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Operation Choke Point 2.0, Monopolistic Favoritism, or the Velocity of Money?
Operation Choke Point was initiated in 2013 by the United States Department of Justice to protect consumers from fraud perpetrated by third-party payment processors. The DOJ issued subpoenas to approximately 60 financial entities, some of which were FDIC-supervised. The FDIC also issued supervisory guidance that raised suspicions that financial regulators were “pressuring financial institutions to terminate business relationships with lawful lenders” that were considered “high risk.” In particular, the FDIC’s supervisory guidance made references to specific merchant groups, such as firearms dealers and payday lenders, which created a perception among bank executives that the FDIC discouraged banks from doing business with those parties. Transcripts of a bank chairman’s deposition also exposed “blatant intimidation” by the FDIC as the bank official was asked by regulators if “he was aware that bank directors could be subject to criminal prosecution.”
An audit conducted by the FDIC’s Office of the Inspector General found that “the manner in which the [FDIC’s] supervisory approach was carried out was not always consistent with the FDIC’s written policy and guidance.” After a Congressional probe and multiple lawsuits, the FDIC agreed to limit the ability of personnel to terminate account relationships and to stop making informal or unwritten suggestions related to account terminations or criticism of a bank’s risk management with regards to its deposit accounts.
On March 17, 2023, the Wall Street Journal seemed to confirm growing speculation of Operation Choke Point 2.0 targeting the digital asset sector through a steady stream of increasingly discriminatory behavior and aggressive oversight by state and federal regulators that has had real-world, detrimental consequences for businesses, entrepreneurs, and the spirit of innovation in America.
Thus far, there have been reports of digital asset firms being de-banked, meaning that bank accounts linked to cryptocurrency and digital asset companies are being closed while companies who want to open new bank accounts are being refused. Without digital or physical access to banking, are legally-operating American businesses able to thrive? A flurry of other events also suggests that the digital asset industry has been increasingly under attack by regulators.
Some of the most notable actions by regulators include:
The statement noted: “[b]ased on the agencies’ current understanding and experience to date, the agencies believe that issuing or holding as principal crypto-assets that are issued, stored, or transferred on an open, public, and/or decentralized network, or similar system is highly likely to be inconsistent with safe and sound banking practices. Further, the agencies have significant safety and soundness concerns with business models that are concentrated in crypto-asset-related activities or have concentrated exposures to the crypto-asset sector.”
● January 23, 2023: The Federal Reserve issued a policy statement that discourages banks from holding or issuing cryptocurrencies.
The statement noted: “[i]n particular, the preamble [to the proposed policy statement] would provide that the Board would presumptively prohibit SMBs from holding most crypto-assets as principal, and also would provide that any SMB seeking to issue a dollar token would need to demonstrate, to the satisfaction of Federal Reserve supervisors, that the bank has controls in place to conduct the activity in a safe and sound manner, and to receive a Federal Reserve supervisory nonobjection before commencing such activity.”
The statement also clarified Section 24 of the FDIA, which generally prohibits insured state banks from engaging as principal in any activity that is not permissible for national banks, unless authorized by federal statute or the FDIC, noting: “[t]his principle of equal treatment helps to level the competitive playing field among banks with different charters and different federal supervisors and to mitigate the risks of regulatory arbitrage.”
● January 27, 2023: The White House National Economic Council released a statement highlighting the “imperative of separating risky digital assets from the banking system”
● February 23, 2023: The Federal Reserve, FDIC, and OCC released a joint statement on liquidity risks to banks from crypto-related market vulnerabilities.
Without more information, it is difficult to discern whether regulators have been taking extraordinary measures, similar to those exposed during Operation Choke Point 1.0, to choke off the digital asset industry from the traditional banking system. At least two of these recent policy statements by federal officials have included the following statement:
[B]anking organizations are neither prohibited nor discouraged from providing banking services to customers of any specific class or type, as permitted by law and regulation
perhaps in an effort to thwart Operation Choke Point 2.0 rumors in advance. However, the aggregate impact of these federal policy statements is unmistakable: they have had a chilling effect on crypto-related innovation and activity in America.
