The Breakdown - Python Politics Part 2: Operation Choke Point 2.0 Begins

Episode Date: February 11, 2023

The crypto industry is increasingly facing a U.S. banking system that has been weaponized against it. In this second part of a two-part special, NLW looks at the post-Brian Brooks era at the Office of the Comptroller of the Currency, and examines how crises like Luna and FTX have changed the situation.  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 - 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. - “The Breakdown” is written, produced by and features Nathaniel Whittemore aka NLW, with editing by Rob Mitchell 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: Lusky/Getty Images, modified by CoinDesk. Join the discussion at discord.gg/VrKRrfKCz8.

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 Friday, February 10th. And today we are doing part two of Python politics, the U.S. government's slow squeeze on crypto via the banking system. 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. Now, first up, I know that there are a ton of things going on right now as I'm recording this on Thursday afternoon, actually. It appears as though Cracken has made a settlement with the SEC. I will use the weekly recap coming out on Saturday to get into that stuff, but this is part two of this special kind of background series on this broader set of Crackdown type actions that we're seeing, and that many have been noticing especially this week. If you haven't listened to yesterday's Part 1 yet, I definitely suggest you go do that now. That episode lays out first the slate of events in the last month and a half or so that show this slow squeeze of crypto via the U.S. banking system.

Second, I get into the key recent history of the main U.S. banking regulator, the office of the comptroller of the currency. And specifically Brian Brooks, who headed that office up, who had previously been the G.C. at Coinbase. In our story so far, we'd seen how Brooks had used his six-ish months in office to open up crypto custody for nationally regulated banks, to ensure that those institutions could work with stable coin issuers, and to try to stop banks from being legally able to prejudice customers based on the industry they operated within. However, where we start now is November and

December of 2020, and by that point, a key inflection had come and gone. Democrat Joe Biden had beaten Republican President Trump in the general election, and so Washington D.C.'s attention was turning firmly toward the transition. Despite Trump's official nomination of Brooks to a five-year term as the comptroller, it was pretty clear that that wasn't going to come to a vote before the Democrats came into power. And so, Brooks's time was running short. That didn't mean discussion around the OCC had ended, though. No, far from it. On December 4th, 2020, House Financial Services Committee chairwoman Maxine Waters, who had later become famous for blowing FTX's Sam Bankman Free to Kiss after a congressional hearing, wrote to then-President-elect Joe Biden with a number of policy recommendations,

saying, quote, I would like to highlight several areas where you and your team should immediately reverse the actions of your predecessors. She recommended specifically that Biden rescind guidance that banks may interact with stable coins and that federally chartered banks and financial institutions could provide crypto custody services. Basically, her recommendation was undo everything that Brian Brooks had done. But boy, if Brooks wasn't going to use his last week's in office to try and leave a dent. In the first week of January, the OCC published an interpretive letter, saying that national banks and federal savings institutions were allowed to participate as nodes on a blockchain as well as to store and validate payments. They were also, according to the

interpretive letter, allowed to use stable coins for payment settlement, which would put stable coins in a role that had been previously reserved solely for Swift and ACH. My podcast at the time suggested that this might be the most significant crypto regulation yet. And even on top of that, other seeds that Brooks had planted were blossoming. Just before he left, Anchorage became the first crypto company to receive a federal trust charter, something that was later repeated by Protigo and Paxos. Now, it is also worth noting here, just for the sake of not fully falling into the trap of viewing the crypto regulatory story as Dees versus R's, that even as Brooks was doing this, outgoing Treasury Secretary Stephen Mnuchin, was pushing through his absurd crypto wallet rule through FinCEN.

The rule from the U.S. Financial Crimes Enforcement Network, or FinCEN, would have required exchanges collect personal info, including names and home addresses, of people who transfer money to themselves, aka to self-hosted wallets. Indeed, this was one of the first instances of the politicization of the term unhosted, for what most crypto users would call self-hosted or self-custody, or just wallets. The rule was vaguely defined, given an extremely short comment period, and was generally seen as a parting f***u from a political opponent. So again, not all Dems' bad Republicans good here. But, back to Brooks. His tenure was coming to an end, and on January, January 14th, 2021, he formally stepped down. His departing statement reinforced his position on

