Regulation & Policymaking: Part II

Jun 06, 2023

We’re back for Part II of our mini-series on crypto regulation and policymaking in the US.

Topics covered:

Operation Choke Point 1.0 in 2013 & Similarities with the Crypto Industry Today
MiCA Passage in Europe and Regulatory Game Theory
Potential Outcomes

Disclaimer: Views expressed are the author's personal views and should not be taken as investment or legal advice.

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Let’s go.

Operation Choke Point 1.0

Starting in early January, we’ve observed widespread enforcement actions taking place across the crypto industry. Per a joint statement by the Fed, FDIC, and OCC on January 3rd highlighting “Crypto Asset Risk to Banking Organizations,” it’s fair to say it’s been a coordinated effort. We listed each action in a prior report if you need a refresher.

The intent should be to curtail fraud and punish bad actors. To facilitate responsible innovation. And to protect investors.

But some are claiming that something more sinister may be happening. They're calling it “Operation Choke Point 2.0.”

This implies that Operation Choke Point 1.0 came first.

So what exactly was Operation Choke Point 1.0 (the government’s official name)?

Why was the initiative deemed to be illegal and unconstitutional?

What are the similarities we see today with crypto? And what can we learn from the ultimate outcome?

Let’s dive in.

Overview

Operation Choke Point was an initiative by the United States Department of Justice that began in August 2013.

In essence, it was a coordinated effort to “choke off” unfavored industries (firearms dealers, credit repair services, cigar manufacturers, dating services, payday lenders, telemarketing, online gambling, etc.) by cutting off access to banking services.

“Don’t like an industry? Send a message to its Bankers.”
- William Isaac, Former Chairman of the FDIC 11/21/14 (in a scathing opinion piece in the WSJ)

“I feel that activists at the DOJ and the FDIC are abusing their power and authority and are going after legal businesses and, in effect, they are weaponizing government to meet their ideological beliefs.”
-Sean Duffy, House Financial Services Sub-Committe Chair 3/24/15

Operation Choke Point was “asking banks to identify customers who are simply doing something government officials don’t like. Banks then *choke off* those customers' access to financial services, shutting down their accounts.”
-Frank Keating, American Bankers Association

Outcome

While the government denied any wrongdoing, recovered emails painted a different picture. It turned out that high-ranking regulators at the FDIC were passing around notes about how much they “couldn’t stand” various industries while directing banks to close the accounts of legal businesses.

It took over 3 years of contentious litigation, several Congressional investigations, and ultimately a change in presidential administration to put an end to Operation Choke Point’s campaign against legal American businesses.

Operation Choke Point officially ended in August 2017 with the FDIC settling multiple lawsuits with injured parties who had been frozen out of the financial system.

In addition to monetary settlement, the FDIC promised Congress “limitations on the ability of FDIC personnel to terminate banking account relationships,” and “additional training.”

Similarities to Current “Crack Down” on Crypto

If your jaw dropped while reading the prior section, we don’t blame you. It was surprising to learn that it all took place within the last 10 years. This stuff isn’t supposed to happen in America. But it might be happening again, right under our noses.

Cooper & Kirk was the law firm that defended injured parties during Operation Choke Point 1.0. Per their recent white paper on the topic, history is repeating itself. They’ve outlined the below similarities:

Democrat-controlled White House.
The FDIC Chair from Operation Choke Point 1.0 is back in office.
Targeting banking relationships for a specific, politically unfavored industry.
Publication of informal guidance documents by the prudential bank regulators and a covert campaign of coercion, threats, and backroom pressure.
Banks fear that regulators will turn on them, and therefore cave to their threats. “Smother your customers that we don’t like, or we’ll smother you with costly audits and examinations.”

Differences:

One target: Crypto.
Global, disruptive industry.
More retail + sophisticated investors.
Crypto touches important financial & payment infrastructure.
Publicly traded companies and major financial service providers are involved in the industry.

Red Flags

We’re trying to avoid jumping to any conclusions, but the circumstantial evidence doesn’t look good.

Per Cooper & Kirk, there isn’t just one event that indicates a coordinated effort to “shadow-ban” businesses within an unfavored industry is underway. It’s more about the confluence of many events & circumstances.

With that said, we want to highlight the closure of Signature Bank.

Signature Bank was seized by the FDIC on Sunday, March 12, 2023. The firm was one of the two major banks that serviced large crypto firms facilitating liquid, 24/7 global markets. The other was Silvergate, which ceased operations on March 8th.