Evidence to support Operation Choke Point 2.0 claims is starting to accumulate. For example, between December 2022 and January 2023, two banks—Signature and Metropolitan Commercial Bank—announced the closure of their cryptocurrency services.
Only a few months later, in March 2023, Signature Bank was seized by the New York Division of Financial Services and given to the FDIC so that the bank could be sold. Although Signature held a diverse deposit base that included law firms and real-estate developers and allegedly had enough deposits to ride out a run on deposits, there was suspicion that state regulators targeted Signature because of its strong ties to the crypto industry. The NYDFS denied these claims and alleged that the bank was closed due to a “significant crisis of confidence in the bank’s leadership.”
Notably, in the weeks following Signature’s seizure by regulators, the FDIC sold Signature Bank to Flagstar Bank, however the deal did not include approximately $4 billion of deposits related to Signature’s digital asset banking business. Although those crypto-related deposits will be returned directly to customers, they will not continue to be insured by the FDIC. Whether the divestiture of digital asset deposits from Signature’s sale was Flagstar’s decision or mandated by the FDIC is unclear. As more information comes to light about the reasons for seizing and selling Signature, the rumors about a possible Operation Choke Point 2.0-style “execution” will either be confirmed or rejected.
In March 2023, Silvergate Bank, which has been described as the “go-to bank for the cryptocurrency industry,” also wound down its services and liquidated its assets. Although the move was supposedly voluntary, the bank blamed the crypto market meltdown as well as “recent regulatory developments” for its decision to shutter. One reason for the liquidation might simply be capitalization issues. For example, at the end of the fourth quarter of 2022, Silvergate had a high risk-capital ratio (~57%), but its deposit base declined by 68%, which “dragged Silvergate into mounting investigations by regulators[,] social media campaigns by short sellers, as well as litigation from investors as its stock price fell.” However, one should also question how voluntary the decision to liquidate was or if there was regulatory pressure lurking behind the decision due to the bank’s involvement with crypto activities.
The shuttering of banking services that cater to an unfavored industry sub-sector amidst a backdrop of aggressive regulatory enforcement and discouraging policy messaging sends a strong signal to the rest of the market. It not only chills the freedom of banks to engage in any legal, capitalistic activity of their choice, but it also prevents legitimate cryptocurrency and digital asset businesses from starting up, expanding, receiving funding from private investors, and applying for federal research grants. Furthermore, without the traditional banking system as a player and partner in the digital asset ecosystem, American citizens who choose to transact or trade with cryptocurrencies have fewer options to on-ramp and off-ramp their dollars into crypto, and vice versa. Without established payment networks, a diversity of options to transact in the digital age, freedom of choice, and political neutrality towards a new type of technology, innovation suffers and American progress decelerates. Instead, fear governs policymaking.
Despite Operation Choke Point 2.0 rumors that have been circulating in the media, there have been reports that regional and smaller upstart banks are “rolling out a welcome mat” for cryptocurrency firms in need of banking services, which stymies some of the most vocal claims of an alleged crypto choke point operation.
Nevertheless, if the rumors turn out to be accurate, then lawmakers and the American public should take notice. A potential Operation Choke Point 2.0 is deeply un-American, and it deserves the bipartisan attention it is already getting. For example, former Democratic Representative, Chair of the House Financial Services Committee, and co-sponsor of the Dodd-Frank Act, Barney Frank, has already alleged that New York financial regulators seized Signature Bank “to send a message to get people away from crypto.” Additionally, Republic House Majority Whip, Tom Emmer, proactively sent a letter to the FDIC Chairman to inquire about reports that financial regulators were “weaponizing their authority … to purge legal digital asset entities and opportunities from the United States.”
In order to hold regulators accountable and rein in regulatory overreach, Congress should act by conducting closer oversight of agency activity and internal regulatory affairs with regards to the aforementioned events that have negatively impacted the crypto industry and possibly abridged the constitutional rights of American entrepreneurs.