crypto and banking. Blockchains fundamentally, he said, are banking, because what they're doing is allowing the transaction of value across networks. They're just doing it in an orthogonally different way. So we're now in early 2021, Brooks is back off into the private sector to what happens at the OCC. Well, almost right away, a hold is put on Brooks' anti-operation chokepoint slash Fair Access Rule. On January 28th, the OCC put the rule on hold pending review by the new OCC chief whenever they were appointed. A few months later, new Treasury Secretary Janet Yellen appointed Michael Sue as acting comptroller to follow Brooks and his interim replacement. Sue had previously been an associate director at the Federal Reserve, focusing on the division

that oversaw major banks. At the time of his appointment, Yelan said, quote, Mike has devoted his career to the stability and supervision of America's banking system. He is among the most talented and principled regulatory officials that I have ever had the pleasure of working with, and I am confident he will execute this role with integrity and efficiency. Initially, there was little to suggest how Sue felt about crypto. As a daily observer of the industry, my impressions of him certainly weren't as some anti-crypto zealot. He struck me instead as more of a process-oriented bureaucrat. For example, in mid-May, he requested a review of all of the OCC's recent interpretive letters and guidance,

saying, at the OCC, the focus has been on encouraging responsible innovation. For instance, we created an office of innovation, updated the framework for chartering national banks and trust companies, and interpreted crypto custody services as part of the business of banking. I've asked staff to review these actions. My broader concern is that these initiatives were not done in full coordination with all stakeholders, nor do they appear to have been part of a broader strategy related to the regulatory perimeter. I believe addressing both of these tasks should be a priority. You can see here that the critique comes in terms of process and deliberateness.

discussing the trust charters for companies like Anchorage, he said. Recognizing the OCC's unique authority to grant charters, we must find a way to consider how fintechs and payment platforms fit into the banking system, and we must do it in coordination with the FDIC, Federal Reserve, and the states. I suppose looking back, one could see his emphasis on regulatory perimeters as a desire to see crypto-firewalled from the traditional financial system, but by and large, it was benign, wait-and-see-type language. Other lawmakers, though, were far less sanguine. Around the same time, Senate Banking Committee Chairman Sherrod Brown wrote an open letter to Sue expressing concern over the OCC charters. He said the OCC is not in a position to regulate these entities comparably to traditional banks and questioned whether Brooks had done appropriate due diligence. By June 21, Sue was reinforcing the idea that he wanted to work with other regulators to create this regulatory perimeter.

And this, I think, is in many ways to his credit. While many of his colleagues, as we would find out, were jockeying for agency supremacy to regulate crypto, what he wanted was coordination. At one point, he said, the strongest view I have right now is that we all need to talk to each other and decide on this together. What we need to avoid is effectively competing with each other in a way that leads to a race to the bottom. Now, in September of that year, things got spicy when President Biden nominated Cornell Professor Saleh Omarova to be the official comptroller. Omarova had been previously critical of crypto, but that was just the tip of the iceberg of her challenges. She had an extremely tense confirmation hearing, and ultimately

in December, her nomination was withdrawn. In November of 21, we got sort of an interesting in-between from the OCC regarding the Brooks-era interpretive letters. Rather than repeal them outright, basically the OCC said, Fine, this is fine, but you have to check with us first. Quote, this letter clarifies that the activities addressed in those interpretive letters are legally permissible for a bank to engage in, provided the bank can demonstrate to the satisfaction of its supervisory office that it has controls in place to conduct the activity in a safe and sound manner. The bank should not engage in the activities until it receives written notification of the

supervisory office's non-objection. In deciding whether to grant supervisory non-objection, the supervisory office will evaluate the adequacy of the bank's risk management systems and controls and risk measurement systems to enable the bank to engage in the proposed activities in a safe and sound manner. This probably ruffled a lot of Democratic feathers who had wanted to see a more direct repeal of these Brooks-era OCC interpretive letters. However, as the market's turn in 2022 begins, we did begin to see the discussion of systemic risk start to become a bigger theme. In many ways, this makes sense. Over the previous years, bull market, stablecoins had become a much bigger force than they had been just a year earlier. That meant bank regulators were getting

more concerned about contagion risk. In a speech, Sue said, the growth in mainstreaming of crypto means that a stable coin run would not just impact those directly invested in it. There would be collateral damage, and the potential scope of that damage will continue to grow as long as crypto expands. Fortunately, we have an effective tool to mitigate run risk, bank regulation. Now, of course, crypto crashes would go from theoretical to very, very real in just a few short months. And in the wake of Terra and Lunas collapse, Sue actually had another measured response, noting that the contagion hadn't spilled over. That said, we would see later that his conclusion, it seems, from those episodes,

