Regulatory deterrence, policy debate and litigation: crypto's future

Bloomberg News

WASHINGTON — Before the March bank failures brought core banking issues like capital and liquidity back to the fore, regulators repeatedly warned banks against exposure to digital assets. 

Though banks were largely unscathed by the collapse of giant crypto exchange FTX late in 2022, the event reinforced regulators' skeptical posture, culminating in a January joint guidance in which the Fed, Office of the Comptroller of the Currency and the Federal Deposit Insurance Corp. together advised the banks they oversee to be wary of crypto.

"The agencies have significant safety and soundness concerns with business models that are concentrated in crypto-asset-related activities or have concentrated exposures to the crypto-asset sector," the regulators wrote in the joint guidance.

In addition to discouraging banks from working with crypto, they have penalized crypto firms that engage in behavior that too closely resembles banking, including marketing materials that claim crypto customers' accounts are covered by FDIC insurance. The FDIC issued cease and desist orders to crypto firms for misrepresentations of deposit insurance in February, after making similar requests to firms Voyager and FTX.

Regulators like Acting Comptroller of the Currency Michael J. Hsu have since doubled down on the tone in the joint guidance. Hsu indicated at a June press conference that the agencies are continuing to recommend banks use caution toward digital assets. He also noted that recent volatility may have made banks less interested in crypto.

"The crypto winter was pretty tough for the crypto industry," he said. "Those who I put into the bucket of crypto curious — on the banking side — lost some of that curiosity, given some of those events. The issue of scams, fraud, hacks; those continue, those haven't gotten better over time. So that issue has kind of receded in terms of materiality, it's something we care about, it's something that we still expect banks to approach prudently, but I'm just not hearing as much noise or demand for banks to get in on crypto."

A few days later, in remarks delivered to the American Bankers Association in June, Hsu reiterated that the crypto industry — particularly anonymous, decentralized platforms — is immature and rife with risks. He added, however, that policymakers are increasingly interested in exploring how crypto's underlying "tokenization" technology could be applied to make payments in traditional finance more efficient.

Biden administration bank regulators have made clear that they will continue to try to retain separation between crypto and traditional banking, and some experts argue that they have good reason to do so. 

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Art Wilmarth, a law professor at George Washington University, said this spring's bank failures provided regulators with concrete evidence that banks that did business with crypto companies faced unique risks. The turmoil in the crypto market, triggered by the collapse of major crypto industry partner banks like Silvergate, Signature and Silicon Valley Bank, was, according to Wilmarth, evidence of the growing risks of interconnection between the crypto industry and traditional finance.

"[Circle had] $3.3 billion of reserves for their USD stablecoin [at SVB. When it failed,] there was a panic in the crypto markets, and the USD coin fell to 90 cents in the dollar," Wilmarth said. "Doesn't this just show us the dangers, once we start linking our banking system with this unregulated crypto industry? The problems in the crypto industry are going to spill over into the regulated industry and vice versa."

Will Congress weigh in?

 
Regulators can only do so much without congressional action. Despite this, bipartisan talks about advancing a comprehensive regulatory framework have been stalled in Congress after discussions between House Financial Services Committee Chairman Patrick McHenry, R-N.C., and ranking member Rep. Maxine Waters, D-Calif., fell apart in dramatic fashion in July during a markup of a bipartisan stablecoin bill. Any legislation facing opposition from House Democrats is unlikely to get very far in the Democratic-majority Senate.

At the same time, multiple bipartisan coalitions in the Senate have made progress on crypto-anti-money-laundering provisions. Senators Kirsten Gillibrand, D-N.Y., Cynthia Lummis, R-Wyo., Elizabeth Warren, D-Mass., and Roger Marshall, R-Kan., successfully included a crypto anti-money-laundering provision in a Senate-passed version of the annual National Defense Authorization Act in July. 

A bipartisan group of senators, led by Jack Reed, D-R.I., has also introduced legislation that would toughen AML regulation of the crypto space: the Crypto-Asset National Security Enhancement and Enforcement or "CANSEE" Act.

Both bills respond to a concern regulators have long expressed: that public blockchains are incompatible with BSA and AML compliance. January's guidance memo explained the agencies' concerns in more detail.

"The agencies believe that issuing or holding as principal crypto-assets that are issued, stored, or transferred on an open, public, and/or decentralized network, or similar system is highly likely to be inconsistent with safe and sound banking practices," the guidance noted.

Hsu also echoed this skepticism toward permissionless blockchains in June.

"The non-permissioned nature of public blockchains makes them attractive to criminals and others engaged in illicit finance and full compliance with anti-money-laundering rules is extremely difficult for crypto intermediaries to achieve," he said.

Are crypto tokens securities?

With few clear paths to a comprehensive framework, banks are taking a wait-and-see approach. Meanwhile, the Securities and Exchange Commission, the head of which, Gary Gensler, has said that he believes cryptocurrencies are largely securities, has taken an aggressive approach in enforcing securities laws against the crypto industry.

According to Cornerstone Research, as of June 6, the SEC brought two dozen cryptocurrency-related enforcement actions, including litigation and administrative proceedings. 

The SEC took legal action against two major cryptocurrency exchanges — Binance and Coinbase — early in June, alleging both exchanges offered cryptocurrencies that were actually unregistered securities. The SEC further accused Binance of more serious infractions like operating illegally in the U.S., deceiving its customers, providing false information to regulators and misappropriating customer funds for its CEO's trading firm.

These lawsuits could matter greatly for the future of the crypto industry, investors and crypto partner banks. Court rulings may better define which cryptocurrencies are securities and outline legal precedents like crypto firm consumer protection obligations and AML requirements.

While the SEC has had some success in reigning in crypto, the agency's authority faced a minor setback after a recent court ruling that deemed XRP, the token issued by Ripple, not to be a security when sold to the general public, but only when sold to institutional investors. The ruling complicates the SEC's strategy of claiming jurisdiction and enforcing regulations against crypto platforms by deeming tokens to be securities.

Members of the crypto community expressed enthusiasm over the ruling, describing it as a potential game-changer for other crypto-related cases. Gensler, however, did not appear deterred, reiterating his agency's commitment to bringing noncompliant firms into alignment with SEC rules in remarks to the National Press Club in July. 

"We're still looking at it and assessing that opinion," he said.