If Not Operation Choke Point 2.0, Then What?
In the absence of direct evidence of Operation Choke Point 2.0, there are other theories that may provide additional color regarding the government’s treatment of a new technology and industry that has challenged the dominance of the traditional banking industry and its embedded power structures in the United States:
(1) Does the Government Have A Regulatory Double Standard?
When Silicon Valley Bank collapsed, the FDIC announced that all deposits, both insured and uninsured, would be protected by the FDIC’s deposit insurance fund. This unprecedented decision to backstop uninsured deposits was made despite the fact that the FDIC has a long-standing rule that $250,000 per depositor is protected by the full faith and credit of the United States government in the event of a bank failure. The cap on insurance was instituted, in part, to limit moral hazard, where banks take on more risk than they would because there is little incentive for depositors and creditors to monitor bank riskiness.
Almost a year earlier, the FDIC issued an advisory notice warning consumers that non-bank entities offering crypto assets to customers were not protected by FDIC deposit insurance. The advisory notice also stated that “inaccurate representations about deposit insurance … may [confuse customers] to mistakenly believe they are protected against any type of loss.” In the wake of numerous crypto-related bankruptcies, such as BlockFi, Celsius, and Voyager, did the FDIC step in to protect customer deposits? No. Without FDIC insurance, many customers lost the entirety of their deposits in crypto companies, and systemic risk also spread throughout the digital asset sector.
On the one hand, it is well-noted that the crypto-related deposits at BlockFi, Celsius, and Voyager were not insured, nor were these companies categorized as insured banks. But similarly, many deposits at Silicon Valley Bank were also uninsured. Thus, when federal regulators bend their own rules to protect uninsured deposits for certain entities and not others, it raises questions of favoritism. On the other hand, crypto-related deposits held at Signature Bank were, in fact, protected by the FDIC due to Signature’s status as an insured bank, so claims of favoritism should be measured. Whether these crypto-related deposits were denominated in crypto or dollars is currently unknown.
These extraordinary federal interventions were exercised pursuant to a Dodd-Frank-era law that allows the FDIC to guarantee uninsured deposits under a “systemic risk” exception. For the exception to apply, banks must fail and the threat of systemic risk to the financial system must be present. Even though regulators are framing this intervention as a “one-off,” there is a lack of clarity as to whether crypto assets held at other banks will be insured going forward under the systemic risk exception. Regardless, barring policy guidance that says otherwise, the expectation that regulators will continue to insure crypto-related deposits at banks has been created by regulators.
In the absence of FDIC insurance and possible forthcoming explicit exclusion from the systemic risk exception, digital asset companies would benefit from private market insurance to protect customer deposits from future risk events.
(2) Monopolistic Handshake Between the Banking Industry and the Government?
Historically, central banks and the banking industry have been hesitant to embrace the digital asset industry because of its ability to allow customers to bypass traditional financial systems and transact at lower prices without the need for an intermediary. However, more recently, banks have expressed greater interest in digital assets with some banks even offering crypto-related services and investment opportunities for their customers.
One such bank, Bank of New York Mellon, was given approval in 2022 by both state and federal regulators to custody bitcoin and ether on behalf of its customers. With this regulatory approval, BNY Mellon is the first of eight systemically important banks to store digital currencies and allow customers to use one platform to custody both traditional and crypto holdings.
By contrast, Custodia, a de novo special purpose depository institution in Wyoming that is not federally regulated or insured, was denied membership to the Federal Reserve Banking system despite submitting an application in August 2021. A separate submission to the Federal Reserve Bank of Kansas City requesting a Fed master account was submitted in October 2020.
