US bank collapse does not necessarily make crypto reliable

The world is saved in “Superman: The Movie” when (spoiler alert) our eponymous hero flies around the world so fast that he turns back time and undoes a confluence of cataclysmic events where a nuclear missile detonated in the San Andreas Fault. (Wait, could he do that all the time?)

This sequence of events may have seemed familiar, and so did our collective sigh of relief when the Treasury Department, the Federal Reserve and the Federal Deposit Insurance Corporation (FDIC) announced extraordinary measures on March 12 to “strengthen confidence in the US banking system” following the dramatic shutdown by Silicon Valley Bank (SVB).

Jess Cheng is a partner in the New York office of Wilson Sonsini Goodrich & Rosati and a former senior advisor to the Board of Governors of the Federal Reserve System in Washington, DC. Amy Caiazza is an securities, fintech and blockchain partner in Wilson Sonsini Goodrich & Rosati’s Washington, DC office.

make one like this deus ex machina of the crypto industry exists, or can it? Should it? Silicon Valley Bank (SVB) headlines weren’t about crypto. However, there are important lessons for the crypto community to consider, especially as the recent instability in the banking system has once again fueled calls for decentralized finance to solve many of the problems raised by traditional banks and established financial systems.

SVB was closed on March 10 by the California Department of Financial Protection and Innovation, with the FDIC appointed receiver. Among the measures announced Sunday were measures taken to enable the FDIC to complete its resolution of SVB in a manner that “protects everyone depositors [such that] depositors will have access to everyone of your money starting Monday, March 13” (emphasis added).

Even deposits above the $250,000 FDIC insurance limit would not take a loss under this measure. Signature Bank, which was also closed that day by the New York Department of Financial Services with the FDIC appointed receiver, received similar treatment, with all depositors to be made whole.

Any losses to the FDIC’s deposit insurance fund to cover these uninsured deposits will be recovered in a special assessment on banks. In other words, the cost of making SVB’s and Signaturbanken’s customers whole has fallen directly on the banking industry as a whole: not customers, and not taxpayers. Regulators have stepped in, but they place the financial responsibility for protecting depositors firmly with the private sector.

Importantly, a new measure was announced on Sunday. The Federal Reserve also created a new lending facility to ensure banks have the ability to meet the needs of their depositors, with the Treasury Dept. making available up to $25 billion as a backstop. The facility offers loans for up to one year against certain securities – including long-term US Treasuries and government-backed mortgages, whose market prices have fallen as interest rates have risen. Importantly, these assets will be valued at face value, not market value. As a result, a bank desperate for liquidity will not need to sell its portfolio of long-dated securities at a loss; it could provide that security for a loan at par.

The Fed can stand up to this liquidity facility because it is special. Like any balance sheet, the Fed consists of assets on one side and equal liabilities on the other – but the Fed can expand its balance sheet in ways that other entities cannot, and central bank money is unique in that it serves as the foundation. for the security and efficiency of the US payment system as a whole.

It remains to be seen whether the measures announced on Sunday are enough to calm investors, depositors and the wider market. Just as the US banking supervisory and regulatory framework may be at a crossroads, so may the crypto community.

A challenge to consider: Can technology recreate, for the crypto markets, the effect of the Fed’s unique central banking powers, backed by the full faith and credit of the US government?

Maybe, to some extent. It doesn’t take a central bank or finance minister (or Superman) to develop clear, well-calibrated loss allocation schemes. As a point of comparison, the concept of loss sharing is already a fundamental principle in payment systems in that the burden of unforeseen operational losses should lie with the providers of the payment system rather than with the users of the payment system. The crypto community may consider developing clear, enforceable legal terms or system rules that leverage this basic loss spreading principle – beyond operational losses and on an industry-wide basis.

But of course there isn’t one deus ex machina of crypto, which appears to be in philosophical tension with the decentralization goals of many in the blockchain and crypto industries. At the end of the day, although crypto and traditional banking appear to compete in financial services, they live in fundamentally different realities. In the aftermath of the Terra and FTX collapses, there was no Superman to step in and undo the catastrophic consequences.

The resulting cascade of losses has undermined confidence in crypto outside of the close community. In response, this means that the crypto community itself must be united, vigilant and disciplined – through strict rules, standards and protocols that protect customers and strengthen trust. Only by rebuilding this trust can crypto have a chance to regain its momentum and a chance at mainstream adoption.