How Policy Shaped Crypto’s Banking Prospects

For years crypto businesses have been plagued with an inability to establish and maintain banking relationships – a situation downstream of a general lack of regulatory clarity. Today, banks in the U.S. and reportedly the European Union are facing increasing pressure to stand aside from the crypto industry. While it might sound like a positive thing for a movement looking to establish a parallel financial system – one bound by code rather than human intervention – the return to a lack of bank access would be devastating for many in crypto.

But that’s an unlikely scenario. Instead, in the coming years more banks – with higher profiles – will likely be willing to work with crypto firms. Better policy will be put in place, and mature crypto firms that survive, or start in, the bear market will have to meet tighter regulations and submit to more scrutiny. This prediction is in part based on a hunch, and a few background calls with bankers who could not go on the record and who said that crypto is still an area of business development. While things seem bleak, it’s important to recognize that bitcoin did not go to zero and that much of the industry is more than holding up.

This article is part of CoinDesk's "Policy Week." A version of it published first in The Node newsletter.

Crypto is not going away, in other words, and the longer that stays true the more likely it is that banks will again see it as a growth area. But compliance is dear to banks, and there is a patchwork of laws snaking through federal and state legislative processes that may impose strict requirements for both banks and their crypto clients. There are a number of institutions, such as crypto exchange Coinbase and stablecoin issuer Circle, that already function more like fintech firms than crypto-anarchists. It’s that “form factor” to which banks will try to sell banking services.

Far from challenging banks, regulated blockchain products and the companies that build them are only going to improve legacy financial businesses.

All of this cuts counter to the trend of crypto-friendly banks stepping back from the industry. These few, relatively small regional institutions saw digital assets as an opportunity for growth and have summarily been battered by the market downturn. Metropolitan Commercial Bank, which counted 6% of its deposits from crypto companies, will cut ties by the end of the year with its crypto clients in light of “recent developments” and regulatory shifts. Signature, which isn’t exiting entirely, is scaling back – including recently imposed restrictions on its dealings with the Binance exchange.

Signature and its competitor Silvergate, the crypto bank par excellence, both saw a dramatic drawdown in crypto-related deposits. That’s in part because both offered similar intercompany payment rails – Signet and Silvergate Exchange Network, respectively – that facilitated the exchange in hundreds of billions of transfers between their crypto clients. Both companies lost an astounding amount in crypto-client withdrawals last year, and have since taken out loans from the United States Federal Home Loan Banks System (FHLB), an agency created in the Great Depression to backstop the mortgage industry. (Turns out there is a buyer of last resort for crypto, the U.S. taxpayer.)

The worst may not yet be over, however. Silvergate, a much smaller bank with a relatively much broader exposure to crypto, may be implicated in the ongoing FTX fallout. It sold assets at a major discount last quarter to fulfill $8 billion of customer withdrawals, and lost more than it ever made from crypto since it entered the industry in 2014. That may serve as a serious disincentive for other banks thinking about crypto, all the more because some of the highest-profile clients – Voyager Digital, Celsius Network and BlockFi failed and filed for bankruptcy protection.

Meanwhile, three U.S. governmental institutions published a letter at the beginning of the month strongly discouraging banks from dealing in crypto. In a Jan. 3 joint statement, the U.S. Federal Reserve, Federal Deposit Insurance Corporation (FDIC) and the Office of the Comptroller of the Currency (OCC) said issuing or holding cryptocurrencies, tied to public, decentralized networks, was "highly likely to be inconsistent with safe and sound banking practices.”

"It is important that risks related to the crypto-asset sector that cannot be mitigated or controlled do not migrate to the banking system," the letter read. Likewise, across the pond, the European Parliament's Economic and Monetary Affairs Committee is looking to limit the amount of unbacked cryptocurrencies lenders can hold – a preventative measure meant to stymie the chance that problems in the digital asset industry will spill over to the wider finance system.

A leaked version of a bill, which still needs to be passed by higher chambers of the European Union government, will require banks to hold an equivalent amount of fiat for every euro they hold in crypto, CoinDesk’s Jack Schickler reported. While that may sound onerous, it’s not far from collateralization requirements used by blockchain-based lenders such as Maker, the issuer of the dai stablecoin, which have better weathered the crypto contagion.

None of this is hard to interpret: It’s going to be harder for banks to deal with crypto. Regulators have taken a victory lap over supposedly insulating traditional finance from crypto contagion. As Sen. Elizabeth Warren (D-Mass.) said, discussing the FHLB loans, “This is why I’ve been warning of the dangers of allowing crypto to become intertwined with the banking system … Under no circumstance should taxpayers be left holding the bag for collapses in the crypto industry – a market brimming with fraud, money laundering and illicit finance.”

See also: EU Plans Digital Euro Bill, Metaverse Policy for May, Commission Says

But, importantly, there are no outright banking bans being suggested, a premise that flies in the face of the commitment to free markets and regulators’ goal of promoting capital formation. So long as the majority of crypto users buy into the crypto economy with fiat and intend to exit with dollars in their pockets, crypto firms will need banks. Likewise, banks need deposits.

The hope is the industry changes enough so the headline and reputational risks Warren mentions remains history. Crypto is already learning to adopt new ways of presenting itself, and will be forever changed by increased governmental supervision and stipulations. Regulation is a sieve – it may filter out products for which there is clear demand, like lending platforms, but may also prevent the next Gemini-Genesis imbroglio. But whatever gets through by definition would be bankable, even if it’s crypto in name only.