The cryptocurrency market may face "deadly" regulation from the U.S.; is there any basis for the rumors?

Original Title: 《Operation Choke Point 2.0 Is Underway, And Crypto Is In Its Crosshairs》

Author: Nic Carter, CoinDesk columnist & partner at Castle Island Ventures

Translation: Linqi, ChainCatcher

The Biden administration is quietly attempting to ban cryptocurrency.

What started as a trickle has turned into a flood: the U.S. government is orchestrating a complex and widespread crackdown on the crypto industry through banking organizations. In fact, the efforts of the U.S. government are no longer a secret: they have been clearly articulated in memos, regulatory guidelines, and blog posts. However, the breadth of this plan, which nearly encompasses every financial regulatory agency, and its highly coordinated nature have even the most steadfast crypto veterans worried that crypto businesses may ultimately be completely disconnected from bank accounts, stablecoins may struggle to manage the inflow and outflow of crypto assets, and exchanges may be entirely shut out of the banking system. Let’s take a closer look.

For crypto companies, accessing the onshore banking system has always been a challenge. Even today, crypto startups find it difficult to gain support from banks, with only a few able to serve them. This is why stablecoins like Tether became popular early on: to facilitate fiat settlements where traditional banking services were unavailable. However, in recent weeks, efforts to restrict the entire crypto industry and isolate it from the traditional banking system have significantly intensified.

Specifically, the Biden administration is currently executing what appears to be a coordinated plan across multiple agencies to prevent banks from dealing with cryptocurrency companies. This applies to traditional banks that serve crypto clients as well as crypto-focused companies seeking to obtain banking licenses. It includes the government itself, influential members of Congress, the Federal Reserve, the Federal Deposit Insurance Corporation, the OCC, and the Department of Justice. Here’s a recap of significant events related to banks and policy-making in recent weeks:

• On December 6, Senators Elizabeth Warren, John Kennedy, and Roger Marshall sent a letter to crypto-friendly bank Silvergate, accusing them of servicing FTX and Alameda Research and criticizing them for failing to report suspicious activities related to these clients.
• On December 7, Signature (one of the most active banks serving crypto clients) announced plans to halve deposits from cryptocurrency clients, in other words, they would return customers' money and then close their accounts, aiming to reduce crypto deposits from a peak of $23 billion to $10 billion and exit the stablecoin business.
• On January 3, the Federal Reserve, FDIC, and OCC issued a joint statement on the risks of banks engaging in cryptocurrency activities, which did not explicitly prohibit banks from holding cryptocurrencies or trading with crypto clients but strongly discouraged banks from doing so on a "safe and sound" basis.
• On January 9, Metropolitan Commercial Bank (one of the few banks serving crypto clients) announced a complete shutdown of its crypto asset-related verticals.
• On January 9, amid concerns over bank runs and bankruptcies, Silvergate's stock price fell to a low of $11.55, down from a high of $160 in March 2022.
• On January 21, Binance announced that, according to Signature Bank's policy, they would only process fiat transactions for users worth over $100,000.
• On January 27, the Federal Reserve rejected crypto bank Custodia's two-year application to become a member of the Federal Reserve System on the grounds of "safe and sound" risks.
• On January 27, the Kansas City Federal Reserve Bank branch denied Custodia's request for a master account, which would have allowed it to use wholesale payment services and hold reserves directly at the Federal Reserve.
• On January 27, the Federal Reserve also issued a policy statement discouraging banks from holding crypto assets or issuing stablecoins and expanded its authority to cover state-chartered banks that are not FDIC insured (a response to Wyoming's special purpose depository institutions (SPDIs) like Custodia, which can hold cryptocurrencies and fiat for their banking clients).
• On January 27, the U.S. National Economic Council released a policy statement that did not explicitly prohibit banks from serving crypto clients but strongly discouraged banks from directly trading in crypto assets or maintaining exposure to crypto depositors.
• On February 2, the U.S. Department of Justice's fraud division announced an investigation into Silvergate's dealings with FTX and Alameda.
• On February 6, Binance suspended dollar bank transfer services for retail customers (Binance US was unaffected).
• On February 7, the Federal Reserve's January 27 statement was incorporated into the Federal Register, making the policy statement a final rule without requiring congressional review or a public notice and comment period.
• As of February 8, Protego and Paxos followed Anchorage's lead, hoping for approval to become national trust banks, but their applications remain pending (18 months past the deadline) and seem likely to be rejected by the OCC soon.

In summary, in recent weeks, banks that absorb deposits from crypto clients, issue stablecoins, engage in crypto custody, or seek to use cryptocurrencies as principal have faced fierce backlash from regulators. U.S. regulators have repeatedly used the term "safe and sound," clearly indicating that any engagement with public chains is considered an unacceptable risk for a bank.

