Cryptos at the Banking Gate: Too Close for Comfort?

A U.S. Financial Stability Oversight Council report in October on digital-asset risks drew conclusions not unlike those that central bankers and regulators had been reaching even while cryptocurrency valuations were peaking in 2021: Interconnections with, and therefore systemic vulnerabilities of, the traditional financial system were limited, but “some characteristics of crypto-asset activities have acutely amplified instability within the crypto-asset ecosystem.”

Potential spillovers or contagion affecting mainstream, regulated financial services were thus seen as largely contained.

Barely a month after that FSOC assessment – which called attention to lax crypto-business risk controls and included recommendations for closing regulatory gaps and protecting investors – the FTX exchange suddenly hurtled into bankruptcy. The ensuing domino effect threatened the solvency of, or took down, other exposed parties and sullied whatever trust and reputational value virtual currencies were holding onto.

And as that crisis continues to unfold, ongoing scrutiny of FTX and various counterparts is raising suspicions that banking’s protective regulatory boundaries may have been breached.

High-Level Urgency

By early December, the global Financial Stability Board was discussing “preliminary lessons” from the FTX failure. A statement following an FSB plenary in Basel, Switzerland, again characterized “financial stability risks to date from crypto-asset market turmoil” as limited, but added: “Growing linkages of crypto-asset firms with core financial markets and institutions increase the risk of spillovers. Crypto trading platforms, combining multiple activities that are normally separated in traditional finance, can lead to concentrations of risk, conflicts of interest and a misuse of client assets.”

The FSB underscored the importance of supervisory authorities’ “ongoing vigilance” and the urgent need for a global regulatory standard, adding: “The FSB will enhance its crypto-assets monitoring framework to include DeFi- [decentralized finance] specific vulnerability indicators and explore approaches to fill data gaps to measure and monitor interconnectedness of DeFi with traditional finance, with the real economy and with the crypto-asset ecosystem.”

CFTC Commissioner Christy Goldsmith Romero

“There are some dissenting opinions about whether crypto is a real issue at the international level, because some people think that it’s still not a material issue and risk,” Jean-Paul Servais, chairman of the International Organization of Securities Commissions (IOSCO) board, said in a Reuters interview. “Things are changing, and due to the interconnectivity between different types of businesses, I think it’s now important that we are able to start a discussion, and that’s where we are going.”

“Recent events did not create risks; they revealed them, and how real people can be harmed,” Christy Goldsmith Romero of the U.S. Commodity Futures Trading Commission said in a November 30 speech in Singapore. Reiterating earlier calls for action, she spoke of “conflicts of interest and contagion threats,” as well as cybersecurity, as interrelated priorities: “The commission should explore the full measure of existing authorities in all areas related to crypto, including unregulated affiliates. 

“We should be able to demand information, perform risk-based reviews, and limit risks as necessary, related to unregulated affiliates where there are inter-affiliate contagion risk and/or conflicts of interest.”

Enforcing a Perimeter

On the ground, particularly in the U.S., market regulators have been operating with incomplete statutory dictates – legislation is pending, with the current Congress in its final days – on whether, for example, a given digital asset should be treated as a security subject to Securities and Exchange Commission oversight, or as a commodity under the CFTC.

But definitional and turf debates haven’t prevented the agencies from imposing discipline through enforcement actions. Those and the oversight of banking regulators, notably the Office of the Comptroller of the Currency through chartering policies and consideration of an appropriate “regulatory perimeter,” have erected barriers to crypto-related spillovers. In a mid-November speech, Acting Comptroller Michael Hsu highlighted “the quiet trustworthiness of banks throughout this year’s crypto drama.” He credited the OCC’s “‘careful and cautious’ approach to crypto activities by national banks. This helped mitigate the risk of contagion from crypto to the banking system.”

While banks are well capitalized and have ample liquidity, “contagion risk is high within the crypto industry,” concluded the OCC’s semiannual risk perspective report, released on December 8. It also called out that sector’s lack of risk-management maturity and said that the agency’s “focus is on whether banks are engaging in these activities in a safe, sound and fair manner . . . OCC-supervised institutions considering these activities should take a careful and incremental approach to ensure appropriate controls and risk management practices are in place before scaling or engaging in additional activities.”

