Crypto in the Crosshairs: Operation Chokepoint 2.0 Exposed

A comprehensive look at how US regulators are using questionable tactics to limit financial rails for crypto companies

Background

The US government has long been wary of the crypto industry and its potential to disrupt traditional financial systems and foreign capital controls. However in the last year or so, a not-so-subtle and coordinated effort has been made to de-bank the crypto industry through legally questionable measures — recently coined “Operation Chokepoint 2.0” by Castle Island’s Nic Carter. In this article, we’ll explore what Chokepoint 2.0 is, how it’s being used, and what it means for the future of cryptocurrencies.

“Operation Chokepoint 2.0” — an unofficial moniker for coordinated anti-crypto efforts taken by the current administration — has its roots in an official initiative from the DOJ from 2013–2017. At the time banks were pressured to cut off access to banking services for individuals and companies’ that were deemed “high-risk activities’’. This was mainly done through informal and unwritten suggestions, rather than official policy or legislation. These “high-risk activities” included disfavored yet perfectly legal categories like payday loans, telemarketing, and online gambling but also included categories like ammo sales, dating services, pornography, and tobacco sales. Essentially the DOJ was bypassing due process and cutting off access to banking services without having first shown that the targeted companies are violating the law.

The original Operation Chokepoint was exposed in a WSJ story, and it was officially ended in August 2017. The FDIC, responsible for much of this pressure, settled multiple lawsuits and promised Congress more oversight and training for its examiners. People argue that it was an ideological attack (and a violation of the 4th Amendment) on the industries disfavored by the administration at the time, who deputized banks to carry out political objectives under the guise of preventing fraud and money laundering, eerily echoing the rationale given by regulators now.

Though not an official initiative, the US government is undertaking a similar effort to cripple the crypto industry today, and with much less subtlety than its predecessor. Some of the biggest architects of Operation Chokepoint 2.0 have distinct ties to the original Operation Chokepoint (Sen. Elizabeth Warren, current FDIC Chairman Martin Gruenberg, Federal Reserve Vice Chair for Supervision Michael Barr), and it’s not a stretch to assume that many of the same tactics and ideological (career-related) motivations are being applied today.

Efforts to hinder the crypto industry have mainly taken 3 forms:

• Selectively cutting off onshore banking access to digital-asset companies
• Driving up compliance overhead and regulatory capital requirements
• Taking repeated public stances against the crypto industry (via memos, reg guidance, blog posts) in an effort to scare off new and existing participants — which we call “regulation by blog post”.

What all three tactics have in common is a lack of explicit congressional direction and the usage of overly broad legal interpretations in the discriminate targeting of crypto.

Cutting off access to banking and fiat settlements

As they say, there are a million ways to skin the cat, and there are many ways to limit an entity’s ability to utilize the rails of traditional banking. Individually this can take the form of restricting access to credit, refusing to facilitate fiat settlements, or refusing to take someone’s deposits altogether. To limit the crypto industry’s ability as a whole however, regulators have identified certain bottlenecks i.e. “chokepoints” to target for disruption. These include gatekeeping bank charter issuance against crypto-friendly banks (Custodia Bank, Protego), shutting down the 365/24/7 dollar clearing networks created by now-defunct Silvergate and Signature banks (SEN and Signet, respectively), and not providing liquidity support for banks with significant deposits from digital-asset clients (stablecoin issuers, crypto custodian companies, startups). The latter is evident in the fact that at the same time Silvergate and Signature banks were shut down and put into FDIC receivership, other troubled banks with higher-risk balance sheets who did NOT have significant digital-asset related deposits, were afforded liquidity backstops like the BTFP. Silvergate and Signature had been a key “chokepoint” from which US dollars entered and exited the crypto ecosystem. Without Signet or SEN, crypto firms have been struggling with liquidity as there are large frictions in merging the 24–7 nature of crypto with the 9-to-5 world of traditional banking.