Both banks operated real-time payment platforms that uniquely served the 24/7 liquidity needs of large crypto exchanges and market makers. This was critical infrastructure for swapping fiat/crypto that facilitates the global trading of crypto assets 24/7 365.

The circumstances around the FDIC’s seizure are bizarre for a few reasons:

Signature had $110.36 billion of assets to cover $88.59 billion of liabilities at the end of 2022. $10 billion of deposits had left the bank on Friday, March 10th as fears around contagion related to SVB escalated. But by Sunday, March 12th (the date of seizure), the bank had shored up its capital situation and the deposit exodus had slowed. The bank was solvent. As such, the stated reason that the FDIC provided for taking control of Signature Bank was “poor management.” The FDIC itself conceded that the bank was solvent when it was closed. In the storied history of banking in the US we cannot find another instance of a bank being seized for “poor management.”
During the investigation by Cooper & Kirk related to Operation Choke Point 1.0, it was revealed that a head examiner at the FDIC threatened that the FDIC was simply not concerned if “a piss ant, $200 million bank failed.”
Barney Frank (D-MA, former Rep who wrote the Dodd-Frank Wall Street Reform and Consumer Protection Act) sits on Signature’s Board and was quick to suggest that Signature Bank was the victim of a political attack.

“We’re not a big high-tech lender. We’re a big NYC housing lender more than anything else. We weren’t having crypto as our own asset — we were simply allowing two businesses that were customers of ours that wanted to deal with each other in crypto to do so. We were a facilitator. The regulators wanted to send a very strong anti-crypto message.”

4. According to two anonymous sources, the FDIC required bidders for Signature to agree not to bid on Signet — the 24/7 365 payment infrastructure asset that facilitated liquid global markets. This meant that key infrastructure serving crypto markets was now completely severed. It also meant that many legitimate crypto firms no longer had a banking partner. Given the circumstances surrounding the hastily sold bank, the WSJ opined that actions taken by the FDIC “confirm Mr. Franks’s suspicions — and ours —that Signature’s seizure was motivated by regulators’ hostility toward crypto.” Here’s Barney Frank when asked if it’s legal to seize a solvent bank, and exclude certain assets of the bank in the subsequent sale:

“Well that’s worrisome. Somebody ought to look and see. I wonder, are we the first bank to be closed, totally, without being insolvent? And if so, why? I think the DFS, the state of New York people should have to answer that. That’s why I speculate that using us as a poster child to say “stay away from crypto” was the reason.”

This doesn’t look great, but we’ll have to wait and see as more information comes to light. For more on the topic, you can check out the (40 min) interview that Nic Carter did with David Thompson of Cooper & Kirk — the law firm that defended injured parties in Operation Choke Point 1.0, and who is now coming to the aid of crypto firms in 2.0.

What’s Next?

Cooper & Kirk are requesting that crypto firms come forward and share their experiences over the last several months.

If the allegations are true, we should anticipate that Congress and the courts will come down hard on any abuses of power from unelected regulators. Harsh punishments are necessary because it’s a dangerous precedent that political power can be wielded to freeze politically unfavored legal businesses out of the financial system.

As far as timelines, Cooper & Kirk projects it could be multiple years before the investigation is complete and cases are heard.

MiCA & Regulatory Game Theory

In the US we have a divided Congress. We have further division amongst regulators at the SEC and CFTC. We have hostile and potentially illegal behavior from unelected regulators at the FDIC. We have posturing from the White House. And we have at least one Senator campaigning on building an “Anti Crypto Army.”

It’s a bit messy.

But this isn’t the case around the world.

With the recent passage of the Markets in Crypto Assets (MiCA), the European Union is saying to the US “Your trash is our treasure.”

Regulatory Game Theory has commenced.

Why? Incentives. If crypto truly has the potential we think it does, the industry will create jobs and tax revenues globally. So, why not regulate the space thoughtfully and attract the best entrepreneurs to your jurisdiction?

That’s the thinking. And it’s not just Europe. The UK wants to be a leader. Japan is moving forward with a regulatory framework. UAE is taking a leadership role. Places like Singapore, Switzerland, and Australia have been forward-thinking.

Even China is now stepping back into the game (via Hong Kong) at the precise moment the US has become more hostile toward the industry.