Congressional Inquiries

Yet even as regulators were raising their game to keep pace with accelerating technological change [see, for example, Regulators Are Off to the (Tech) Races and Regulators and Innovation: A Reconsideration], some crypto-market players were coveting the privilege of owning a bank with that halo of trustworthiness. Concerned that some proverbial noses may have gotten under the tent, lawmakers are reacting.

Senator Elizabeth Warren

Citing “reports of banks’ relationships with crypto firms and potential loopholes that crypto firms may exploit to gain access to the banking system,” Democratic Senators Elizabeth Warren of Massachusetts and Tina Smith of Minnesota fired off letters on December 7 to the heads of the OCC, Federal Reserve Board and Federal Deposit Insurance Corp., with questions designed to draw them out on whether “crypto firms may have closer ties to the banking system than previously understood.”

One open case involves fintech lender Social Finance (SoFi), which had a digital-assets business and in January 2022 obtained conditional OCC approval to acquire Golden Pacific Bank, thereby to become a $5.3 billion-in-assets national bank within a holding company regulated by the Fed. Approval required “confirmation that the resulting bank will not engage in any crypto-asset activities or services.”

In publicly disclosed letters in November, Senate Banking Committee Chair Sherrod Brown, Democrat of Ohio, along with Smith and two other members, suggested that SoFi was lagging in its commitment and posing “significant risks to both individual investors and safety and soundness.”

Alameda’s Piece of a Bank

A trigger for the senators’ interrogatories was Alameda Research’s investment in a small-town Washington State bank, historically Farmington State Bank and doing business as Moonstone Bank. It is regulated as a Federal Reserve member bank.

Alameda was run as a hedge fund with close ties – alleged to be legally and ethically questionable – to FTX and its former chief executive Sam Bankman-Fried. He co-founded both entities and announced the shutdown of Alameda when FTX was filing for bankruptcy protection in November.

Alameda made its $11.5 million private placement in Moonstone’s parent, FBH Corp., whose chairman, Jean Chalopin, is also chairman of Deltec Bank & Trust, which has a relationship with the Tether stablecoin as well as Alameda. (FBH, Deltec and FTX are all Bahamas-headquartered.) Wherever regulators might stand about the propriety of those connections and whether they raise the specter of stability risk, such transactions can escape widespread notice. In and of itself, the dollar amount committed by Alameda was too small to cause dire systemic reverberations, and the shareholding was below a threshold that would require a change-in-control filing.

That didn’t preclude sounding off in the media.

“The fact that an offshore hedge fund that was basically a crypto firm was buying a stake in a tiny bank for multiples of its stated book value should have raised massive red flags for the FDIC, state regulators and the Federal Reserve,” Camden Fine, a former president and CEO of the Independent Community Bankers of America, told the New York Times. “It’s just astonishing that all of this got approved.”

In a CoinDesk opinion column, FTX’s Collapse Was a Crime, Not an Accident, David Z. Morris wrote that Alameda’s investing an amount larger than the bank’s prior net worth was problematic, and “in the broader context of the FTX story, the bank stake goes from ‘questionably legal’ to ‘incredibly ominous.’”

In American Banker, Washington Bureau chief John Heltman noted that Alameda kept its bank stake under 10% and opined, “If this episode of the FTX saga means anything, it is that at least one crypto firm – that we know of – was sniffing around the perimeter of the banking system for some unknown reason.”

Fintech Bank Under Pressure

The moves and motivations of other “sniffers” were more transparent.

Silvergate Bank of La Jolla, California, which bills itself as a B2B fintech and crypto leader and has relationships with exchange operators such as Bitstamp and Coinbase, bolstered its crypto strategy with a January 2022 agreement by its parent holding company, Silvergate Capital Corp., to acquire payment network assets from the Diem Association. Diem was the successor of the Meta Platforms-Facebook project originally known as Libra.

