Finance Runs on Trust. Crypto Should Get to Earn It Too.‍

Do cryptocurrency markets need to be protected from the banking system? Alternately, could cryptocurrency provide a vehicle for authorities to reexamine what a bank ought to be?

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Concerns about the dangerous crypto market affecting the banking industry have been expressed as a result of a number of bank issues. The top two U.S.-based financial institutions for crypto ended in failure: Silvergate thru the voluntary liquidation as well as Signature through federal involvement. Regulators also shut down Silicon Valley Bank, and First Republic Bank is still having trouble. Regulators asserted that Signature's abrupt closure had nothing to do with its exposure to cryptocurrencies, although the company's digital assets division was expressly left out of the sale to Flagstar that followed.

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Bank authorities are reasonably concerned that similar instability could spread to the financial sector after a year of crypto disasters and scandals, including the bankruptcy of Terra Luna, Celsius, BlockFi, Three Arrows Capital, and, most significantly, FTX. They were undoubtedly not comforted by the $20 billion in cryptocurrency hacks, frauds, laundering, and other illegal activity that Chainalysis revealed during 2022. 

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In both January and February, the large federal banking regulators published joint comments noting hazards to banks of keeping or custodying digital assets. Regulators did not impose a ban, but their comments raised questions about the necessity of regulated banks acting as a bridge between the conventional financial system and bitcoin trading or payment systems. The closures of Silvergate and Signature followed. While the top U.S.-based cryptocurrency companies, like Coinbase and Circle, still have connections to money center institutions like JP Morgan and BNY Mellon, others are rushing to provide their consumers dollar onramps and offramps.

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It makes sense that authorities and decision-makers would be apprehensive of the unpredictable and oftentimes dubious crypto sector during a good old-fashioned financial panic. Although maintaining indirect access to U.S. markets, several large crypto firms keep going offshore with little to no effective oversight, taking risks and participating in other activities that would be illegal for operators of traditional financial services. Stablecoins, alternative digital assets, providers, and decentralised finance protocols must all function inside a clear regulatory framework that safeguards users and investors, prevents financial crime like money laundering, and imposes prudential and macro - prudential risk oversight. Yet instead of pushing cryptocurrency outside the regulatory boundary, that calls for bringing it inside.

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Few significant economies are adopting the strict American strategy. Some nations permit regulated banks to provide services to cryptocurrency businesses with restrictions and heavy regulation. For instance, Sygnum and SEBA, two crypto-native banks, have extended to foreign countries including Singapore and the United Arab Emirates after receiving licenses from Switzerland. Even in the United States, established financial services companies like Fidelity offer cryptocurrency custody services, and the Office of the Comptroller of the Currency gave Anchorage Digital Bank a charter in 2021 to act as a digital asset custodian. Despite Anchorage having to change its compliance program as a result of a settlement with the OCC, none of these businesses encountered issues in 2022 despite the decline in cryptocurrency prices and other crypto-related crises. There is a lot of activity in payouts, tokenization, treasury, and decentralized finance, driven by state institutions trying to chase the promise of a more effective, transparent, robust, and adaptable financial infrastructure built on blockchain foundations, even though some parts of the cryptocurrency trading ecosystem could be accurately characterized as casinos.

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It is true that with the bankruptcy of Silicon Valley Bank, the USDC stablecoin, managed by Circle in collaboration with Coinbase, briefly lost its peg. When Circle revealed that the bankrupt bank had frozen $3.3 billion of its reserve assets, the stablecoin dropped to around 80 cents on the dollar. But in that instance, rather than the contrary, the failure of a conventional, regulated bank threatened to taint cryptocurrency. Just 8% of the overall reserve assets were exposed to USDC, and Circle had ample resources on hand to make up for any shortfall if it had to take a hit on its Silicon Valley Bank deposits. Immediately after the Fed and Treasury intervened to make Silicon Valley Bank's clients whole, USDC restored its dollar peg in private markets.

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A more sensible regulatory strategy in the United States would acknowledge that the issue is not so much saving banks from cryptocurrencies as it is saving banks and crypto-native companies from one other. Inherent in overall economic model of banks is the tension of taking short-term savings and extending long, and the temptation to abuse the deposit base to seek higher yields. The wisest course of action is to govern both assets and liabilities. To avoid the potential conflicts of interest and money mixing that are said to have damaged FTX, a crypto bank—or a traditional institution that wants to hold crypto—should be subject to tight scrutiny. A bank in this industry also needs limits on what it can store, auditing to verify its reserves, financial buffers to handle with unstable times, the adoption of quality standards for custody and cybersecurity, and a rigorous countering the financing your customer program.

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These are all common components of bank supervision, although in the case of cryptocurrencies, the specifics could differ. To avoid events like the FTX bankruptcy from having a catastrophic effect, stronger risk thresholds and limits may be necessary given the volatility and instability of the crypto-trading ecosystem. The intrinsic transparency & immutability of blockchains can be used to make crypto banks even more secure and compliant than conventional ones using processes like proof of reserves, zero knowledge encryption, and smart contracts as a regulatory technology. In order to achieve this, legislators and regulators will need to differentiate between different digital asset activities based on risk rather than treating "crypto" as a single entity and adopt principles-based regimes that give businesses the freedom to choose the best answer to the public policy problem.

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The best option for a bank that only deals in cryptocurrencies is probably a restricted banking model that forbids lending. This would rule out the scenario that caused problems for Silicon Valley Bank (and numerous other failing banks before it). Banks that act as the link between the conventional financial system with digital assets can create successful businesses that operate as utilities, generating income from low-risk returns on full-reserve accounts and service fees. Yet early this year, Custodia, a bank that was chartered in Wyoming under the Special Purpose Depository Institution regime, applied to the Federal Reserve, which was denied. 

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The Securities and Exchange Commission's most recent moves on digital assets are comparable to the Custodia rejection. Regulators have every right to request that cryptocurrency companies implement the safeguards designed to protect investors as well as the financial system in each of these situations. Nonetheless, they have been hesitant to offer a clear route to compliance. Understandable regulatory risk aversion exists. There are several negative actors and regulatory arbitrageurs in the cryptocurrency industry who have harmed the industry significantly. Creating a functional regulatory framework for the legitimate users, who would subsequently exclude shady firms as part of its compliance duties, is the best approach to undercut them.To level out the jagged surfaces where traditional rules presuppose arrangements that aren't practical in the setting of blockchain technology but other mechanisms are, legislation will ultimately be needed. Regulators should work to clarify what crypto-oriented enterprises should be doing in the meantime rather than merely what they shouldn't.

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The latest wave of bank robberies should serve as a reminder that trust is still essential to the financial system. As shown by recent SEC actions, crypto companies must build trust in the same way that everyone else does. They would have the chance to with the right protections.

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In the end, legislation will be needed to smooth out the jagged edges where conventional regulations presume situations that aren't realistic in the context of blockchain technology but are in alternative methods. But in the interim, regulators ought to focus on defining what organizations focused on cryptocurrencies should be doing, rather than just what they shouldn't.

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We should be reminded by the current wave of bank robberies that trust remains a foundational element of the financial system. Crypto firms must establish trust in the same way that other businesses do, as recent SEC proceedings have shown. They would have the chance to with the right safeguards in place.