Two years after Custodia submitted its membership application, the Federal Reserve issued a 86 page report explaining the reasons why it denied Custodia’s membership to the Federal Reserve system. In evaluating the membership application, the Federal Reserve Board considered four factors, including (1) the general character of management; (2) the bank’s financial condition; (3) whether the corporate powers to be exercised are consistent with the purposes of the Federal Reserve Act; and (4) the convenience and needs of the community. The report highlighted deficiencies in Custodia’s application, such as inadequate risk management systems, overconcentration of bank activities in a narrow sector of the economy, and the fact that the crypto-asset sector presents "heightened illicit finance and safety and soundness risks.”
One distinction with the Board’s reasoning is that much of its analysis was based on the fact that Custodia has not yet commenced operations. For example, in analyzing the first factor regarding management expertise, the Board commented that “the overall effectiveness of board and senior management remains difficult to determine, as Custodia has yet to truly commence operations and the Board is not sufficiently assured that Custodia’s proposed management team could conduct its proposed activities in a safe and sound manner.” Furthermore, some of Custodia’s planned crypto-activities are apparently still in the early stages of development, which has made it difficult for Custodia to tailor risk-management policies and procedures to their planned activities. Even though the Federal Reserve welcomed new applications from Custodia, the high bar that is set by the evaluation framework seems to favor existing banks that are large, well-funded, and diversified, rather than startup banks. As a result, Custodia possibly finds itself in a “catch-22” situation where it cannot grow, evolve, or meet the Fed’s requirements without additional startup funding, which may or may not be contingent on access to the Federal Reserve system and a Fed master account.
One criticism of the report is that some of the Federal Reserve’s reasoning assigns too much risk to the fact that Custodia’s proposed business activities are novel and unprecedented. Some of the risks highlighted include “risks of runs and contagion,” which are not exclusive to the crypto industry (think Silicon Valley Bank and other regional banks). While it is accurate that crypto-related activities are novel and unprecedented, some of which carry significant risk—such as anonymized illicit finance activity, the Federal Reserve might consider taking a more accommodating view of the general risk of new business models and activities, which may, in fact, diversify the existing, traditional, homogenized financial system.
The report also suggests that the Federal Reserve is waiting for these “novel" activities to be tested by national banks first, rather than by state banks, which might unintentionally give the larger, national banks an unfair, “first-mover advantage.” For example, in the report, the Board notes: “[i]f the Board were to approve Custodia’s membership application, it would prohibit Custodia from engaging in a number of the novel and unprecedented activities it proposes to conduct—at least until such time as the activities conducted as principal are permissible for national banks and Custodia can demonstrate that it can conduct the activities in a safe, sound, and compliant manner.” While the Fed’s goal might be to create a level playing field for state and national banks and eliminate regulatory arbitrage, national banks are likely to benefit from the Federal Reserve’s position on novel banking activity. One example of this partiality is the Fed’s CBDC pilot collaboration—indeed, a novel banking activity—with national banks such as Wells Fargo, Citi, and BNY Mellon.
Although the Federal Reserve provided ample information regarding their denial of Custodia’s access to the Federal Reserve system, the reasons for denying Custodia’s access to the Fed master account is still outstanding. Access to master accounts and services will be based on a new set of guidelines, which was implemented by the Federal Reserve in 2022 in response to the rapidly evolving payments landscape and a recent uptick in novel bank charter types.
The new guidelines note that Tier 1 institutions (like Bank of New York Mellon) would face a “less intensive and more streamlined” review because those institutions are already subject to a set of “homogenous and comprehensive set of federal regulations.” By contrast, Tier 3 banks (like Custodia) would receive the “strictest level of review.” Apart from the denial received by Custodia, there is very little transparency on how the Federal Reserve applied the new three-tiered review framework and how regulators analyzed the “substantial risks and complexities” that Custodia’s novel business model presented.
As suggested in a similar argument above, perhaps an unintended effect of these new guidelines is that they favor existing and well-funded traditional banks that have the organization framework and budgets to comply with a significant and expensive regulatory burden. Granting new lines of business, such as crypto services, to systemically important banks while preventing de novo banks from competing increases concentration risk and decreases competition in the industry.