Driving up compliance overhead and capital requirements

Federal regulators can also drive up the cost of compliance and raise capital requirements so that it becomes marginally unprofitable to service crypto companies. By making it so that only smaller, risk-tolerant banks would want to touch crypto, crypto deposits become consolidated into banks where these digital-asset clients are the main source of deposits and flows relative to their core business. This creates concentration risks and excessive exposure to single counterparty types with highly correlated flows (i.e. large deposits and withdrawals in and out at similar times). This concentration risk became undeniably evident in the closure of Silicon Valley Bank where a highly correlated deposit book made up of tech-savvy, social-media active clients contributed to a massive bank run.

More concretely, US federal regulators have achieved this inflation of compliance and capital costs by assessing higher FDIC premiums (insurance) on crypto deposits, indirectly increasing capital and liquidity ratio requirements, placing implicit restrictions on certain business activities, and subtly hinting at a risk framework that places a large premium on crypto-related entities (lessening any M&A potential and harming reputation) .

Taking repeated public stances against the crypto

Federal regulators can also instill fear and uncertainty into anyone participating in or thinking about participating in crypto as an institution or company. Regulators have used a constant barrage of “regulatory guidelines”, memos, and blog posts where agencies state expansive new views and interpretations of the law, often at odds with other agencies and unchecked by either the public or Congress. New legislation can only be adopted via public process, and yet federal agencies have taken a continued and public stance against crypto using rationale that has yet to be vetted by proper due process.

A Timeline of supporting evidence:

