It is no secret that, for the moment, Washington is consumed 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 crypto assets in mind, and banking agencies, through both action and inaction, are pummeling crypto with vigor.
The Fed, the Office of the Comptroller of the Currency and the Federal Deposit Insurance Corp. have 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 undertaken high-profile enforcement actions against executives at the fallen crypto exchange FTX. Regulators have also slow-walked or turned down applications for banks to engage in crypto activity and for crypto companies to gain banking licenses.
Some of this is clearly needed. The FTX collapse, the liquidation of Three Arrows Capital and the bankruptcy of the 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 merely to accept ordinary deposits from companies working in crypto played a role in the scrutiny and rumor-mongering that led to the bank's failure. In that regard, financial innovators are better advised to use terms like "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, in the current frenzy to right crypto's wrongs, Washington will go too far and inadvertently undercut the banking system. There is also reason to fear that Washington will fail to get at the heart of the FTX problem. These themes are interrelated.
With respect to the negative impact on the banking system, there are at least three things to worry about. First, the term "crypto" is a misnomer being used to cover a diversity of practices and technologies. Importantly, the term has had the effect of conflating "cryptocurrency" secure web transactions (Web 3); sophisticated approaches to payment, document and information exchanges (blockchain); and safe ways to do business with legitimate nonbanking customers in volatile industries (e.g. "crypto companies' dollar deposits with banks").
But if Washington is right to protect the public from abuse and malfeasance, regulators and policymakers need to consider the unintended consequences of any clumsy approach. There will be serious costs to wholesale prohibition of the banking sector's safe and sound engagement with this new technology. American banks will be condemned to lagging technological innovation, giving foreign banks an upper hand. Ham-handed efforts to curtail crypto will spur the industry to grow outside the umbrella of regulation and supervision altogether. And that will simply open the door to a new risk: Because more and more financial transactions will be conducted outside the federal financial safety and soundness and compliance frameworks, everyone will be more vulnerable to a big financial blow.
In other words, our present Maginot line mentality, which aims to veil the banking system behind artificially constructed defenses, actually makes the banking system weaker. If customers move outside the regulated system, more of the broader financial system will be impervious to safety and soundness control. If history is any guide — look, for example, to 2007 — an explosion in the nonbanking sector will eventually blow back on the banking system. Finance is always interrelated.
As to 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 U.S. financial system both safer and fairer. It will put banking on a level playing field with nonbank competitors. Perhaps most important, it will also better ensure that consumers are treated fairly by all financial services providers.
I would encourage 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 the regulators to make sure that banking is not locked away from useful and groundbreaking innovation.
