Bank regulators warn about liquidity risks in crypto-related deposits

Regulators in Washington, D.C., want banks to be wary of liquidity concerns when dealing with customers funded by cryptocurrencies.

The Federal Reserve, Federal Deposits Insurance Corp. and Office of the Comptroller of the Currency issued a joint statement Thursday morning urging banks to be diligent in assessing run risks related to deposits from crypto firms. 

The agencies singled out deposits kept at banks on behalf of a crypto firm's underlying customers and deposits used as reserves for stablecoins as being particularly prone to runs. 

The comments on liquidity risks come after Silvergate Bank, a San Diego-based depository that specializes in serving crypto and financial technology firms, saw a drawdown of $8.1 billion of its $11.9 billion of deposits during the fourth quarter of last year. The run followed the collapse of the crypto exchange FTX.

Sen. Sherrod Brown, D-Ohio, chair of the Senate Banking Committee, said in a statement Thursday that the regulators' letter was a step in the right direction toward a broader, comprehensive regulatory system for crypto assets. 

"As we continue to learn the full extent of the fallout from the crypto industry's collapse, it's important that we use our existing financial safeguards to protect consumers and our economy from crypto's risks," Brown said. "This is the right step to provide more clarity to banking organizations and protect people's hard-earned money as we continue to consider a comprehensive regulatory framework for digital assets."

The Silvergate episode has caused regulators and lawmakers to take a closer look at the interrelationship between crypto and the traditional banking sector. 

The agencies' letter does not include any new risk management requirements for banks, but rather encourages them to apply existing standards. It also notes that banks are not prohibited or discouraged from doing business from any particular type of business, so long as it is legal.

Still, the guidance notes that the volatility of crypto assets can lead to rapid and unpredictable inflows and outflows of deposits. This volatility can present a risk to banks that service firms in the space. 

To mitigate these risks, regulators are encouraging banks to understand the factors that might influence deposit behavior in the crypto space broadly as well as the specific vulnerabilities of the deposits from their specific customers.

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They also urge banks to perform "robust due diligence" on their crypto-funded customers to assess concentration risks and interconnections with other entities in the space. Within this evaluation, banks should see if their potential counterparties have made any false or misleading statements to end users about their offerings, such as claims that their deposits will be FDIC insured.

Last summer, the Fed and FDIC sent a cease and desist letter to the now-bankrupt crypto firm Voyager Digital, which had marketed their products as being federally insured. In reality, the deposits that were placed with Voyager's banking partner, Metropolitan Commercial Bank, were insured, but that distinction was not made clear, the regulators said at the time. The deposits at the bank would only be insured if Metropolitan failed, not Voyager.

End user confusion about insurance coverage can "exacerbate" volatility for crypto-funded deposits, the agencies' statement warned Thursday, adding that market movements and media reports can also trigger runs.

The regulators singled out stablecoins as an area of concern, noting that because end users expect that to maintain a certain value at all times, any loss of confidence can lead to a run. They said banks should be aware of how their stablecoin-issuing customers are managing risks related to the assets.

The potential volatility of stablecoins was thrown into stark relief last spring with the collapse of TerraUSD, an algorithmic coin that is not backed by cash, when its value plummeted amid a mass drawdown event last summer.

Overall, regulators said banks that do business with crypto-funded entities should account for the liquidity risks they present and adjust their contingency funding plans accordingly. This could include stress testing or the implementation of other asset-liability governance and risk management protocols.

The regulators' statement also noted that banks should ensure they are complying with disclosure requirements related to deposits from crypto-backed firms. The letter specified call report filing and compliance with brokered deposit rules as key areas of concern.

The relationship between crypto-backed firms and brokered deposit rules — which were amended in 2020 — came into the spotlight after the Silvergate episode. Some policy specialists and advocates noted that the rapid withdrawals faced by the bank could have come from deposits that were previously considered brokered. 

While lawmakers on both sides of the aisle have called for legislation governing digital assets, regulators have been less eager to rewrite any rules. 

Last fall, Fed Vice Chair for Supervision Michael Barr said that high-profile collapses like FTX show the volatilities of crypto are already ring-fenced from the banking system. Fed Gov. Lisa Cook echoed that sentiment, saying regulators are already well equipped to manage the risks presented by crypto. More recently, Fed Gov. Christopher Waller noted that the technology underpinning the emerging sector could prove valuable to banking and finance more broadly.

The topic of crypto volatility was discussed during the Fed's most recent Federal Open Market Committee meeting as part of a broader discussion of financial stability concerns, according to the meeting's minutes released this week. The consensus among those involved in the conversation was that the recent failures in the crypto space have had limited impact on banks, indicating there are likely few connections with traditional banking.

More pressing threats noted during the meeting were risks associated with the Fed rapidly increasing interest rates. Specifically, the participants pointed to valuation pressures on commercial real estate, run risks in some nonbank financial institutions and unrealized securities losses on many banks' balance sheets. Overall, Fed staffers determined the current vulnerability of the U.S. financial system to be "moderate," according to the meeting minutes.