But Europe is the first to pass substantial legislation. Here are the takeaways concerning MiCA:

Passed with a vote of 500 to 30
Expected to go into law in July. Compliance for firms is projected to commence in 2024.
The focus initially is on centralized Crypto Asset Service Providers or “CASPs”
Exchanges. OTC Desks. Stablecoin issuers. Issuance of tokens.
Scoped out DeFi and NFTs. Unlikely to see new rules here until 2027.
Primary Focus: Illicit finance. Protecting retail. US-denominated stablecoins.

We’ll see how the implementation goes, but we think this is a great start. Focus on stablecoins and centralized service providers. Allow DeFi and NFTs to continue to innovate. Watch. Learn. And address that space in a few years’ time.

We have reason to believe the UK wants to be a global crypto hub. It’s possible that Europe is providing a template for the UK and other jurisdictions to follow.

Meanwhile, the US is falling behind as we fight over politics and existing power structures.

Potential Outcomes

Bear Case.

The Draconian Stance toward Crypto Persists or Gets Worse in the US: in this scenario, the US takes a similar approach toward crypto that China previously held. Entrepreneurs cannot innovate in the US. Financial institutions cannot offer products or services leveraging transparent, public blockchains. RIAs cannot advise their clients on crypto. Crypto funds cannot raise capital, hindering capital formation within the industry.

We think the likelihood is low here. Let’s call it less than 5%. Why? Incentives. Crypto will be blessed when the incentives for policymakers line up with the incentives of industry participants. It’s messy and we’re not there yet. But we remain optimistic.

Base Case. Timeline 12-24 months.

Sentiment toward Crypto Shifts Positive in the US: We think this is more likely than what is currently priced into markets. The FTX fraud is still only 6 months old. Not surprisingly, the blowback has been harsh and swift. But we think we’ve likely seen the worst. Why? Again, incentives. The uniquely diverse nature of crypto users will present challenges for policymakers that continue to ignorantly use “crypto bros” as a scapegoat for some other agenda. We think the next bull run will be kicked off by a return of liquidity to markets as well as regulatory developments both inside and outside of the US. Look for competition with China to re-enter the conversation. Interestingly, China is becoming more friendly toward crypto as the US becomes more hostile. Some policymakers are already picking up on this. As we’ve stated, this is Regulatory Game Theory.

Bull Case. Timeline 24-48 months.

Sentiment Toward Crypto Does a Complete 180. Coinbase and/or Ripple settle or win their cases with the SEC. It is revealed that illegal actions were taken against crypto firms during Choke Point 2.0. As this news comes out, there is significant backlash toward policymakers and regulators. This adds fuel to the already burning fire regarding *a lack of trust in institutions.* Gary Gensler is out at the SEC. Congress introduces thoughtful new legislation that is signed into law. Clarity and a shared consensus among the population that “crypto is the future” officially take hold. We see another massive influx of capital into US markets. The stigma is officially erased. Innovation thrives, and the US regains its position as a leader in the crypto space.

Summary

To put a bow on our two-part series covering policymaking and regulation in the US, our current views are as follows:

The SEC wants to apply the framework that was created in 1933/1934 to crypto. This won’t work because crypto assets are fundamentally different.
We need a new framework for crypto that can ensure proper disclosures and investor protections. This will ultimately come from Congress, with the SEC and/or CFTC enforcing the new rule set.
We’re seeing some progress in this direction with the currently drafted legislature. Despite the hostility toward crypto from the Executive branch (& President appointed regulatory agencies), the Legislative branch appears to support responsible innovation.
The SEC's cases against Coinbase and Ripple (and now Binance) are important to keep an eye on as the outcomes could help to shape policymaking going forward.
Incentives will drive the sentiment within Congress. Because crypto users are uniquely diverse and bi-partisan, we think it will be difficult for policymakers to oppose the industry.
Bitcoin and crypto are likely to become more relevant as we approach the next election cycle.
Crypto desperately needs regulation and a cleansing of bad actors. With that said, it appears some actions taken by regulatory agencies may have overstepped the law. We’ll be keeping an eye on Cooper & Kirk and the work they are doing on behalf of the industry.
With groundbreaking legislation going into law in July in Europe, regulatory game theory is on. We think this will have an impact on the sentiment toward crypto from American policymakers.
Despite the challenges we see today, ultimately we think crypto will be properly regulated in a way that fosters innovation while protecting investors. It’s just going to take some time. We’re projecting a 2-5 year timeline.

As ever, we expect the path to evolve. We’re here to provide updates as new developments unfold.

Thanks for reading.

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