It’s not Choke Point. It’s Crypto Quarantine.

Regulators are not trying to kill crypto, but they are trying to isolate the rest of the economy from what they believe could be very, very big.

It’s not Choke Point. It’s Crypto Quarantine.

Regulators are not trying to kill crypto, but they are trying to isolate the rest of the economy from what they believe could be very, very big.

On Sunday Feb. 13th, the WSJ reported that the Paxos received a Wells notice from the Securities and Exchange Commission (SEC) claiming that its Binance USD coin (BUSD) was an unregistered security.

At the same time, the NY Department of Financial Services (NYDFS) forced Paxos to cease issuance of new BUSD.

BUSD is an Ethereum token issued by Paxos, based in New York, regulated by U.S./state law and fully-backed 1:1. Paxos only licenses the ‘Binance’ trademark; the token is not issued or controlled by Binance.

Significantly, neither the SEC nor the NYDFS took issue with Paxos’ other stablecoin, Pax Dollar (USDP), which is basically identical to BUSD except that it does not use Binance’s trademark.

See Paxos’ website, which states that “these two tokens are very similar in design and reserve operations…”

In a statement to Bloomberg, NYDFS said that it directed Paxos to end its relationship with Binance, citing “several unresolved issues related to Paxos’ oversight of its relationship’” with the exchange.

At least for now, the regulators seemed to have been taking aim at Binance, not the concept of fully-backed fiat-collateralized stablecoins as a whole.

If the latter were the case, the Wells notice and NYDFS’ orders should have targeted USDP as well.

There has so far been no uniform enforcement pattern that treats fully-backed, fiat-collateralized stablecoins as securities.

We’ve seen this numerous times over the past couple of years: regulators say one thing, but seem to behave inconsistently with those statements. What is driving their enforcement actions?

Based on our discussions with ex-regulators on our cap table, review of over one hundred enforcement actions over the past two years, and analysis of hundreds of pages of regulator reports and statements, there are five types of behavior that have so far triggered enforcement actions:

Four of these are old news.

  1. Running an unregulated exchange which offers tokens that are obviously securities.
      August 2021: the SEC settled its case against Poloniex for
      September 2022: the FTC penalized bZeroX founders $250K
  2. Lax AML/KYC, allowing circumvention of sanctions, etc.
      October 2022: the U.S. Treasury announced nearly $50m in penalties
             against Bittrex for "deficiencies" in its AML/KYC standards
      November 2022: Kraken paid U.S. Treasury a $360K fine for
              violations of USA's Iranian sanctions regime.
  3. Outright scams, insider trading, vaporware ICOs, etc.
      December 2020: the SEC charged Ripple for its unregistered securities           offering during its ICO
      July 2022: the SEC charged a former Coinbase Product Manager with        insider trading
      June 2022: the DOJ charged a former OpenSea Product Manager at        OpenSea with insider trading for front-running NFT listings on        OpenSea’s homepage
  4. Discretionary investment of custodied customer funds
      Feb 2022: the SEC penalized BlockFi $100m for its lending
      Jan 2023: the SEC penalized Nexo $45m for its Earn Interest
      Jan 2023: the SEC charged Genesis and Gemini for
           their Earn program
      Feb 2023: the SEC settled its case against Kraken
           for its "staking-as-a-service' offering for $30m.

      In each of these four cases, the SEC specifically pointed to the
      'discretion' the corporations exercised over customer's
      custodied assets.

The last, 5th type is the most recent and most expansionary:

Authorities are attempting to limit *contagion risk* to the broader economy.

They’re effectively quarantining a sector they view as “risky” away from the “real” stuff.

As part of this philosophy, it’s striking just how ‘big’ the regulators project the cryptoeconomy will be.

This line of reasoning was first disseminated in the Biden Administration’s November 2021 “Report on Stablecoins”.

In the report, the Administration repeatedly emphasized the contagion risk of stablecoins:

“If insured depository institutions lose retail deposits to stablecoins, and the reserve assets that back stablecoins do not support credit creation, the aggregate growth of stablecoins could increase borrowing costs and impair credit availability in the real economy.”

ELI5: Stablecoins could overtake banks as consumer’s preferred deposit institutions. If that happens, banks will have less money to loan out, which means they would charge a higher interest rate, which would constrict the global credit market.

“The perception of the safety of insured depository institutions relative to stablecoins could also shift during times of stress, with large and sudden inflows or outflows of deposits possible.”

ELI5: public preferences in banks vs. stablecoins could oscillate quickly, causing volatility in the total amount of deposits held in the banking system.

On the subject of a potential ‘run’ on a stablecoin, the Administration wrote:

“Fire sales of [a stablecoin’s] reserve assets could disrupt critical funding markets, depending on the type and volume of reserve assets involved.”

ELI5: because stablecoins’ reserves typically include vast amounts of commercial paper or bonds, their ‘fire-sale’ in the event of a ‘run’ would affect market prices for debt instruments generally, making waves in the real economy.

They concluded dramatically:

“A run occurring under strained market conditions may have the potential to amplify a shock to the economy and the financial system.”

In a Joint Statement issued on January 3rd of this year by the Federal Reserve, the FDIC, and the OCC, regulators expanded the philosophy to all crypto assets generally, stating that “It is important that risks related to the crypto-asset sector that cannot be mitigated or controlled do not migrate to the banking system.”

In a nutshell, if shit hits the fan in cryptoland, it better not spill over into the banking system.

A few weeks later, in a January 27th statement the Biden Administration expressed its approval: “The banking agencies issued joint guidance, just this month, on the imperative of separating risky digital assets from the banking system.”

Each of the recent regulatory actions/statements of late fall into this category, including those on stablecoins, banking regulations, and “qualified custodian” rules.

On January 23rd of this year, the Federal Reserve issued guidance that stated it “would presumptively prohibit state member banks from holding most crypto-assets as principal”, insulating the banking system from balance sheet risk of crypto.

A few days ago on February 15th, the SEC proposed rule changes to heighten standards for investment advisers investing client money in crypto by restricting which firms can hold custody of crypto assets, discouraging TradFi hedge and pension funds from investing in the asset class.

In response to these actions, many in the industry feel that regulators should publish rules in advance instead of “rule-making by enforcement.”

Be careful what you wish for. In numerous cases U.S. regulators have taken expansive views on their jurisdictional reach but have so far enforced this view in a limited way.

In the Kraken case, the SEC seemed to take aim at staking products in general but has so far not initiated anything on Coinbase’s Earn program.

During the course of its investigation of Uniswap, the SEC hinted strongly that many DeFi products being built by teams in the U.S. constitute securities products. So far, the SEC has not pressed forward against any of these teams.

In the most-recent filings against Do Kwon of Luna, prosecutors make sweeping claims about what constitutes a security. For the most part, these claims are used in egregious cases like Luna, but not yet enforced against the crypto ecosystem widely.

Securities lawyers will tell you that many of the regulatory enforcement actions (nearly all of which have been settled to-date) would hold up in court. A yield-bearing product that allows the exchange to invest customers’ assets at their discretion is textbook “security”. This is why companies like BlockFi pay $100m settlements.

What this all boils down to is that regulators are pressing forward through a complicated dance of selective enforcement, private settlements, and public statements.

The common thread is a desire to isolate, insulate, and quarantine the crypto ecosystem from the broader economy while still taking down the obviously bad actors.

It’s not quite a desire to ‘choke’ it out so far. We’ll see if that remains the case.

Notably, it highlights just how profoundly consequential the government thinks crypto will be.