Would the crypto jungle be a safer place for Americans if the companies where they keep their cryptocurrency holdings were permitted to do business with regulated banks? Some industry watchers point to the demise of the crypto exchange FTX and the fall of other crypto companies like BlockFi and Celsius as evidence that regulators should bring a measure of safety into crypto investing by enmeshing it with the tightly controlled traditional financial system.
For the moment, regulators seem to be doing the opposite: trying hard to keep crypto far from banks. It's essentially a new Operation Choke Point operation targeting the crypto space in the U.S., according to Nic Carter, general partner of Castle Island Ventures.
"It is a well-coordinated effort to marginalize the industry and cut off its connectivity to the banking system — and it's working," he tweeted in February.
Dozens of bankers have told Carter they are freezing plans to onboard new crypto clients and to add new services for existing clients.
"There's a new risk-reward calculus: If the banks themselves are going to have to do a ton of extra work to do due diligence on their clients, it's not worth it to start these relationships," Carter said in an interview. "There's been an immediate direct chilling effect, especially from the [Federal Reserve's] Custodia decision."
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Custodia, a
Many industry participants and observers say the way to mitigate risk for crypto markets and investors is not to keep banks away from crypto, but to let them in.
This would lessen the concentration risk of having a few banks serve a large market. It could reduce the risk of a run on these banks. It could also help instill compliance procedures and regulatory oversight over the movement of digital assets. And it could reduce cost and risk and increase choice for investors who need custody services for their crypto holdings.
"From the perspective of the future of digital-asset policy and connectivity to the banking industry, [not letting banks serve crypto-related companies] is an incredible lost opportunity," Caitlin Long, founder and CEO of Custodia, said in an interview. "Because this technology is not going away. What they've learned is that the scammers and grifters were able to get much deeper into the financial system than they anticipated, and that's just going to keep getting worse until there's a regulated pathway."
While some banks think crypto right now is too risky to touch, "I think it's too risky not to touch," said Georgia Quinn, general counsel at Anchorage Digital Bank. "It's too dangerous not to embrace and regulate. Look at entities that went under and lost client assets like Celsius — they were not regulated and yet were engaging in banking activities. They were taking deposits, they were lending on those, and they were not regulated in any way."
Regulators cast a chill on banks' crypto plans
On Jan. 3, the Fed, OCC and Federal Deposit Insurance Corp. released a
"The agencies believe that issuing or holding as principal crypto assets that are issued, stored or transferred on an open, public, and/or decentralized network or similar system is highly likely to be inconsistent with safe and sound banking practices," the statement said. "Further, the agencies have significant safety-and-soundness concerns with business models that are concentrated in crypto-asset-related activities or have concentrated exposures to the crypto-asset sector."
The OCC declined a request for an interview, but pointed to its
The regulators' statement is "chilling a lot of opportunities for banking institutions to innovate and stay competitive," said Gabriella Kusz, CEO of the Global Digital Asset and Cryptocurrency Association, which has been pushing regulators to write clear rules.
"A degree of regulation exists already," she said in an interview. "The problem is that it is somewhat ambiguous. It's difficult to navigate. When we talk about the concept of mainstreaming, which is allowing traditional financial sector players to engage in the space, with some of the protections and aspects of internal control and governance that consumers have long appreciated and enjoyed, I think that is a positive in terms of being able to mature the digital-asset industry and ecosystem and offer customers and clients consumer choice."
Banks could safely provide digital-asset custody, she said. They could provide accounting, bookkeeping and independent audits. And bank-issued stablecoins offer opportunities both for the banking sector and for the United States, she said.
"Being able to access stablecoin in this way is one of the ways that I think we not only advance American banking institutions and desires, but also national security and U.S. global prominence," Kusz said.
Asked about JPMorgan Chase CEO Jamie Dimon's recent comment that cryptocurrencies are a "pet rock" and a "Ponzi scheme," Kusz said opinions about digital assets come down to risk appetite.
