Banking can work with crypto, but crypto banking doesn’t work

The securities and banking regulators enforce existing rules and clarify the permitted interactions between the financial industry and cryptocurrency. This is a positive development for the development of the digital asset class, but the regulatory actions are making some market participants very nervous.

There are companies that want to start “cryptobanks”, and seek to merge cryptocurrency into the banking system. In the face of regulatory pushback, one argument used to support their ideas is that if the change doesn’t happen quickly, the US will fall behind other countries in embracing the benefits of crypto innovation. Cryptocurrency proponents reject the caution expressed by the guardians of the US banking system and want to see far greater interaction between banks and the new crypto-first companies. There are some participants, such as Binance, which operate globally and without a primary regulator, seeking to switch banks in the US and abroad.

Banks are held to high standards

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

It is not easy for anyone to get government approval to own or operate a bank chartered in the United States. The high hurdle exists to protect individual bank customers and the stability of the entire banking system. The approvals required include a banking regulator at either the state or 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 Federal Reserve Board. All the regulatory bodies have a duty to ensure that the banking system is safeguarded, and that the participants in the banking industry have appropriate competence and experience.

Poor results hurt the industry

In the few cases where approval was granted to operate a bank, the history of cryptocurrency-focused institutions has damaged the industry and resulted in a loss of credibility for anyone 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 order for failure to meet the terms of the operating agreement.

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

The other lesson that investors should take away from the failures of these crypto firms is that simply offering banking products and services does not make a company a bank. There is a huge difference between the safety and security of a US chartered bank and any other institution.

The exact reasons for the failures of these three institutions vary somewhat, and in some cases may involve abuse, but there is some commonality. All suffered from insufficient capital and concentration risk. Banks are simply not allowed to take outsized risks, and these firms bet very heavily on a small number of clients who had extremely risky business models.

Interestingly, the two most cited cryptocurrency risks – liquidity and sensitivity to market risk – were not the direct cause of the failures. They failed because they gave 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 risks of cryptoassets to banking organizations. They listed a number of key risks, warning 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 the statement that “the issuance or holding of cryptoassets that are issued, stored or transmitted on an open, public and/or decentralized network or similar system is highly likely to be inconsistent with safe and sound banking practices.” This announcement was effectively a ban on banks issuing a stablecoin or holding cryptocurrencies on their balance sheets.

Bank regulators are simply responding to threats to the safety and stability of the US banking system. Given the tone of all the headlines in the media, one can understand their response as the desire to be absolutely sure that the nation is protected.

There are also reports that it is difficult for businesses in the cryptocurrency industry to access banking services. It is definitely difficult for firms in the digital asset space to find banks to accept accounts, and it shouldn’t be. Any company providing a legal 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 increased compliance risk and can pose liquidity risk (see my article on Silvergate). Once again, one can understand the high-risk categorization given all the failures, media coverage of bad actors, and necessary 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 suffer from being lumped in with the rest. This period will pass, and well-managed firms will find and maintain banking relationships – but it may not be easy.

A strength of the American 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 seems to be justified by recent events. The good news is that banking regulators are not saying no to cryptocurrencies – but they do want to see that firms that interact with the asset class have the experience and systems necessary to ensure that risk is well managed. These requirements suggest that offering innovative banking services in the cryptocurrency asset class must come with the strict risk controls found in the banking industry.

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

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