was that it shouldn't be allowed to spill over because the crypto industry should not be allowed to have access to the banking system. Still at the time he made those comments, others in government weren't content with his response. In August of last year, U.S. Senators Elizabeth Warren, Bernie Sanders, Dick Durbin and Sheldon Whitehouse asked the Office of the comptroller of the currency to rescind those interpretive letters that we've been talking about and to explain just how involved traditional banks had become in crypto. The letter stated, given the risks posed by cryptocurrencies to banks and their customers, we request that you withdraw OCC interpretive letters 1170, 1172, 1174, and 1179, and coordinate

with the Federal Reserve and the Federal Deposit Insurance Corporation to develop a comprehensive approach that adequately protects consumers and the safety and soundness of the banking system. While you declare that there has been no contagion from cryptocurrencies to traditional banking and finance during this recent market turmoil, it is clear that stronger protections are necessary to mitigate crypto's risks to the financial system and consumers. Now, in many ways, even more important than the substance of that letter were the Senators' request for information about which banks had gotten involved. They wanted to know which banks have obtained OCC permission to engage in crypto-related activities specified under these interpretive

letters. In total, please specify the number and names of banks regulated by the OCC, which are currently engaged in providing crypto custody services, holding dollar deposit, serving as reserves, backing stablecoins, acting as nodes to verify customer payments, and facilitating stablecoin payment transactions. The list of questions goes on, but they're all about how the existing financial system and banks specifically are interacting with crypto. And then, of course, FTX happened. And if the concern about systemic risk had been high before, it now hit a whole new fever pitch. On December 7th, Senators Elizabeth Warren and Tina Smith sent more open letters, this time to the Fed chairman, the acting head of the FDIC, and the acting comptroller of the currency.

And again, it was all about the relationship between banks and crypto. They wrote, thankfully, the banking system has been spared of the FTX-induced turmoil, despite the industry's efforts to gain access to the banking system and the benefits that come with federal recognition from bank regulators, crypto is so far not deeply integrated with the traditional banking system. Nonetheless, it appears that crypto firms may have had closer ties to the banking system than previously understood. Banks' relationships with crypto firms raise questions about the safety and soundness of our banking system and highlight potential loopholes that crypto firms may try to exploit to gain further access to banks. While the banking system has been fairly unscathed in the latest

crypto crash, FTC's collapse shows that crypto may be more integrated into the banking system than regulators are aware. And this brings us back to Nick Carter's and many others, spidey senses that something bigger is happening. What's clear is that there is a group of politicians in the U.S., some of whom are elected, many of whom are not, who believe that the only thing saving the traditional financial system from the contagion of crypto is the fact that crypto doesn't have good access to the banking system. These are folks then for whom they are not interested in creating quality paths for crypto companies to be banked, but who are instead more interested in whether that lack of access can be enshrined with the force of law, or if not

the force of law, the force of political pressure, to strangle at the source the crypto industry's ability to operate in the United States. Join CoinDesk's Consensus 2023. most important conversation in crypto and web three, 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 yourself in all that blockchain technology has to offer creators, builders, founders, founders, brand leaders, entrepreneurs, and more. Use code breakdown to get 15% off your pass. Visit consensus.com or check the link in the show notes. Now, Nick Carter wrote a longer piece about this in Mike Solana's pirate wires called Operation

Chokepoint 2.0 is underway, and crypto is in the crosshairs. It does such a good job explaining, I'm going to read a big excerpt from it. Think about it a little like a long-read Sunday inside a Friday show, but hopefully now, over the last couple days, you've gotten more context in recent history that helps you understand what Nick is arguing. Nick writes, what began as a trickle is now a flood. The U.S. government is using the banking sector to organize a sophisticated, widespread crackdown against the crypto industry, and the administration's efforts are no secret. They're expressed plainly in memos, regulatory guidance, and blog posts.

