Capone: Crypto Yield Programs Threaten Another Great Recession
Loopholes in SEC regulations repeat the same mistakes from the 2008 financial crisis.
by Matthew Capone | 23.02.23 at 04.00
Moonstone, formerly Farmington State Bank, once served local farmers in Washington state. But in recent years, the bank has expanded its services to cryptocurrencies.
When Sam Bankman-Fried’s crypto trading firm, Alameda Research LLC, bought an $11.5 million stake in the bank in March 2022 — at 37 times the price someone else had bought the bank just 18 months before — Moonstone’s valuation shot up to about $115. million, according to the Wall Street Journal. Although Moonstone’s venture into high-risk cryptocurrency industries was allegedly intended to appeal to a new target customer, it reflects the larger problem of banks intentionally exploiting uninformed consumers. It also threatens to destabilize the entire financial system because of its attempt to circumvent Securities and Exchange Commission regulations.
Part of the promise of Moonstone’s expansion into the crypto industry was the ability to offer interest-bearing cryptocurrency accounts, which allow customers to deposit their digital assets with Moonstone. The bank can then use these assets for other investment activities. In exchange for depositing their assets, consumers will receive a variable monthly interest payment. The interest rates on these investments, commonly called “crypto-yield” programs, are higher than traditional bank interest rates, so customers can theoretically make much more money by depositing their money on CYPs than if they had just deposited it on a savings account.
For CYPs to work properly, consumers’ deposited digital assets – usually cryptocurrencies – must act as securities such as stocks or bonds. That way, banks can let investors earn interest on their assets by putting them into a common pool, which can then be lent by the bank to borrowers. These borrowers are usually sophisticated crypto trading firms like Alameda, and they borrow cryptocurrency so that they can trade the assets as if they were their own in an attempt to make even bigger profits. The idea is that they can get a large enough return from the trade to cover the interest on their loan to the bank, which in turn covers the bank’s interest payment to the original depositor. As you can see, there are a lot of dodgy moving parts here.
Current SEC rules for regular banks are designed to “limit the amount of risk that banks and credit unions are allowed to take with your deposited funds [in order] to reduce the possibility that your bank or credit union becomes insolvent and cannot give you your money when you want to withdraw [them].” In contrast, the cryptocurrency market is one of the least regulated. In particular, a specific regulatory exemption that neglects digital exchanges and cryptocurrencies means that CYPs are not even regulated as securities. These high-risk investments can therefore spread like wildfire because it allows banks like Moonstone circumvent SEC regulations designed to prevent dangerous risky behavior in the traditional market.
If the intention to avoid regulation wasn’t alarming enough, the structure of CYPs is strikingly similar to the bundling practices of investment banks during the financial crisis of 2008. Calls for deregulation in the early 2000s increased the popularity of financial assets called derivatives – a type of security – that enabled similar bypassing risk profiling processes. This allowed Wall Street to take risky bets without reasonable limits.
In the period leading up to the market collapse in 2008, traditional banks would sell mortgages to investment banks. These firms then combined thousands of mortgages and other forms of debt together into one collateralized debt obligation, which was considered a complex derivative. Investment banks would then sell these CDOs as financial packages that clients could invest in—and to get a higher price, investment banks would pay rating firms to rate CDOs as a low-risk investment, even though they weren’t.
Worryingly, the current architecture of CYPs closely resembles the basic interactions evident in the 2008 system. The basic logic is that individual assets are combined and sold to a large firm, which then repackages those assets to convert it into an investment that earns regular income. In 2008, these assets were mortgages. Today it is crypto.
Not only has this lending-investing structure led to historic market collapse, but so is the impact on the consumer. In 2008, investment banks were able to borrow huge sums of money to buy massive amounts of CDOs, increasing the proportion of their portfolios. This increased the perceived “investability” of CDOs by making them appear mainstream. Uninformed consumers can thus be led astray into a volatile and much more risky investment without acknowledging the structural problems.
Moonstone, Alameda and FTX—the latter being Alameda’s sister company, also founded by Sam Bankman-Fried—operated in a similar fashion. We know that circular reinvestment, as with what happened in the financial system in 2008, artificially inflates the value of what is invested in. After Alameda’s initial investment, deposits increased sevenfold and assets as a whole grew from $18 million to $99 million over the same. period. On the surface, these numbers may indicate that CYPs are a promising, lucrative and safe investment. However, regulatory filings reveal that 77% of total deposits were from a subsidiary of FTX.
The collapse of the financial market in 2008 was not only due to CDOs per se. It was also because stakeholders in the system were rewarded for success but not held accountable for any failures. CDOs simply reinforced existing incentives to take dangerous risks. While banks were bailed out after the market crash, with crypto exchanges and an emphasis on decentralization – the idea that financial interactions are non-custodial and therefore do not need to go through a regulatory intermediary – bailouts are not a plausible option. Moreover, the risk falls directly on consumers. Due to decentralization, individual consumersnot big banks, they are the ones who engage in this type of behaviour.
I want to clarify that I am not explicitly opposed to crypto yield programs. However, I am opposed to uninformed or misinformed investment practices. If the foundation of our market economy is each individual actor, what happens when too many people put their money into a program that collapses and can’t pay it back?
The upside is that earlier this year the Board of Governors of the Federal Reserve, the Federal Deposit Insurance Corporation and the Office of the Comptroller of the Currency issued a joint statement highlighting the risks that cryptoassets pose to banks. ‘ stability. Also, the SEC recently reached a cease-and-desist settlement against BlockFi – which ran similar crypto lending programs to Moonstone – on the grounds that those programs contain unregistered securities. But is this enough? Given the recent collapse of FTX, I don’t think so.
Decentralized exchange platforms like FTX can remain decentralized but still be subject to basic regulation that treats packaged digital financial assets as securities. In the case of crypto return programs, this means treating them like securities. In addition, consumers should be made fully aware of the risks of using CYPs and recognize the potential losses that may occur. These two safeguards can only prevent a repeat of 2008.