“An Obscure Bank Found Its Key to Success. Then FTX Collapsed,” said a December 9 Bloomberg headline about Silvergate and its links to Alameda and FTX.

Silvergate CEO Alan Lane

On November 28, $15.5 billion-in-assets Silvergate Capital disclosed that its total exposure to BlockFi, a crypto lender that filed for bankruptcy after FTX did, amounted to less than $20 million in deposits.

Senator Elizabeth Warren, with Republicans John Kennedy of Louisiana and Roger Marshall of Kansas, addressed a letter on December 5 to Silvergate CEO Alan Lane, asking questions about the bank’s dependence on deposits from digital-asset customers, the FTX deposits that it held, how it may have “facilitated the transfer of FTX customer funds to Alameda,” and the recent replacement of its chief risk officer. The same day, Lane sought to “set the record straight about Silvergate’s role in the digital asset ecosystem,” asserting, “We take risk management and compliance extremely seriously,” and “we conducted extensive due diligence on FTX and Alameda Research.”

Nexo Comes and Goes

Nexo, a global digital-asset management and lending platform and competitor of BlockFi and of Celsius Network, another bankrupt crypto lender, on September 27 said it was acquiring an unspecified stake in Hulett Bancorp. The OCC-regulated Summit National Bank in Hulett, Wyoming, is owned by that holding company.

“The deal will allow Nexo to offer its U.S. retail and institutional clients services that include bank accounts, asset-backed loans, card programs, as well as escrow and custodial solutions through Summit National Bank,” said the press release. Summit would be “reimagining itself and its offering to serve customers’ needs as a modern digital fintech bank” and gaining “access to a sophisticated product suite for digital assets, creating a bridge between web3 and traditional finance and boosting both companies’ capabilities and addressable markets.”

“The Nexo team” on December 5 reversed course, stating that Nexo “will be phasing out its products and services in the United States in a gradual and orderly fashion over the coming months.”

The company blamed the U.S. regulatory patchwork. “More than 18 months of good-faith dialogue” with state and federal authorities, during which Nexo replied to requests for information and modified business plans, had “come to a dead end.”

“Despite rhetoric to the contrary,” Nexo complained, “the U.S. refuses to provide a path forward for enabling blockchain businesses, and we cannot give our customers confidence that regulators are focused on their best interests.”

Nexo Managing Partner Antoni Trenchev

An “impossible environment” was compounded by a Consumer Financial Protection Bureau finding that “it has jurisdiction to investigate our Earn Interest Product, which the SEC and state regulators have simultaneously insisted is a security subject to their jurisdictions,” Nexo said. “In addition, a number of the very state securities regulators we had been cooperating with for several months blindsided us by filing actions against us without advance notice.”

With the CFPB holding its ground in probing whether Nexo made false or misleading statements about the interest-earning product, the SEC, in a ruling on BlockFi, said it “believes interest-bearing crypto lending products are securities.”

Co-founder and managing partner Antoni Trenchev used the occasion of Nexo’s registration December 8 as a virtual asset service provider (VASP) in Poland to state, “We’re relentless in our pursuit of full compliance with both global and local jurisdictions.”

Across the Divide

The legal divide between banking and nonbank businesses has been tested before, along with the delineation of activities deemed closely related to banking.

Banking’s separation from other lines of commerce long prohibited institutions from engaging in both commercial and investment banking in the way that European “universal banks” did. The Gramm-Leach-Bliley Act of 1999 relaxed those restrictions, in part by giving bank holding companies more latitude. (The late E. Gerald Corrigan reviewed the “separation doctrine” and the GLB law in a March 2000 article, revisiting an essay, Are Banks Special?, he published in 1983 while president of the Federal Reserve Bank of Minneapolis.)

During the 1980s economic expansion, the liberalization of savings institution charters gave industrial companies a route to diversify, as Ford Motor Co. did with First Nationwide Bank.

Digital assets are clearly closer to financial services than auto manufacturing, and the boom in cryptocurrencies spurred not only traditional firms’ toe-dipping into that space, but also crypto ventures’ interest in conventional banking.

