Bloomberg Law
March 23, 2023, 8:00 AM

Bank Regulators’ Contagion Fears Are Misdirected Toward Crypto

Daniel Davis
Daniel Davis
Katten Muchin Rosenman
Gary DeWaal
Gary DeWaal
Katten Muchin Rosenman

The recent collapses of Silvergate, Silicon Valley Bank, and Signature Bank highlight the contagion risk between the cryptocurrency industry and traditional banking that regulators have warned about.

But in these instances, the contagion flowed in the opposite direction anticipated by regulators—from traditional finance to the crypto industry.

In particular, after SVB’s formal collapse on March 10, $3.3 billion of reserves backing Circle Internet Financial’s widely popular USDC stablecoin held by the bank were made temporarily unavailable. This amount was approximately 8% of Circle’s total USDC reserves of approximately $42 billion—most of which it maintained in short-term Treasury bills.

Initial concerns that Circle might only recover $250,000 of its reserves at SVB—the maximum amount guaranteed for repayment by the Federal Deposit Insurance Corporation—caused USDC’s price to decline to approximately $.88, a significant discount to USDC’s ordinary value of $1.

However, the price of USDC reverted back to its ordinary and expected $1—after a joint March 12 statement by Treasury Secretary Janet Yellen and US prudential regulators that all depositors at both SVB and Signature Bank would be made whole.

Collapse Unlinked From Crypto

Although Silverbank had crypto-industry enterprises as customers, and SVB and Signature Bank did to a lesser extent, their collapse ultimately had little to do with recent turmoil in the crypto industry. According to one published report, the New York Department of Financial Services said the agency’s decisions to shut down Signature Bank “had nothing to do with crypto.”

Instead, these factors hastened the banks’ demise:

  • The failure of each institution’s management to adequately address rapidly increasing interest rates prompted by recent Federal Reserve policies to combat inflation.
  • The resulting decreased value of longer-term Treasury securities held by the banks as investments.
  • Losses taken by the banks when they were required to liquidate their longer-term Treasury securities that were trading below their cost to meet cascading withdrawal demands by depositors when rumors regarding the banks’ solvency began circulating. With SVB, particularly, these losses were obfuscated on the bank’s balance sheet by booking such assets on a held-to-maturity basis, obviating the need to disclose market-to-market losses on an ongoing basis.

Moreover, the banks’ damage from these circumstances was probably exacerbated by the snowball effect of customers’ ability to request near-instantaneous transfers of their deposits to other banks remotely relying on internet applications.

According to media reports, it now appears that the Federal Reserve expressed serious concerns about SVB’s business model and risk management controls since 2019, and most recently, regarding the bank’s financial condition—and took insufficient measures to counter the problems it identified.

These recent events stand in contrast to express concerns regarding stablecoins articulated by the Financial Stability Oversight Council in October 2022 when it noted that “[t]raditional asset markets could experience dislocation if stablecoin activities were to obtain significant scale and if runs on stablecoins were to lead to fire sales of traditional assets backing the stablecoins.”

The FSOC was correct to raise such concerns, but appears wrong to have limited its concerns only to stablecoins. It turns out that traditional banks with bad risk management are prone to identical problems.

Regulators Warn Banks Against Crypto

Twice this year, the Federal Reserve, the FDIC, and the Office of the Comptroller of the Currency issued joint statements discouraging traditional banks from engaging in business with crypto industry entities. In one statement, the regulators highlighted purported volatility risks of crypto enterprises, focusing on alleged unique risks of the sectors such as fraud and scams, legal uncertainties, run risk of stablecoins, and lack of maturity in risk management and governance practices.

The regulators cautioned that banking organizations “are neither prohibited nor discouraged from providing banking services to customers of any specific class or type, as permitted by law or regulation.” But these joint statements discouraged banks from engaging with crypto-industry customers, and scared away potential investors from investing in banks with crypto-industry clients.

Indeed, the availability of legitimate US-based traditional banking institutions for crypto-entities has significantly declined after the demise of Silver and Signature banks. This has caused great disruption to such enterprises and forced some crypto institutions to reluctantly consider initiating relationships with non-US banks.

The crypto industry requires more effective regulation. But traditional banking regulators should stop solely warning about the potential contagion from the crypto-industry to traditional finance and discouraging such banks from doing business with crypto-industry companies. Financial regulators must additionally consider how to enhance risk management practices of traditionally financed banks and the regulatory oversight of traditional banking entities.

This article does not necessarily reflect the opinion of Bloomberg Industry Group, Inc., the publisher of Bloomberg Law and Bloomberg Tax, or its owners.

Author Information

Daniel J. Davis, former CFTC general counsel, is a partner at Katten Muchin Rosenman.

Gary DeWaal is senior counsel to Katten Muchin Rosenman.

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