The Acting Comptroller of the Currency has already acknowledged that some banks in America are already so big and complex “that control failures, risk management breakdowns, and negative surprises occur too frequently … not because of weak management, but because of the sheer size and complexity of the organization.” The OCC’s response to monopolization of the banking industry is to break up large, traditional banks by “divesting businesses, curtailing operations, and reducing complexity.”
While reducing monopoly power in America is a worthy goal, another and perhaps better solution exists: create a regulatory environment that encourages innovation and competition and supports the diversification of business models and non-homogenous regulatory frameworks.
(3) The Velocity of Money
The February 23rd joint statement by federal regulators that warned banks of liquidity risks from crypto-related activities is accurate. The digital asset sector has been subject to numerous liquidity events, such as the FTX deposit run and the Terra/Luna stablecoin meltdown, which unquestionably presents significant risks to depositors and investors.
Liquidity risk, however, is not limited to crypto activities or businesses. As evidenced by the collapse of Silicon Valley Bank (SVB), the combination of social media rumors and digital infrastructure that enable deposits to move funds at lightning speed with a few taps and swipes played a role in SVB’s run. Furthermore, the run at Silicon Valley Bank had no direct relationship to the digital asset sector, but instead was due, in large part, to capitalization issues from an otherwise low risk activity: exposure to long-term, low yielding government and government-backed securities that resulted in significant unrealized losses in the bank’s securities portfolio due to a high inflationary environment. Other than SVB’s abysmal financial condition, which was evidenced by the bank’s low availability of equity capital, poor bank risk management was another reason for SVB’s demise.
Social media risk is another factor that has fueled the velocity of money and run risk. It has even been suggested that the issuance of the February 23rd joint statement by federal regulators was the first trigger for multiple bank runs as it put pressure on Silvergate’s operations, causing depositors and investors to weigh the gravity of the warning regarding the “unpredictability of the scale and timing of deposit inflows and outflows.”
As regulators attempt to mitigate the type of liquidity or run risk that is attributable to both crypto-related and traditional banking activities, it is important to note that the asset itself should not be singled out as the root cause of the problem, but rather the increased velocity of money in the digital age due to advanced payment networks and platforms.
With the upcoming launch of FedNow instant payment services and continuing research on a US central bank digital currency (CBDC) and a digital dollar, the speed at which money or cryptocurrency will travel throughout traditional and alternative financial networks may be just as rapid and volatile as what has been witnessed in the crypto sector. Considering that the Fed is testing a proof of concept CBDC pilot with several of the nation’s largest banks, the very type of risk that regulators are trying to prevent may be inadvertently re-introduced into the traditional financial system through CBDC usage. Regulators should take note that the velocity of money presents a new risk for regulators that may be difficult if not impossible to contain regardless of a bank’s involvement with crypto. Thus, the crypto sector should not be unfairly penalized on account of liquidity risk when the traditional banking system is also subject to the same risk.
A Blessing in Disguise?
The digital asset industry originally flourished by embracing permissionless innovation in a vacuum of regulatory clarity and cooperation. Lately, however, it can be argued that federal banking regulators have placed significant regulatory pressure on the digital asset industry that could be interpreted as overly cautious, even discriminatory, which has resultantly curtailed the industry’s growth. It can also be argued that regulators have had valid reasons to subject these pressures on the digital asset industry to ensure the stability of the overarching financial system, which impacts the vast majority of Americans.
In the end, the digital asset sector stands to benefit from the recent turbulence by learning from market discipline, something which the traditional banking sector has systematically escaped over the years due to regulatory and political bailouts. To preserve innovation and competition within the financial sector, digital asset companies should focus on refining business models to mitigate the risks exposed by failures in the industry and to advocate for non-homogenous regulatory frameworks that support the development of alternative payment networks and de novo bank business models that challenge and compete with the traditional financial system. It would also benefit regulators to collaborate more with both state and national banks to pilot novel financial activities so that novel business models have room to flourish. In doing so, such experimentation might help diversify an increasingly homogenized and monopolized financial system and create cooperative pathways for bridges to be built between banks and the crypto industry.
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