Warnings on Crypto Risk Prove Timely

April 3, 2023
Robert T. Smith Commentary in Arkansas Business 

While the failure of Silicon Valley Bank of Santa Clara, California, drew the greater share of coverage as Americans watched a classic bank run in real time, the collapse of Signature Bank of New York might have a similarly long-lasting effect on regulatory enforcement given the implications to the crypto industry. 

Regulators had already been busy addressing crypto-related issues. On Jan. 3, the Federal Reserve, Federal Deposit Insurance Agency and Office of the Comptroller of the Currency issued a joint statement on crypto-asset risks to banks. The statement highlighted risks associated with both the asset class and industry participants, including enhanced volatility in crypto markets (and likely impact on deposit outflows), contagion risk in the crypto sector and the risk of fraud among crypto-asset sector participants. 

Three weeks later, the Board of Governors of the Federal Reserve issued a Crypto policy statement providing strict limits on the ability of state member banks to engage in crypto business lines. Specifically, the guidance essentially prohibits (in most cases) a state member bank from holding crypto-assets as a principal. Serving as custodian is permissible provided the bank has effective controls in place to appropriately monitor risks inherent in holding digital assets as compared to other asset types. 

That same day, the Federal Reserve rejected an application by Custodia Bank to become a member bank in the Federal Reserve System. Custodia is a state-chartered Wyoming special purpose institution that aims to provide financial services to crypto industry participants. The agency’s order rejecting the application describes Custodia’s plan as a “non-viable business model” with an overreliance on the speculative crypto sector. Custodia has sued, seeking judicial review.

In late February, with ominous foresight of things to come, the agencies issued a second joint statement addressing key liquidity risks in banking crypto customers. The statement noted the “unpredictability of the scale and timing of deposit inflows and outflows” in the sector. The agencies stressed the importance of banks implementing strong risk management and internal controls to monitor liquidity risks. These practices would include assessing potential interconnectedness across deposits from crypto entities and associated liquidity risk, incorporating funding volatility associated with crypto-related deposits into contingency funding planning, and performing robust due diligence and ongoing monitoring of crypto entities that establish deposit accounts. 

Signature Bank (which is not related to Signature Bank of Arkansas Inc. of Fayetteville) was a significant partner to the crypto industry, playing a key role in the U.S. crypto ecosystem, although it was not entirely a crypto bank. Signature held a large commercial real estate loan portfolio and was known for its specialty line in serving professional firms. During the enormous growth of crypto during the past few years, Signature proudly embraced the sector, reportedly holding in excess of $10 billion in crypto-related deposits in early 2021. This heavy concentration appears to have sealed Signature’s fate. On March 10, the same day that Silicon Valley Bank was placed into receivership, Signature customers withdrew more than $10 billion in deposits leading to the third-largest bank failure in U.S. history.

Banks experienced overwhelming customer interest in crypto assets during 2020 and 2021 as valuations exploded. This interest had slowed substantially even before the recent industry turmoil. The clear message from regulators is that the relatively young crypto sector carries substantial risk, including age-old liquidity risks resulting from a combination of concentration and volatile funding sources. The FDIC reported that as of January, 136 banks had current or planned crypto-related activities. We expect that many of those plans will be slowed, if not completely discarded for the time being, as banks tread carefully in evaluating any crypto-related activities and the related regulatory implications.

“Warnings on Crypto Risk Prove Timely (Robert T. Smith Commentary).” Arkansas Business, www.arkansasbusiness.com/article/143958/warnings-on-crypto-risk-prove-timely-robert-t-smith-commentary.