However, the breadth of this plan spanning virtually every financial regulator, as well as its highly coordinated nature, has even the most steely-eyed crypto veterans nervous that crypto businesses might end up completely unbanked, Stablecoins may be stranded and unable to manage flows in and out of crypto, and exchanges may be shut off from the banking system entirely. For crypto firms, obtaining access to the onshore banking system has always been a challenge. Even today, crypto startups struggle mightily to get banks, and only a handful of boutiques serve them. This is why stablecoins like Tether found popularity early on, to facilitate fiat settlement where the rails of traditional banking were unavailable. However, in recent weeks, the intensity of efforts to ring fence the entire crypto space and ice

isolated from the traditional banking system have ratcheted up significantly. Specifically, the Biden administration is now executing what appears to be a coordinated plan that spans multiple agencies to discourage banks from dealing with crypto firms. It applies to both traditional banks who would serve crypto clients and crypto-first firms aiming to get bank charters. It includes the administration itself, influential members of Congress, the Fed, the FDIC, the OCC, and the DOJ. Nick then goes through a long list of all the recent actions, which we shared something similar on at the top of yesterday's show. Going back to Nick's piece. In some, banks taking deposits from crypto clients, issuing stable coins, engaging in crypto custody, or seeking to hold crypto as

principle, have faced nothing short of an onslaught from regulators in recent weeks. Time and again, using the expression safety and soundness, they've made it clear that for a bank, touching public blockchains in any way is considered unacceptably risky. While neither the Fed, FDIC, OCC statement, nor the NEC statement a few weeks later, explicitly banned banks from servicing crypto clients, the writing is on the wall, and the investigations into Silvergate are a strong deterrent to any bank considering aligning itself with crypto. What is clear now is that issuing stablecoins or transacting on public blockchains where they could circulate freely like cash is highly discouraged or effectively prohibited. It is equally evident that a bank-issued

fiat token would only be acceptable to regulators if it were domiciled on a surveilled private blockchain. No unhosted wallets allowed. And perhaps most damagingly, the Fed's devastating denial of Wyoming SPDI Bank Custodia, as well as their policy statement, effectively ends any hope that a state chartered crypto bank might get access to the Federal Reserve System without submitting to FDIC oversight. Today, the outlook for banks remotely interested in crypto is precarious. Bankers tell me that crypto is toxic and the risks of engaging with the asset class aren't worth it. In the wake of the custodia decision, obtaining a new charter for a crypto bank, looks extremely unlikely. Banking innovations at the state level, like Wyoming's SPDI for crypto banks,

appear dead in the water. Federal charters for crypto firms with the OCC also look dead in the water. Traders at liquid funds and businesses with crypto working capital are nervously examining their stablecoin portfolios and fiat access points, wondering if bank connectivity might be severed with little notice. Privately entrepreneurs and CEOs in crypto tell me that they sense a regulatory news tightening. As crypto-facing banks de-risk, younger and smaller firms will struggle to get banking, taking us back to the 2014-2016 period when fiat access for crypto businesses was at an extreme premium. premium. Exchanges and other businesses that rely on Fiat onramps are concerned that their few remaining bank partners will shut them off or institute draconian standards for scrutiny.

As a venture capitalist operating at the early stage, I am directly witnessing the chilling effects of this policy in action. Founders are reckoning with new uncertainties around whether they'll be able to operate their businesses at all. So why the push by bank regulators now? The FTCS collapse in its ensuing effects, particularly on Silvergate, provides much of the answer. Financial regulators weren't interested in FTCS while the fraud was underway. with the exception of the SEC and its chairman Gensler, who had oddly close ties to the organization, but ever since the exchange failed in spectacular fashion, they are now contemplating ways to avoid the next such collapse. FtX, as an offshore exchange, was not directly supervised by financial

regulators, aside from FtXUS, which was a marginal stub. So it was outside of their direct aegis. However, regulators believe that they might have a silver bullet on the fiat on and off ramps on which the industry relies. If they can choke off-rash-fayat access, they can marginalize the industry on and offshore without regulating it directly. In some key respects, crypto-chokepoint 2.0 differs from the original. It appears that the administration has learned from the efforts of its predecessors. In chokepoint 1.0, guidance was mainly informal and involved backdoor off-the-record conversations. Its main tool was the threat of investigation from the DOJ and FDIC if financial institutions didn't internalize the administration's risk standards. Because

