The banking and securities regulator is enforcing existing rules and clarifying allowed interactions between the financial services industry and cryptocurrency. This is a positive development for the digital asset class, but regulatory measures are making market participants very nervous.
There are companies that create "cryptobanks" and try to integrate cryptocurrencies into the banking system. Despite pushback from regulators, one argument used to support his ideas is that unless change happens soon, the US will lag other countries in reaping the benefits of cryptocurrency innovation. Crypto advocates reject the caution expressed by US banking regulators and want to see more interaction between banks and crypto startups. There are some players that operate globally without a major regulator, such as Binance, which is trying to transform the banking sector in the US and abroad.
Banks are held to high standards
Allowing an interest group, especially one with large and powerful foreign participants, to directly or indirectly influence US regulatory policy is a recipe for disaster. The US financial system leads the world in overlapping regulatory bodies and multiple mandates to protect consumers, investors and industry.
Getting regulatory approval to own or operate a licensed bank in the US is not easy for anyone. There is a major hurdle to protect individual bank customers and the stability of the entire banking system. Required approvals include state or federal banking regulations through the Office of the Comptroller of the Currency (OCC) and the Federal Deposit Insurance Corporation (FDIC). Also, the Federal Reserve Board of Governors for bank holding companies. All regulators have a responsibility to ensure that the banking system is protected and that banking sector participants have the right skills and experience.
Malpractice harms the industry
In the few cases where a bank has received a license to operate, the practice of cryptocurrency-focused institutions has damaged the industry, resulting in a loss of trust for everyone involved in the industry. For example, in January 2021, the OCC granted Anchorage Digital Bank conditional permission to form a National Association, and less than 15 months later, Anchorage received a cease and desist order for failure to comply with the terms of its operating agreement.
The experience of non-banks offering bank-like products in the cryptocurrency space has also been lacking. In addition to FTX, the companies are Celsi
Another lesson that investors should learn from the failure of these cryptocurrencies is that simply providing banking products and services does not make a company a bank. There is a big difference between the security of a licensed US bank and any other institution.
The exact reasons for the failure of these three institutions are quite different, and in some cases may be due to abuse, but there are some commonalities. All suffered from insufficient capital and concentration risk. Banks simply can't take too much risk, and these companies are betting big on a small number of customers with extremely risky business models.
Interestingly, the two most cited risks of cryptocurrencies, liquidity and vulnerability to market risk, were not the direct cause of the failure. They failed because they gave loans to customers who couldn't repay them.
Above all, safety and durability.
Earlier last month, on January 3, the OCC, FDIC, and Fed issued a joint statement on the risks of cryptocurrencies for banks. They listed a number of key risks and warned that "risks that cannot be mitigated or controlled will not migrate to the banking system."
Perhaps the most important part of the statement was the statement that "it is unlikely that" issued or held as an underlying cryptographic asset issued, stored or transmitted in an open, public and/or decentralized network or similar system will meet security requirements. and protection”. “banking system”. practices.” The announcement effectively prohibited banks from issuing stablecoins or holding cryptocurrencies on their balance sheets.
Bank regulators are simply reacting to threats to the security and stability of the US banking system. Given the tone of all the media headlines, his reaction could be interpreted as a desire to make sure the nation is fully protected.
There are also reports that companies in the cryptocurrency industry are having trouble obtaining banking services. Finding banks that accept business accounts in the digital asset space is extremely difficult, and it shouldn't be. Any company offering a legitimate product must have access to the banking system.
There is no ban on banks servicing businesses in the cryptocurrency space. On the other hand, banks are in the business of risk mitigation, and cryptocurrency companies are at higher compliance risk and can create liquidity risks (see my article on Silvergate). Still, given all the bugs, poor coverage of the actors in the media, and the necessary regulatory measures, it is understandable that it is classified as high risk.
Credibility is hard-earned and easily lost. As a group, the cryptocurrency industry has little credibility with the regulatory community, with good players struggling to blend in with the rest. That time will pass and well-run businesses will find and maintain banking relationships, but it may not be easy.
A strength of the US banking sector is that it is stable and, by definition, slow to change. A cautious approach to the relationship between cryptocurrencies and the banking sector seems warranted based on recent events. The good news is that banking regulators are not against cryptocurrencies, but they do want companies that interact with the asset class to have practices and systems in place to ensure risks are well managed. These requirements suggest that the provision of innovative banking services in the cryptocurrency asset class must be accompanied by the strict risk controls that exist in the banking sector.
A special thanks to my colleague Stephen Patrick for his contribution to this article.