"But I think that there's also something to be said for keeping an open mind and ensuring that if these are spaces that we know banking customers and clients are looking to engage in, then ensuring that they engage in that in the safest, most appropriate ways so that it is balanced with their needs and appetites and desires to engage," she said.
Aftermath of FTX
The recent regulatory crackdown came after FTX's collapse affected the banks that worked with it, including Moonstone, Deltec, Silvergate and Signature. These banks have been subject to deposit losses, investigations and lawsuits. But some say these problems occurred not because digital assets are too dangerous for banks to touch, but because FTX committed fraud.
"The issue with FTX has nothing to do with crypto per se," Seoyoung Kim, associate professor of finance and business analytics at Santa Clara University's Leavey School of Business, said in an interview. "It was a bad custodian. It could have done that bad custodianship with dollars, just the way that Bernie Madoff was an awful custodian. You are not supposed to commingle funds as a custodian. Whether you give me crypto or dollars or rupees or yen or gold, I am not supposed to hold on to that for you, and then say, 'I have bills to pay, why don't I dip into the things that people have trusted me to take custody of?'"
FTX "was a very sophisticated fraud," said Carter. "Sam [Bankman-Fried, the founder of FTX] duped a lot of people, including the best investors in the world. Would it have been possible for him to dupe his banks? Yes. The fraud was vast and the number of people that were tricked in some way was enormous and spans the whole industry. It's certainly plausible to me that he may have been able to meet [the banks'] diligence requirements on paper. It will all come out in court eventually."
One challenge for traditional banks like Signature and Silvergate was that they thought the deposits they received from crypto exchanges were sticky, according to Mike Cagney, CEO of Figure, a blockchain holding company with lending, payments and marketplace businesses.
"They weren't actually very sticky," he said in an interview. "In fact, they were highly correlated amongst one another. And when there was a run on crypto, those deposits vanished." The banks hit a perfect storm where they lost deposits and couldn't sell their assets, but "even if you could sell them, they're at a fraction of where you bought them, which impedes your equity capital," Cagney said.
"You could certainly make the argument that from a safety-and-soundness standpoint, it would've been better to have lots of banks have small relationships with the Coinbases and FTXs of the world versus a couple banks having significant relationships with those entities," Cagney said.
FTX raised several red flags for Digital Asset Research, a firm that vets crypto companies and does quarterly analyses of 450 crypto exchanges, including Coinbase, Gemini and Genesis, according to CEO Doug Schwenk.
The first was its know-your-customer and anti-money-laundering practices. "They allowed you to deposit and withdraw and trade funds without proving your identity," Schwenk said in an interview. "That is an immediate red flag."
The second was the chatter in the marketplace about FTX's relationship with Alameda.
"There was no public information about how they dealt with conflicts between Alameda and FTX," Schwenk said. "And when asked, they would not provide any transparency around policies or processes around conflicts."
Asked if there are other FTXs out there, Schwenk said there are other exchanges that have not been as transparent as they should be.
"One of the things we are really pounding the drum on right now is these exchanges all need to raise the level of transparency to their clients, to their counterparties, to their banks," he said. "We see some that are still opaque about certain important aspects and Binance is one that has some opaqueness. We would like to see them be more transparent."
Concentration risk
Having so few banks available to serve crypto businesses creates concentration risk and increases the risk of a run on the few that do, some say.
"We literally saw this with Silvergate," Carter said. "Silvergate is the main crypto-facing bank, and of course they dealt with a run because there are only three real banks that service crypto clients meaningfully: Silvergate Capital, Signature Bank and Metropolitan."
New York City-based Metropolitan Commercial Bank announced on Jan. 9 that it will "fully exit the crypto-asset related vertical." Signature, which was sued for its dealings with FTX in early February, has dramatically curtailed its crypto business.
"The regulators may be trying to make things more safe, but in practice they're rendering things much more fragile," Carter said.