Although the statements from the Federal Reserve/FDIC/OCC, as well as the NEC statement weeks later, did not explicitly prohibit banks from serving cryptocurrency clients, it is effectively a done deal, and the investigation into Silvergate serves as a powerful deterrent for any bank considering cooperation with cryptocurrencies. It is now clear that issuing stablecoins or trading on public chains (which can circulate freely like cash) is highly discouraged, or effectively prohibited.

It is equally evident that fiat tokens issued by banks will only be accepted by regulators if registered on monitored private chains. The use of "non-custodial" wallets is not permitted. Perhaps most destructively, the Federal Reserve's devastating rejection of Wyoming's SPDI bank Custodia, along with their policy statement, effectively ended any hope that state-chartered crypto banks could enter the Federal Reserve system without FDIC oversight.

Why are cryptocurrency entrepreneurs wary of the FDIC? This traces back to "Operation Choke Point." Some in the crypto space believe that the recent attempts to encircle the crypto industry and sever its connections to the banking system evoke memories of this little-known Obama-era initiative.

The "Choke Point" initiative began in 2013, aimed at marginalizing specific legally operating industries. Not through legislation, but by exerting pressure through the banking sector. In 2011 and 2012, the Obama Justice Department successfully marginalized the online poker industry by threatening banks that supported poker companies. Under the "Choke Point" initiative, government agencies decided to ramp up efforts and target other industries, starting with uncontroversial targets like payday lenders.

Subsequently, the U.S. Department of Justice collaborated with the FDIC and OCC to pressure member banks to "draw red lines" against certain legal but politically unpopular industries, deeming that doing business with these industries posed too great a risk, with gun manufacturers and the adult entertainment industry being the primary targets. Banks and payment processors internalized this guidance, and even after Trump officially ended the initiative in 2017, its shadow lingered. Today, even without specific guidance, banks will attribute riskier behaviors to actions they suspect may anger the government.

Since the "Choke Point" initiative was ostensibly concluded, the practice of using financial channels as an extrajudicial political tool has become more popular. In 2017, under pressure, several banks withdrew from the Dakota Access Pipeline project. In 2018, Bank of America and Citigroup removed gun companies from their client lists, and Bank of America began reporting customers' gun purchases to the federal government. In 2019, Alexandria Ocasio-Cortez announced her intention to marginalize private prisons through her position on the House Financial Services Committee.

Financial regulators have also been urged to advance reforms. In 2021, the Democrat-controlled House passed the Federal Reserve Racial and Economic Equity Act, which requires the Federal Reserve to aim to "eliminate disparities in employment, income, wealth, and access to affordable credit among racial and ethnic groups." The SEC, led by Gensler, now maintains a controversial climate agenda, as does the Federal Reserve (on a smaller scale). Kamala Harris has tasked banks with advancing a racial equity agenda, effectively soliciting equality in credit provision.

Today, explicit conservative organizations like Gab or Parler, along with various dissenters and those opposed to regime politics, find themselves deprived of services from banks, fintech, and payment processors, which is even quite common. For those who support this practice, I would ask you to imagine what inclusive (or exclusionary) finance would look like under a similarly zealous DeSantis administration. "Build your own bank," right? If the Federal Reserve has any say in the matter, then it won't happen. As the stillborn Wyoming SPDI indicates, the crypto industry attempted this route but was thoroughly blocked.

In an environment where obtaining new licenses is challenging, banks are highly regulated public-private partnerships, and thus, they remain de facto state weapons. It has been trivial to have them execute political objectives in the past and present. If there is any doubt, it is now clear that the Obama administration and its successor Biden's regime have easily circumvented the First Amendment by hiring nominally private companies to do their dirty work.

Anyone paying attention will notice the strange, close revolving door between monopolistic big tech companies and security state officials from the Obama/Biden administrations. Since Elon Musk leaked the Twitter Files, the U.S. government and its security agencies have openly used Twitter as a proxy for censorship and narrative control. Yet, Twitter is "just a private company," right?

In 2017, Trump and Republican legislators like Luetkemeyer briefly halted the "Choke Point" initiative, but it did not last long. One of the first actions taken by the OCC under Biden was to rescind Brian Brooks' Fair Access Rule, which prohibited political discrimination in banking. Biden's deputies picked up where Obama's regulators left off. Now, after digesting Biden's executive orders, regulators are tightening the screws.

Today, the outlook for banks with even a slight interest in cryptocurrency is bleak. Bankers tell me that cryptocurrency is toxic, and the risks of engaging in this asset class are not worth it. After the Custodia ruling, obtaining new licenses for crypto banks seems extremely unlikely. State-level banking innovations, like Wyoming's SPDI for crypto banks, appear to have stalled. Federal charters for OCC crypto companies also seem to be at a standstill. Traders, liquidity funds, and businesses with crypto liquidity are nervously checking their stablecoin portfolios and fiat access points, wondering if bank connections will be severed without notice.