• Dec 7 — Senators Elizabeth Warren, John Kennedy, Roger Marshall write a public letter to Alan Lane, CEO of Silvergate bank lambasting the bank for providing services to FTX and utilizing the FHLB for a cash injection, though Silvergate’s only exposure to FTX were deposits (no loans, no custody of crypto).
• Jan 3 — The Federal Reserve, FDIC and OCC issue a statement discouraging banks from holding crypto or servicing crypto clients, citing contagion risk, fraud, and lack of governance. They explicitly write that “Banking organizations are neither prohibited nor discouraged from providing banking services to customers of any specific class or type, as permitted by law or regulation.” and yet blatantly paint a bleak, risk-fraught picture of servicing crypto companies.
• Jan 6 — Signature Bank begins to shrink deposits related to crypto, likely due to pressure and uncertainty from the previously mentioned letters/statements. Signature had also serviced a sizable amount of stablecoin firms, most notably USDC’s Circle, which may have brought on more pressure from the Fed.
• Jan 9 — Metropolitan Bank publicly announces its exit of the digital-asset vertical, dropping $342m in deposits, again — likely due to implied regulatory headwinds from Federal banking agencies.
• Jan 27 — Fed rejects Custodia Bank’s August 2021 application to be a Federal Reserve Member bank. On the same day the Kansas City Fed also denied Custodia’s application for a master account. Custodia is a “Special Purpose Depository Institution” (SPDI), which does not lend money and can only receive deposits and offer custody or asset management services. SPDIs must maintain 100% of these deposits in unencumbered reserves. Becoming a Federal Reserve member bank and having a master account would have allowed Custodia to access the Federal Reserve liquidity facilities and access the Federal reserve payment system (e.g. FedWire). Given the safety of having 100% backed deposits (unlike most banks with fractional reserve banking), the decision to deny both applications on the same day is suspicious and indicative to say the least.
• Jan 27 — In a response to Custodia’s application and as a forewarning to others, the Fed issues a policy statement declaring that uninsured state member banks (not insured by FDIC) would be subject to the same rules and restrictions as insured state banks (and national banks). Practically, this was a deterrent against state banks (like Custodia) from seeking membership into the Federal Reserve system as a way to engage in digital-asset activities. As crypto-asset activities are not expressly authorized by the OCC or the FDIC, this is essentially a restriction against state banks looking to utilize Fed services on the grounds of regulators’ expectations for “safety and soundness” — a vague, catch-all requirement that leaves membership up to subjective judgment.
• Jan 27 — The National Economic Council issues a blog statement detailing their stance on cryptocurrency as a systemic risk. The statement details the NEC’s views that Congress should not allow mainstream institutions like pension funds to invest in cryptocurrencies, though at the same time admitting the recent fallouts in crypto were not systemic. The blog post asks Congress to give law enforcement more power and reach over crypto activities, with no mention of better legislation or thoughtful frameworks for crypto entities to follow. The focus of the post is on harsher enforcement and greater risk premiums, rather than legislative frameworks that give digital-asset entities a clear roadmap for compliance.
• Jan 27 — DOJ investigates Silvergate though no allegations of wrongdoing had been made
• Feb 6 — Binance suspends USD transfers for retail clients while looking for new banking partner
• Feb 7 — The policy statement made on Jan 27 (above) is issued into the Federal Register (the official record of the federal government’s regulatory action) turning a simple policy statement into a final rule with no congressional or public comment period, a violation of the Administrative Procedure Act.
• Mar 2 — Silvergate fully repays 4.3bn loan from FHLB, likely with pressure from the FDIC, accelerating the sale of securities and threatening capital ratio requirements in order to repay these loans. Some speculate that this led to the collapse, though the FHLB denies this.
• Mar 2 — Silvergate delays filing of annual 10-K report, citing regulatory pressures and other “inquiries and investigations” into Silvergate. Shares of Silvergate Capital plunge 57%.
• Mar 8 — Silvergate Bank officially winds down operations after shutting down the SEN network a week prior.
• Mar 10 — Silicon Valley Bank shuts down and is placed into FDIC receivership
• Mar 12 — Signature Bank shuts down and placed into FDIC receivership
• Mar 12 — Federal reserve opens the Bank Term Funding Program (BTFP), a liquidity backstop for bank deposits immediately AFTER the shutdown of Silvergate, Signature, and Silicon Valley Bank, the three most prominent crypto-friendly banks.
• Mar 13 — Biden releases a proposal on excise tax on cryptocurrency mining electricity, though unlikely to pass through senate and house, but a signal nonetheless.
• Mar 17 — The OCC spokesperson tells Fortune magazine that Protego did not meet the proper requirements for a permanent national trust banking charter — and served as a sign that the OCC was closing its doors to crypto firms. The charter would have allowed Protego to custody digital assets, amongst other things.
• Mar 19 — Flagstar Bank takes over deposits from Signature Bank, with the exception of the $4.3bn in deposits related to Signature’s digital-assets banking business and Signature’s 24/7 fiat settlement network Signet28, arguably its most valuable asset. These remain provisioned directly by the FDIC. Although the FDIC has a self-mandated strategic goal of “maximizing net return”, they left arguably the most profitable portions without returning them to the private sector in clear signal of anti-crypto sentiment.
• Apr 6 — US Dept of Treasury releases 2023 DeFi Illicit Finance Risk, a 42-page report highlighting the negative aspects of DeFi of which the most prominent seemed to be the lack of AML/CFT compliance. Another cut to the crypto industry made by blog post, and possible preamble to the targeting of decentralized finance protocols.

Effects of cutting off crypto industry

Cutting off banking for crypto companies has far-reaching consequences for the US. Firstly, it leads to off-shoring of innovation and development as crypto companies would be forced to seek banking services in more crypto-friendly jurisdictions. Pushing business and development offshore would also mean pushing much-needed intellectual capital offshore and forcing crypto companies to redomicile and operate in often unregulated, opaque, and unsafe markets — leading to potential risks for investors and customers alike.

Fostering a risk-fraught hostile banking environment and limiting onshore options for crypto companies creates massive concentration risks — funneling all crypto exposure into a few larger entities and increasing the likelihood of systemic risks (FTX, Silicon Valley Bank).

Courtesy of Nic Carter via Pirate Wires

Finally, stifling the onshore crypto industry would allow foreign powers to capture market share in a new paradigm of global finance. Jurisdictions like Hong Kong, UK, UAE, and Singapore are increasingly taking a more thoughtful and calibrated stance towards crypto while creating regulatory clarity in an attempt to bring business to their shores. Currently the U.S., though accounting for only 24% of global GDP, impressively accounts for 41% of the global equity market cap. Marginalizing an emerging capital sector like digital assets would be detrimental to the US’s status as a global financial powerhouse.

