Cryptocurrency: Operation Choke Point - USA Slaughters "Securities" And Banking Paths

grarpamp grarpamp at
Thu Feb 9 21:18:50 PST 2023

What Could Recent Banking Agencies’ Statements Mean for Crypto?
byLinda Jeng
February 4, 2023
in News Analysis
Red flag laws in the UK and US helped warn people that cars were coming.

Not so long ago, our city streets were primarily dirt roads, for
pedestrians, pushcart vendors, and horse-drawn carriages. Then came
the car.  As more people drove cars in the 1920s, accidents and deaths
skyrocketed. Local governments responded, creating laws to police this
novel activity. And yet it’s hard now to imagine anything else.  In
the United States we now, for better or worse, primarily view streets
as a place for cars and sidewalks as a place for pedestrians.

Back in the 1920s, cities like New York, Philadelphia, and Chicago
treated cars as dangerous intruders. In Chicago in 1926, as in most
cities, “nothing” in the law would “prohibit a pedestrian from using
any part of the roadway of any street or highway, at any time or at
any place as he may desire.”  Battles were waged in these cities’
courts, legislative halls and in the public “courts”, the newspapers.
In New York City’s traffic court in 1923, a judge explained that
“Nobody has any inherent right to run an automobile at all.” How did
legislators respond?  In the UK, and in states like Vermont, “red flag
laws” required someone to walk in front of the vehicle carrying a red
flag, to warn everyone of its impending arrival. The back and forth
may have been dramatic, but it was also consequential. Ultimately, the
automotive industry and its consumers made their case, the cars ruled
the roads – a revolution in transport was made safer through
improvements in technology as well as in law, and a dramatically new
way of ordering things became the accepted norm for generations.

We are at a similar crossroads today with the transformation of money
and assets, and their overall implications for the financial services
sector and society at large. The rise of the internet and advances in
modern computing power have led to the creation of blockchain and
other types of distributed ledger technologies. They have also led to
the unbundling of financial services and fintech firms finding
innovative ways to disintermediate, providing services and tokenizing
assets along the financial services stacks.  Make no mistake, this is
a revolution.

This revolution also comes with risks. Last year, we saw some of the
worst hacks and scams in crypto history. According to Chainalysis,
consumers lost $3 billion to crypto hacks, including the Wormhole
Crypto Bridge, Axie Infinity and the most high profile of all – the
bankruptcy of FTX.

Following the events of last year, we have seen a series of
strongly-worded policy statements from US federal banking agencies
released in recent weeks:

1.       US Banking Agencies’ Joint Statement on Crypto-asset risks to
banking organizations

2.       Federal Reserve Board’s denial of application by Custodia
Bank, Inc. to become a member of the Federal Reserve System

3.       Federal Reserve Board’s policy statement to promote a level
playing field for all banks with a federal supervisor, regardless of
deposit insurance status
Worrying prospects for the future of finance

It is not hard to hear echoes from initial responses to the revolution
in transportation. Together, these policy statements present a
worrying prospect for the financial ecosystem for a number of reasons.

First, the Joint Statement could be viewed as a warning to banks not
to support the crypto industry, which will effectively de-bank the
crypto industry and drive it to the shadows.

Second, the Fed’s policy statement sets out a “rebuttable presumption”
under section 9(13) of the Federal Reserve Act that state member
banks, regardless of deposit insurance status, are limited to
activities permissible for national banks. This presumption can be
rebutted if there is a “clear and compelling rationale” for the Fed to
deviate in regulatory treatment among federally supervised banks and
state banks. The Fed goes on to state that it “has not yet been
presented with facts and circumstances that warrant rebutting its

The Fed then explains why national banks (and therefore state banks)
are not currently permitted to engage in crypto-asset activities.

The Fed’s main argument is that there is no federal statute or rule
that expressly permits either national banks or state banks to hold
most crypto-assets. But this reasoning is simply arbitrary. Congress
passed the Federal Reserve Act in 1913 – the same year Henry Ford
began mass producing automobiles. The National Bank Act was signed
into effect by President Lincoln in 1863 – long before the advent of
the computer, internet and crypto. Needless to say, it would be
unrealistic to expect legislative drafters to include express
permissions of crypto activities, but Hollywood has portrayed
President Lincoln as a time traveler – so who knows!

The Fed is not waving a red flag in front of a moving automobile, it
is building a brick wall.

Furthermore, this policy stance further segregates crypto finance from
traditional finance, dangerously bifurcating our financial system as
it continues to grow and transform. This could lead to distortions in
market integrity and efficiencies. We may end up with part of the
economy transacting in Fed-sanctioned US dollars while the other part
transacts in non-USD digital assets outside the governance and
monitoring of the Fed. As this shadow economy grows, the Fed loses
more and more of its ability to effect effective monetary policies and
economic stability.

Finally, this leads us to the Fed’s denial of Custodia Bank’s
application for a master account with the Federal Reserve System, and
thereby denying it access to the Federal Reserve System. A number of
reasons were raised by the Fed as to why Custodia’s application was
“inconsistent with the required factors under the law”:

    Custodia does not have federal deposit insurance
    Custodia proposed to engage in novel and untested crypto
activities that include crypto-assets on open, public and/or
decentralized networks

The Fed then proceeds to conclude that these inconsistent factors
presented “significant safety and soundness risks.” The Fed also found
that “Custodia’s risk management framework was insufficient to address
the heightened risks associated with its proposed crypto activities,
including its ability to mitigate money laundering and terrorism
financing risks.”

