Crypto-Banking Is A Problem

The banking regulators are not saying no to cryptocurrencies – but they do want to see firms that … [+] interact with the asset class to have the experience and systems to ensure that risks are well managed. Federal Reserve Board Chairman Jerome Powell. (Photo by Samuel Corum/Getty Images)

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Cryptocurrency news gets headlines. Stories about massive gains and losses, frauds and scams, politics, and even banking appear across the media. The entire market capitalization of the digital asset class is less than half that of Apple AAPL , Inc., and yet cryptocurrency captures attention like it has a massive valuation – which it is certainly capable of reaching in the future, but only if it can reach that potential by transitioning from a noisy idea into a combination of financial assets and innovative technologies.

The latest crypto headlines are not about bad actors defrauding customers like what allegedly occurred at the failed cryptocurrency exchange FTX, but are about the securities and banking regulators enforcing existing rules and clarifying the permissible interactions between the financial services industry and cryptocurrency.

There are firms wanting to start “crypto-banks”, and warn that if change does not happen quickly the U.S. will fall behind other countries in embracing the benefits of crypto-innovation. Cryptocurrency proponents decry the caution expressed by the guardians of the U.S. banking system, and want to see far greater interaction between banks and the new crypto-first companies. There are some participants, like Binance, that operate globally and without a primary regulator, who seek to change banking in the U.S. and abroad.

Banks Are Held To High Standards

Permitting any special interest group, especially one with large and powerful foreign participants, to directly or indirectly influence U.S. regulatory policy is a recipe for disaster. The financial system in the U.S. is a world leader because of the overlapping regulatory authorities and the multiple mandates to protect both the consumers, investors, and the industry.

It is not easy for anyone to obtain regulatory approval to own or operate a bank chartered in the U.S. The high hurdle exists to protect individual bank customers, and the stability of the entire banking system. The approvals required include a banking regulator either at the state level or the federal level through the Office of the Comptroller of the Currency (OCC), plus the Federal Deposit Insurance Corporation (FDIC). In addition, for bank holding companies, the Board of Governors of the Federal Reserve. All of the regulatory agencies have a duty to ensure that the banking system is safeguarded, and that participants in the banking industry have the appropriate skills and experience.

Poor Track Records Hurt The Industry

In the few cases where approval to operate a bank was granted, the track record of cryptocurrency-focused institutions has hurt the industry and resulted in a loss of credibility for everyone associated with the space. For example, the OCC granted conditional approval for the establishment of Anchorage Digital Bank, National Association in January 2021, and less than 15 months later, Anchorage received a Cease and Desist Consent order for failing to meet the conditions of their operating agreement.

The experience of non-banks offering banking-like products in the cryptocurrency space has also not ended well. In addition to FTX, the firms Celsius CEL Network, Voyager Digital, and BlockFi all declared bankruptcy in 2022, and customers were left with substantial losses. When the banking regulators look at these firms the lesson they take away is that the banking system must be protected from firms not managed in a safe and sound manner.

The other lesson that investors should be taken away from the failures of those crypto firms is that simply providing banking products and services does not make a company a bank. There is a huge difference between the safety and security of a U.S. chartered bank and any other institution.

The exact causes of the failures of those three institutions differ somewhat, and in some cases may involve malfeasance, but there is some commonality. All suffered from insufficient capital and concentration risks. Banks simply are not permitted to take outsized risks, and these firms made very large bets on a small number of customer who had extremely risky business models.

Interestingly enough, the two most cited cryptocurrency risks – liquidity and sensitivity to market risk – were not the direct reason for the failures. They failed because they made loans to customers who could not repay the money.

Safety And Soundness First

At the beginning of last month, on January 3, the OCC, FDIC, and Fed issued a joint statement on crypto-asset risks to banking organizations. They listed a number of key risks, and cautioned that “risks that cannot be mitigated or controlled do not migrate to the banking system.”

In what may be the most important part of the release was that statement 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.” That announcement was effectively a prohibition against banks issuing a stablecoin or holding cryptocurrencies on the balance sheet.

The bank regulators are simply reacting to threats to the safety and stability of the U.S. banking system. Given the tone of all headlines in the media one can understand their response as the desire to make absolutely certain that the nation is protected.

There are also reports that it is difficult for cryptocurrency industry firms to obtain banking services. It is definitely hard for firms in the digital asset space to find banks to accept accounts, and that should not be the case. Any company that is providing a lawful product should have access to the banking system.

There is no prohibition for banks to serve firms in the cryptocurrency space. On the other hand, banks are in the business of risk mitigation and cryptocurrency firms have elevated compliance risk and can pose liquidity risks (see my article on Silvergate). Once again, one can understand the high risk categorization given all the failures, media coverage of bad actors, and required regulatory actions.

Credibility is something hard earned and easily lost. As a group, the cryptocurrency industry has low credibility with the regulatory community, and the good participants are suffering from being grouped with the others. This period will pass, and well managed firms will find and maintain banking relationships – but it may not be easy.

One strength of the U.S. banking industry is that it is stable, and by definition, slow to change. A cautious approach to the association of cryptocurrencies and the banking industry does seem warranted by the recent events. The good news is that the banking regulators are not saying no to cryptocurrencies – but they do want to see firms that interact with the asset class to have the experience and systems necessary to ensure that risks are well managed. These requirements would suggest that providing the innovative banking services in the cryptocurrency asset class must come with the rigorous risk controls found inside the banking industry.

Special thanks to my colleague Steven Patrick for contributing to this article.


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