The methods by which this effort is being undertaken also has profound implications for how US due process is conducted. Regulators have essentially bypassed Congress (and indirectly public opinion) and overstepped their authority to interpret and create de facto law, while selectively determining who these interpretations apply to. In a lawful society, solvent banks are not seized by the government simply because their clientele is politically disfavored. If these tactics are allowed to continue without Congressional oversight, this could lead us down a very dark road and degrade the US system of checks and balances. A helpful thought experiment is to imagine if unconstitutional tools and methods like these were wielded by a political party with extreme ideologies.

Things to watch moving forward

“Operation Chokepoint 2.0” is a concerning development for the crypto industry, with the US government using legally questionable measures and overly broad legal interpretations to limit the industry’s access to traditional banking services and capital. Ironically as regulators continue to pressure the crypto industry, they risk losing intellectual capital and sovereignty over the very industry they are trying to control. While other jurisdictions jockey for position in becoming a hub for crypto business, many in the US still hold out hope of a more conducive regulatory environment to come in the next administration. For many others, the risk of waiting it out is too high. Anyone involved in the digital asset space, however, should be paying full attention and closely monitoring any developments in the sector.

Here are some things to pay attention to moving forward:

Cross River Bank: one of the few remaining crypto-friendly banks — backed by prominent VCs (a16z, Ribbit Capital, Battery Ventures) and a partner with Circle (USDC) for automated settlements and with Coinbase. Pressure on Cross River Bank could have big repercussions for USDC and for Coinbase, one of the few remaining exchanges for US users.

Anchorage Digital Bank: Anchorage is the first federally chartered digital asset bank in the US. Recall that Protego and Custodia were not afforded this designation as Anchorage was essentially grandfathered in before a wild year that included 3AC, Terra Luna, and the FTX debacle. Their services include custody of digital assets as well as staking and lending services. They’ve already faced closer scrutiny from regulators like the OCC32 to fix BSA and AML issues, and have recently laid off 20% of its workforce33 due to current market conditions and regulatory uncertainty. As one of the few remaining bastions of traditional banking for crypto, a hit to Anchorage would have large spillover effects on the onshore crypto business.

BNY Mellon: BNY Mellon currently serves as primary custodian for Circle’s USDC backing reserves. As stablecoins and a potential CBDC start to receive more attention from regulators and Congress, it would be wise to watch for any targeting of USDC reserves (currently the largest US-domiciled stablecoin issuer).

Custodia Bank — Custodia was mentioned previously in this article as having been denied both a Federal Reserve membership charter as well as a Federal master account (i.e. access to FedWire). Custodia has since filed a lawsuit against the Federal Reserve for unlawfully and functionally denying their application for a master account by waiting over a year to provide a decision (rejection) on the application, whereas decisions on masters accounts usually arrive within a matter of days. Monitoring developments in the lawsuit can provide clues as to the judicial branch’s perception on the legitimacy of Chokepoint 2.0 and bring awareness to Congress regarding overstepping of banking regulators’ authority.

In future articles we will explore some of the rationale behind the anti-crypto efforts, regulator pressure from the securities and commodities angle (i.e. SEC, CFTC), who some of these anti and pro-crypto regulators and politicians are, and stablecoins/CBDCs and their implications for both governments and citizens.

Author:

Toby Fan, Web3 Strategist Twitter | LinkedIn:
Toby Fan is the Head Web3 Strategist at LunarCrush, which provides aggregated real-time social media data on crypto, NFT, and traditional equities. He is a graduate of UC Santa Cruz, where he double majored in Econometrics and Information Systems and helped lead departmental research on commodity market dynamics in China and the US. Toby is also an active contributor for CoinMonks (https://medium.com/@tobyornottoby) and a member of the BlockBros DAO