this was patently unconstitutional, it gave Republicans the collateral to ultimately repeal the program. In 2.0, everything is happening in plain sight, in the form of rulemaking, written guidance, and blogs. The current crypto crackdown is being sold as a safety and soundness issue for banks, and not merely a reputational risk issue. Jake Trevinsky of the Blockchain Association calls it regulation by blog posts. No need to ask Congress for new laws if federal regulators can simply make policy, and in the case of the Fed, grow their scope and mandate, by publishing guidance which dissuades banks from doing business with crypto. Custodias Caitlin Long calls the Fed denial of her application, shooting the stallion to scatter the herd. As a consequence, the only banks willing to touch crypto at this point are smaller, less risk-reverse

ones, with more to gain from banking the industry. However, this means that crypto deposits and flows end up being substantial relative to their core business, which introduces concentration risks. Banks prefer not to have excessive exposure to single counterparties or a depository base that is highly correlated in its flows. Silvergate felt this acutely with the bank run that suffered and survived post-FTCX. While it's impressive that they were able to honor a 70% drawdown in their depository base, the episode will dissuade any banks looking to serve crypto clients that might face the same. And practically speaking, labeling crypto-facing banks' high risk has four direct effects. It gives them a higher premium with the FDIC. They face a lower cap rate with the Fed, which inhibits

their ability to overdraw. They face restrictions on other business activities, and management risks a poor examination score with their regulatory supervisors, which inhibits their ability to do M&A. So while some analysts like Wilson-Sasini's Jess Chang have pointed out, somewhat optimistically, that banks are not explicitly barred from providing crypto custody or onboarding crypto clients, they still stand to get labeled high risk and face serious business hurdles as a result. Some might be sympathetic to regulators' attempts to insulate the banking system from the vicissitudes of the crypto space. But thus far, crypto's various disasters haven't produced any meaningful contagion. The industry had a full-blown credit crisis in 2022, with virtually every

major lender going bankrupt. But the damage was contained. The worst fallout of the banking space was suffered by Silvergate, which suffered an $8 billion drawdown, but survived. No onshore fiat-backed stablecoin suffered any meaningfully averse effects, despite the massive crypto selloff in 2021 and 2022. They functioned as intended. And no contagion spilled into traditional finance via mass selling of treasuries, something officials have historically felt might be a key transmission channel. As Biden enters the second half of his term, his crackdown on crypto banking has deflated hopes for a regulatory reproachment in the U.S. Many crypto entrepreneurs now tell me they're waiting for 2025 and a putative DeSantis regime for things to turn. Some can't wait.

that long and are shuddering their plans for businesses which involve any type of regulatory approval, especially with regards to bank charters. Regulators are effectively picking winners with larger, more established crypto firms able to hang on to their bank relationships, while newer ones are shut out. Meanwhile, other jurisdictions are making a bid for their business. Hong Kong has adopted a friendlier tone once again, as has the UK. The UAE and the Saudis are looking to attract crypto firms, and U.S. regulators can scarcely afford to forget what happened with FTX, in which they curtail the business activities of on-shore exchanges, effectively pushing U.S. individuals into the waiting clause of SPF. If bank regulators continue their pressure campaign, they risk not only

losing control of the crypto industry, but ironically increasing risk by pushing activity to less sophisticated jurisdictions, less able to manage genuine risks that may emerge. So another banger from Nick, and I think you understand why I wanted to read such a big piece of it. But all of this brings us back to the question of where we are now. And more importantly, who can solve this? And the short answer is really simple. It's Congress. Jake Chavinsky writes,

without new legislation from Congress, federal agencies lack the authority to comprehensively regulate crypto markets. So their fallback position is to weaponize control over the banking system to mandate discrimination against crypto companies. This must stop. I expect Congress will investigate this issue. The question is,

are there any indications he's right? I've seen one senator tweet about this, Senator Bill Haggerty, from Tennessee. On February 8th, he tweeted, regulators singling out business activities should alarm all Americans. Doesn't matter if it's crypto assets, firearms, or any other lawful business. Using banking regulators to advance political agendas should not be tolerated. So I want to wrap this up by saying that I do believe that this is a major concern. And I don't believe that it requires an outright ban to have an absolutely crippling effect

on the crypto industry in the United States. This is a more subtle and thus more pernicious form of attack. than a lot of the things we've seen thus far, and so it's going to take a different approach to actually addressing it. I don't know exactly what that approach is yet, and I don't know what allies are going to emerge to help, but I'll be keeping a careful eye on it, and I will certainly let you know as soon as I have any ideas.

For now, guys, I hope this two-part series has been helpful in your understanding of where things sit. Until tomorrow, be safe and take care of each other. Peace.