Let’s examine each alleged inconsistent factor.
No FDIC insurance

For a bank to be eligible for the Fed’s lender of last resort
protections, it must be insured by the FDIC. But Custodia was applying
only for a Fed master account, which does not require FDIC insurance.
The Fed provided no explanation as to why it required federal deposit
insurance of Custodia.

More importantly, would deposit insurance be needed if the bank is
100% backed by highly liquid assets and does not make loans, as
Custodia was proposing? In the early 1930s, Congress debated how to
deal with bank runs.There were two options, 100% liquid reserves
(narrow banking) or deposit insurance (fractional reserve banking).
Congress chose deposit insurance, allowing banks to continue to lend
out their deposits. However, if a bank is fully backed by highly
liquid assets and does not engage in maturity transformation, then
deposit insurance would be entirely unnecessary.
Novel and untested crypto activities

Custodia proposed to be a crypto custody bank that could issue
fiat-backed stablecoins backed by deposits (ie, narrow banking). What
is novel about Custodia’s business proposal is that lending was not an
important part of its business model. This means the riskiest part of
banking – credit intermediation – did not exist. Custodia was
proposing to be a utility bank – one that holds deposits to be
tokenized in fiat-backed stablecoins and custodies crypto-assets for
customers. Both lines of business are far less risky than credit
Open, public and/or decentralized networks

The Fed presumes that open, permissionless blockchains are a risk
factor without explaining why. The internet is an open and public
network upon which information travels freely. As explained by Chris
Dixon in his blog, developers building on closed, centrally-controlled
platforms can risk having the platforms unilaterally change their
rules. As a society, we give up rights over our personal data and
expose ourselves to security breaches on such centralized platforms.

Open-source, permissionless networks are more transparent, have fewer
information asymmetries and operate via more democratic governance.
They allow for a virtual cycle in blockchain innovation. Open, public
decentralized networks facilitate innovative and collaborative uses
for the network, which leads to greater user access and user demand,
which in turn contributes to improvements to the public network and
then more innovation in the network. The Internet is an obvious
example. As Peter Van Valkenburgh explains, “anyone can design, build,
and utilize hardware or software that will automatically connect to
the Internet without seeking permission from a network gatekeeper, a
national government, or a competitor.”
Risk management system

I cannot comment on Custodia’s risk management system without a deeper
dive into its architecture and risk controls. But it should be noted
that a new generation of crypto-native banks will be more innovative
and tech-savvy and can take advantage of the myriad new technologies
available for identifying illicit financial activities.

Finally, Fed Chair Jerome Powell remarked that if the Fed had approved
Custodia, then the Fed would be flooded with similar bank
applications, and then who would do the lending? Chair Powell’s fear
is not listed as one of the reasons why Custodia’s application was
denied, but it sounds like it may be an underlying cause. It seems
premature to deny Custodia’s application on an unfounded fear that
there would be a tidal wave of narrow bank applications.

Other central banks are experimenting with crypto activities
themselves*. Mainstream commercial banks are also entering the chat.**
I commend these institutions for their efforts to engage with crypto
technologies. Ultimately, chilling innovation harms not only private
sector innovation but public sector innovation as well. Instead, at a
minimum, the Fed could allow a pilot of a few narrow banks and see how
they fare. The opportunity to engage collaboratively could allow for
education on both sides, while widening the aperture of innovation in
the United States.

We now look back on the “Red Flag Laws” of the early 1900s as quaint
and amusing. Let’s hope our children can afford to feel the same way
when they look back at US agencies’ fear of embracing the
technological developments transforming money and assets in 2023.

* Other central banks are experimenting with crypto activities
themselves. Project Dunbar, led by the BIS Innovation Hub in
partnership with the Reserve Bank of Australia, Central Bank of
Malaysia, Monetary Authority of Singapore, and South African Reserve
Bank, is testing the use of central bank digital currencies for
improving international settlement. Another example is Project
Mariana, a joint project between the Switzerland, Singapore, and
Eurosystem BIS Innovation Hub Centres, the Bank of France, the
Monetary Authority of Singapore and the Swiss National Bank, is
exploring the use of DeFi for the cross-border exchange of
hypothetical Swiss franc, euro and Singapore dollar wholesale CBDCs
between financial institutions to settle foreign exchange trades in
financial markets.

**Mainstream commercial banks are getting into the fray as well. The
New York Fed and the Regulated Liability Network (RLN) banks are
exploring how to use bank deposits to tokenize money.  The RLN
includes Citi, BNY Mellon, Wells Fargo, HSBC and Mastercard are among
the participants. Another project is Project Guardian – a
collaborative initiative with the financial industry that seeks to
test the feasibility of applications in asset tokenization and DeFi
while managing risks to financial stability and integrity.  DBS, JP
Morgan and SBI Digital Asset Holdings explored how they were able to
launch the first industry pilot where the banks conducted foreign
exchange and government bond transactions against liquidity pools
comprising of tokenized Singapore Government Securities Bonds,
Japanese Government Bonds, Japanese Yen (JPY) and Singapore Dollar
(SGD) on public blockchain networks.

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