Privately, entrepreneurs and CEOs in the crypto space tell me they feel the regulatory noose tightening. As banks facing "risks" from crypto businesses will find it difficult to serve younger and smaller companies, this will take us back to the period from 2014 to 2016 when the cost of entering the crypto business was prohibitively high. Exchanges and other businesses relying on "token deposits" are concerned that their few remaining banking partners will shut them down or impose stringent review standards. As an early venture capitalist, I have witnessed the chilling effect of this policy firsthand. Founders are contemplating new uncertainties about whether they can continue to operate their businesses.

So why are bank regulators pushing this policy now? The collapse of FTX and its subsequent impacts (especially on Silvergate) provide much of the answer. During the fraud process, financial regulators were not interested in FTX (except for the SEC and its chairman Gensler, who has a strangely close relationship with the organization), but since the exchange failed in such a spectacular manner, they are now considering how to avoid a similar collapse in the future. FTX, as an offshore exchange, was not directly regulated by financial regulators (except for FTX US), and thus fell outside their direct oversight.

However, regulators believe they may have a "silver bullet," namely the entry points for token deposits and withdrawals that the industry relies on. If they can cut off these entry points, they can marginalize the industry without direct regulation—whether onshore or offshore.

In some key aspects, "Crypto Choke Point 2.0" differs from the original version. It seems the government has learned lessons from previous efforts. In "Choke Point 1.0," guidance was primarily informal, involving secretive, informal conversations. Its main tactic was to threaten that if financial institutions did not internalize the government's risk standards, the DOJ and FDIC would launch investigations. Because this was clearly unconstitutional, it provided collateral for Republicans to ultimately abolish the initiative. In the 2.0 era, everything happens in plain sight in the form of rule-making, written guidance, and blogs. The current crackdown on cryptocurrency is being promoted as a "safe and sound" issue for banks, rather than merely a reputational risk issue.

Jake Chervinsky from the Blockchain Association refers to it as "blog post-style regulation." If federal regulators can dissuade banks from engaging with cryptocurrencies simply by issuing guidance (in the case of the Federal Reserve, expanding its scope and authority), there is no need to ask Congress to enact new laws. Caitlin Long of Custodia describes the Federal Reserve's rejection of her application as "killing the chicken to scare the monkey."

Thus, the only banks currently willing to engage with cryptocurrencies are smaller, less risk-averse banks that derive more benefits from banking with the industry. However, this means that, relative to their core businesses, cryptocurrency deposits and flows are ultimately massive, introducing concentrated risks. Banks do not want excessive risk exposure to a single counterparty and are reluctant to have a deposit base highly correlated with their cash flows. Silvergate felt this acutely during the bank run it experienced after FTX (and narrowly escaped). While it is impressive that they managed to reduce their deposit base by 70%, this event will deter any bank hoping to serve crypto clients that may face similar issues.

In fact, labeling banks that serve cryptocurrencies as "high risk" has four direct impacts: it results in higher premiums for them at the FDIC, they face lower cap rates at the Federal Reserve (which suppresses their overdraft capabilities), they face restrictions on other business activities, and they score lower in risk management under regulatory scrutiny, which inhibits their ability to engage in mergers and acquisitions. Therefore, although some analysts (like Jess Cheng from Wilson Sonsini) somewhat optimistically point out that banks have not been explicitly prohibited from providing crypto custody or serving crypto clients, they will still be labeled as high risk and thus face serious business obstacles.

Some may sympathize with regulators trying to isolate the banking system from the changes in the cryptocurrency space. But so far, the various disasters in cryptocurrency have not produced any meaningful contagion. The industry experienced a full-blown credit crisis in 2022, with nearly all major lending institutions going bankrupt, but the losses were contained. The bank most severely affected was Silvergate, which suffered an $8 billion shrinkage but survived. Despite massive sell-offs in cryptocurrencies in 2021 and 2022, fiat-backed onshore stablecoins did not suffer any serious adverse effects. They performed as expected. Moreover, there was no contagion to traditional finance through massive sell-offs of U.S. Treasuries, which officials had previously considered a key transmission channel.

As Biden enters the second half of his term, his crackdown on crypto banking has weakened hopes for regulatory reconciliation in the U.S. Many cryptocurrency entrepreneurs now tell me they are waiting for 2025 and a presumed DeSantis administration for things to change. Some cannot wait that long and are shutting down their business plans that involve any type of regulatory approval, especially regarding banking charters. Regulators are effectively picking winners—larger, more mature cryptocurrency companies can maintain relationships with banks, while newer companies are shut out.

Meanwhile, other jurisdictions are strategizing to attract crypto businesses. Hong Kong has once again taken a friendly stance, as has the UK. The UAE and Saudi Arabia are seeking to attract cryptocurrency companies. U.S. regulators can hardly forget the FTX incident; they have curtailed the activities of onshore exchanges, effectively pushing U.S. retail investors into the clutches of SBF. If bank regulators continue their pressure campaign, they risk not only losing control over the cryptocurrency industry but, ironically, by pushing the crypto movement into less mature jurisdictions, they may reduce their ability to manage the real risks that may arise, thereby increasing risks.

Author Nic Carter Note: Thanks to Austin Campbell and Tyler Williams for their assistance with this article.