closed by Pennsylvania state regulators, making it the first U.S. banking failure of the year. Public First was a relatively small bank with around $6 billion in total assets. That's nothing compared to, for example, Silicon Valley Bank, which had $209 billion in assets when it was seized.

The FDIC has already entered into an agreement with Fulton Bank, which will assume deposit liabilities. Roughly 50% of deposits were over the FDIC insurance limit, but will be honored by Fulton Bank. While the failure of a small bank isn't a big deal by itself, many other U.S. banks are still facing issues. New York Community Bank received a $1 billion equity investment in March, but there's no indication that this was enough to right the ship. these issues are both linked to Fed policy. The string of hotter than expected macro data continued on Friday, with PCE inflation coming in above expectations. The only data point showing a slowdown is GDP, which came in at 1.6% for last quarter and preliminary estimates released on Thursday.

Back in January, markets were pricing in as many as seven rate cuts for this year. Now, one cut in December is the baseline assumption, with a significant chance of zero rate cuts for the year. Analysts are beginning to mutter about stagflation and even the need for another round of rate hikes. This rapid shift in Fed expectations impacts rate-sensitive institutions, from small community banks all the way up to the economy of Japan. Many entities could hold on for a few months longer for rate cuts to arrive, but another round of rate hikes could be a disaster. This week, we have two important macro events that could set the course for the coming months. The Fed meeting will conclude on Wednesday, but the Treasury's quarterly refunding announcement could be even more important.

In November, the Treasury decided to reduce the duration of debt issuance, which function as a liquidity injection for markets. For this quarter, the Treasury's accounts are flush with cash after a larger than expected tax season. If the Treasury decides to run down its balance to normal levels and hold bond issue and steady, this could provide a liquidity boost for struggling risk asset markets. So lots to watch. As you can probably tell, I am not quite ready to call this Operation chokepoint 2.0 quite yet, but there is certainly a lot going on that seems to all be telling the same story. We will certainly be keeping an eye on it, but for now, just one more big thank you to the sponsor for today's show. Check out the ledger Bitcoin Orange Nano. Five percent of sales

will go to support Bitcoin Development. Until next time, be safe and take care of each other. Peace.