Last January, looking ahead at market structure trends for 2022, Coalition Greenwich predicted that “in addition to traditional financial (TradFi) firms buying into the digital asset ecosystem, we will see crypto-focused firms using their sky-high valuations to buy TradFi firms – the proverbial tail wagging the dog.”

Those valuations fell to earth, and acquisitions didn’t pan out as anticipated.

Siam Commercial Bank in Thailand agreed in November 2021 to pay more than the equivalent of $500 million for 51% of the Bitkub exchange. The deal was abandoned in August when regulatory issues raised by the Thai Securities and Exchange Commission were said to have remained unresolved.

BitMEX Group, pursuing what it termed “the ambitious goal of establishing a one-stop shop for regulated crypto products in Germany, Austria and Switzerland,” announced plans in January 2022 to acquire a private bank in Munich, Bankhaus von der Heydt. The acquisition vehicle, BXM Operations, was formed by BitMEX CEO Alexander Höptner and CFO Stephan Lutz. (Former BitMEX CEO Arthur Hayes and co-founders pleaded guilty after being criminally indicted for U.S. anti-money laundering violations. AML charges are among those that have been leveled against ex-FTX chief Bankman-Fried.)

Höptner, who previously headed Börse Stuttgart, had taken BitMEX’s reins early in 2021. But his bank deal was called off last March by mutual agreement, and Höptner stepped down in October, The Block reported. (Bankhaus von der Heydt agreed this month to sell to an investment company, Bitcoin Group SE, for €14 million.)

Binance CEO Changpeng Zhao

 

Changpeng Zhao, CEO of Binance, is open to either minority or full ownership of banks to bridge the gap between traditional finance and crypto, according to a Bloomberg interview reported by CoinDesk. Zhao, who is known as CZ, is personally and professionally antagonistic toward Bankman-Fried, and Binance, by far the world’s biggest crypto exchange, is reportedly facing a U.S. Department of Justice money-laundering investigation.

Trust and Other Charters

The Bank Policy Institute, which represents the biggest banks, opposes incursions by entities that are not equivalently regulated. In a section of its website, under the heading Fintech and Big Tech Want Access to the Banking System, BPI warns, “Unfortunately, the safety and stability of our system is at risk as technology companies seek to act more and more like banks, but without adhering to a prudential framework. They seek all the benefits of being a bank without taking on the duties and responsibilities that come along with it.”

The institute has critiqued special payments and fintech charters, which were proposed in the past by the OCC; Wyoming-chartered special purpose depository institutions (SPDIs) that do not have FDIC insurance or meet federal capital requirements; and state industrial loan company charters, which have evoked unified industry support of the Close the Shadow Banking Loophole Act.

Senator Bob Casey

“Any company that accepts deposits and makes loans like a bank does should follow the same rules as a bank. That’s common sense,” said Senator Bob Casey, Democrat of Pennsylvania, who introduced that legislation along with Banking Committee Chair Sherrod Brown and Maryland Democrat Chris Van Hollen. “Our bill will make sure loan companies are treated the same way as traditional banks and prevent them from evading the rules that protect consumers and low-income communities.”

With its BitLicense program, since 2015, the New York State Department of Financial Services set a standard for regulating digital-asset ventures. BitGo, Fidelity Digital Assets, Paxos and others are operating as custodians with limited purpose New York trust charters. (Neither Binance nor FTX obtained a New York charter or virtual currency license.) The OCC in 2021 approved national trust charters for Anchorage Digital Bank and Protego Trust Co., and leading incumbent asset servicers like Bank of New York Mellon Corp. and State Street Corp. are staking out positions in digital-asset custody.

Custodia Bank, a Wyoming SPDI that is not yet FDIC-insured and vows to operate under “the very same regulatory capital, compliance and supervisory examination standards that apply to traditional banks,” sued the Federal Reserve after a long delay on its application to gain payment-system access via a Fed master account.

At a November 30 Senate Banking Committee hearing on FDIC board nominations, vice chair-designate Travis Hill put digital-asset servicing in perspective: “There’s a big difference between a bank providing custody services for crypto-related activity versus a bank using its balance sheet to engage in speculative investments.”