Crypto should be given the chance to earn trust, just like the banks have

A series of banking problems have raised concerns that the risky crypto market is putting the banking sector at risk. The two leading US-based crypto banks failed: Silvergate through voluntary liquidation and Signature through federal intervention. Silicon Valley Bank was also shut down by regulators, and First Republic Bank continues to struggle. Although regulators argued that the sudden shutdown of Signature was unrelated to its crypto exposure, Signature’s digital asset business was excluded from the subsequent sale to Flagstar. After a year of crypto crashes and scandals – including the collapse of Terra Luna, Celsius, BlockFi, Three Arrows Capital, and not least FTX – banking regulators are understandably concerned that similar instability could migrate into the banking system. The $20 billion in crypto hacks, fraud, money laundering, and other illegal activity reported by Chainalysis during 2022 certainly didn’t help to reassure them.

In both January and February, the major federal banking regulators issued joint statements highlighting the risks to banks of holding or custodial digital assets. Although regulators did not impose a ban, their statements cast doubt on whether regulated banks should offer any gateways between the traditional financial system and blockchain-based payment or trading systems. Then came the closures of Silvergate and Signature. Although the largest US-based firms in the crypto sector retain relationships with money center banks, such as JP Morgan for Coinbase and BNY Mellon for Circle, others are trying to give their clients dollar onramps and offramps.

In the midst of a good old-fashioned banking panic, it’s understandable that regulators and policymakers would cast a wary eye on the volatile and still occasionally shady crypto sector. Some major crypto firms continue to operate offshore with little effective regulation, engaging in risk-taking and other practices that would be prohibited to traditional financial services operators, while still retaining indirect access to US markets. Stablecoins, other digital assets, service providers and decentralized financial protocols must all operate within a well-defined regulatory context that protects investors and other users, limits financial crimes such as money laundering, and establishes oversight and macroprudential risk oversight. However, that means bringing crypto into the regulatory perimeter rather than pushing it out.

Few major economies follow the hardline American approach. A number of countries allow regulated banks to provide services to cryptocurrency firms subject to restrictions and significant oversight. For example, Switzerland has licensed two crypto-native banks, Sygnum and SEBA, which have expanded to other jurisdictions such as Singapore and the United Arab Emirates. Even in the United States, the Office of the Comptroller of the Currency in 2021 granted a charter to Anchorage Digital Bank as a digital asset custodian, and other established financial services firms such as Fidelity offer crypto custodian services. Although Anchorage had to revise its compliance program after a settlement with the OCC, none of these firms faced problems due to the fall in crypto prices and other crypto explosions in 2022. While some parts of the crypto trading ecosystem are fairly described as casinos, there is also significant activity in payments, tokenization, treasury management and decentralized finance driven by institutional players chasing the promise of more efficient, transparent, robust and flexible financial infrastructure based on blockchain foundations.

It is true that the USDC stablecoin, overseen by Circle in partnership with Coinbase, depegged briefly amid the collapse of Silicon Valley Bank. The stablecoin fell to nearly 80 cents on the dollar when Circle announced that $3.3 billion of its reserve funds were frozen at the insolvent bank. Still, it was a case where the failure of a traditional regulated bank threatened to contaminate crypto, not the other way around. USDC’s exposure was only 8% of total reserve assets, and Circle had significant resources available to cover any shortfall if it had been forced to take a haircut on its Silicon Valley Bank deposits. USDC immediately regained its dollar peg in the secondary markets when the Fed and Treasury stepped in to make Silicon Valley Bank’s clients whole.

A more thoughtful regulatory approach in the US will realize that the problem is less saving banks from crypto than saving both banks and crypto-native firms from themselves. Inherent in the banking business model is the tension between taking short-term deposits and long-term lending, and the temptation to leverage the deposit base to chase higher returns. The best answer is to regulate both on the asset and liability side. A crypto bank – or a traditional bank that wants to hold crypto – should be subject to strict oversight to prevent conflicts of interest and commingling of funds that are alleged to have undermined FTX. A bank in this industry also needs limits on what it can hold, auditing to verify its reserves, capital buffers to deal with periods of volatility, adoption of custody and cyber security best practices, and a thorough anti-money laundering/know your customer program.

These are all standard elements of banking supervision, but the details may be different in the crypto case. The volatility and instability of the crypto trading ecosystem may require stricter risk thresholds and limits to prevent events like the FTX bankruptcy from having a catastrophic impact. Through mechanisms such as proof of reserves, zero-knowledge cryptography, and smart contracts as a regulatory technology, the inherent transparency and immutability of blockchains can be used to make cryptobanks even more secure and compliant than traditional ones. This will require regulators and legislators to adopt principles-based regimes that give companies leeway to identify the best solution to the public policy problem, and risk-based differentiation between digital asset activities rather than treating “crypto” as a single thing.

For a pure crypto bank, the best solution is probably a narrow banking model, where lending is prohibited. This would take off the table the scenario that got Silicon Valley Bank (and many failed banks before it) into trouble. Banks that act as a bridge between the traditional financial system and digital assets can build profitable businesses that act as a utility, making money through low-risk returns on full-reserve deposits and fees for services. Yet earlier this year the Federal Reserve rejected an application from just such a bank, Custodia, which was chartered under Wyoming’s Special Purpose Depository Institution regime.

The Custodia rejection is similar to the recent actions of the Securities and Exchange Commission with respect to digital assets. In either case, regulators are right to require crypto firms to incorporate the safeguards created to protect investors and the financial system. Yet they have been reluctant to provide an explicit path to compliance. Some regulatory risk aversion is understandable. The crypto sector has more than its share of bad actors and regulatory arbitrators, who have done significant damage. However, the way to undermine them is to create a workable regulated environment for the legitimate actors, who will then, as part of their compliance obligations, freeze out unsafe firms. It will ultimately require legislation to smooth out the rough edges where traditional rules require arrangements that are not feasible in a blockchain context, but alternative mechanisms are. In the meantime, however, regulators should aim to define which crypto-oriented firms should do, not just what they shouldn’t.

The latest wave of bank runs should remind us that the financial system still runs on confidence. As recent SEC actions highlight, crypto firms must earn trust just like everyone else. With appropriate security measures, they would have the opportunity to do so.

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