It would be a mistake to regulate banks out of the crypto space

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It’s no secret that Washington is currently preoccupied with reining in crypto activity. Congressional bills and hearings abound. The Lummis-Gillibrand crypto bill has been revived, and the Senate Banking Committee held a hearing in February on the crypto crash. At the same time, the Federal Reserve has issued a new rule specifically with cryptoassets in mind, and banking agencies, through both action and inaction, are cracking down on crypto.

The Fed, the Office of the Comptroller of the Currency and the Federal Deposit Insurance Corp. has issued two joint policy statements since the beginning of the year on the risks to banks from crypto activities. The Securities and Exchange Commission is entertaining a proposal to expand investment adviser safeguards to include crypto assets. And the SEC and the Commodity Futures Trading Commission have both brought high-profile enforcement actions against executives at fallen crypto exchange FTX. Regulators have also slow-walked or denied applications for banks to engage in crypto activity and for crypto companies to obtain banking licenses.

Some of this is clearly needed. The FTX collapse, the liquidation of Three Arrows Capital and the bankruptcy of crypto lender Voyager Digital painted in Technicolor what can happen in unregulated financial markets. And for many, whether fully understood or not, crypto has always seemed shady. Signature Bank’s willingness to only accept regular deposits from companies working with crypto played a role in the scrutiny and rumor-mongering that led to the bank’s failure. In this connection, it is better to use terms such as “open banking” or “fair financing” as opposed to a word that has potentially ominous overtones. “Crypto” sounds like one of Darth Vader’s secret weapons.

However, banks should worry that Washington will go too far and inadvertently undermine the banking system, in the current frenzy to fix crypto’s mistakes. There is also reason to fear that Washington will not be able to get to the heart of the FTX problem. These themes are interconnected.

With regard to the negative impact on the banking system, there are at least three things to worry about. First, the term “crypto” is a misnomer used to cover a multitude of practices and technologies. Importantly, the term has had the effect of confounding “cryptocurrency” secure online transactions (Web 3); sophisticated approaches to payment, document and information exchange (blockchain); and secure ways to do business with legitimate non-bank customers in volatile industries (eg, “crypto-company dollar deposits with banks”).

But if Washington is right to protect the public from abuse and abuse, regulators and policymakers must consider the unintended consequences of any clumsy approach. There will be serious costs for wholesaling the banking sector’s safe and sound engagement with this new technology. American banks will be condemned to lag behind technological innovation, giving foreign banks the upper hand. Ham-handed efforts to limit crypto will spur the industry to grow outside the umbrella of regulation and oversight entirely. And it will simply open the door to a new risk: Because more and more financial transactions will be conducted outside the federal financial framework of safety and soundness and compliance, everyone will be more vulnerable to a major financial blow.

In other words, our current Maginot Line mentality, which aims to hide the banking system behind artificially constructed defenses, actually weakens the banking system. If customers move outside the regulated system, more of the wider financial system will be impervious to safety and soundness controls. If history is any guide – look to 2007 for example – an explosion in the non-banking sector will eventually blow back on the banking system. Economics are always connected.

Regarding this latter very serious problem—one in which two financial systems exist under the same national tent—the Fed has already articulated a way out, one that I have favored since my days as comptroller. Whether one is chartered as a bank or not, the fundamental principle of our federal regulatory architecture should be “same activity, same size, same regulation.” Applying this important principle will make the American financial system both safer and fairer. It will put banking on a level playing field with non-bank competitors. Perhaps most importantly, it will also better ensure that consumers are treated fairly by all financial providers.

I would urge bankers and others concerned about the safety of our financial system to continue to advocate strongly for this latter principle, and to work with Congress and regulators to ensure that banking is not locked out of useful and cutting-edge innovation.