The crypto space is healthier post-FTX, Carter argued. Many of the exchanges that remain are providing audited statements of reserves, proving they have the assets they say they have, which FTX did not do.
"In a crisis, there's a flight to quality," Paul Brody, global blockchain leader at EY, said in an interview. "And one of the problems we have right now is that it's really hard to know what quality is because there's not a lot of detailed regulatory oversight. If we had more top quality, FDIC-insured and regulated banks involved in this space, the market share of bad actors would have been smaller and the damage done would have been smaller."
The challenge for banks like Anchorage Digital that want to operate in this space is that there aren't enough of them and they're new, Julie Hill, law professor at the University of Alabama, said in an interview.
"There is risk associated with having a large number of crypto firms and fintechs use the same handful of what were previously relatively small community banks as the on- and off-ramp to regular U.S. dollars," Hill said. "Nobody is a hundred percent sure what state-of-the-art looks like, and I think that that includes the regulators," she said. "It's hard to determine what exactly the right amount of due diligence is."
Crypto is not going away
Another part of the argument that more banks should be serving the crypto industry is that crypto investing is legal and people are buying the currencies.
"There is demand for crypto investment and activities by the market," Schwenk said. "There is a group of generally younger people who want to invest in crypto and have been looking for ways to trade it. By limiting the banks that are involved in crypto, you push this concentration risk, but also the quality of firms who are willing to enter crypto lowers because they know that they can't go to their traditional banking providers."
This ultimately ends up pushing crypto activities offshore, he said.
"You end up pushing investors into riskier and riskier situations that are nothing to do with the risk of Bitcoin or Ether, but have everything to do with the risk of someone like FTX that was a bad actor," Schwenk said.
Reputable banks that are taking on crypto deposits as custodians are not accepting all crypto, just Bitcoin and Ether, Kim pointed out.
"They knew how to store private keys, safety features to keep in place and how to be a legitimate custodian of crypto," she said. "About five years ago, there were headlines about people who lost their crypto keys. We are not all good at being our own bank. Some of us need a custodian who can do it for you."
Crypto custody is a good fit for large banks, Dan Hoover, founder of Castle Funds, said in an interview. "The margins would be pretty decent and probably pretty durable," he said. His firm uses one of the few banks that offer crypto custody, Anchorage Digital.
Firms like his also need payment rails that operate all the time, Hoover noted.
"The reason you have concentration between Silvergate and Signature is because those are the places that have payment rails that you can use on U.S. holidays and weekends and overnights," Hoover said. "In a market where you have to pre-fund all your trades, that segment of the market that needs to trade right now needs access to those kinds of payment rails."
Some banks EY works with have digital-asset products ready to go and are waiting for regulatory clarity before they launch, Brody said. One of those products is stablecoin.
"There's no more of a pure banking product than stablecoin," Cagney said. "And the fact that it can't exist in banks right now is a little bit crazy."
As regulators proceed, they need to be careful that "they don't act in such a heavy-handed manner that they make it even more difficult to innovate in banking," Hill said. "It has to be the case that there are better ways to handle payments than the ways we've long done it in the United States, and we see some movement within the regulatory framework in that direction. And I don't think that it's in the country as a whole's interest to foreclose innovation that would be better for all sorts of people and businesses that want to make payments."
The other thing regulators also have to be careful about is their own credibility," she said.
"Part of the way banking regulation works is that banks generally want to try to comply with the rules and do what their regulator wants them to do," Hill said. "This gets harder when you start reaching out and applying old rules to new business models."
In the Custodia case, regulators made up a new set of rules to reject the bank's application for a master account, she said.
"Ideally you'd like your rules to be set beforehand, and not to appear to change as businesses try to get closer to complying with what they thought were your rules," Hill said. "It's not in anyone's interest for businesses to spend years and years aiming at where they thought the federal regulators' rules were only to find out that the regulators had moved them to some other continent."
