Crypto Policy Questions Linger Weeks After Historic Banking Crisis
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Crypto Policy Questions Linger Weeks After Historic Banking Crisis

Brownstein Client Alert, March 31, 2023

The crypto industry is at a critical juncture: As it continues to operate absent clear regulatory guidance (other than by enforcement) and prospects dim for legislation that would create a roadmap for regulation—the challenges continue to mount.

The historic collapse of Silicon Valley Bank and Signature Bank, on the heels of the liquidation of Silvergate Capital, rattled an already unsteady economy and left gaping holes in the outlook and the banking prospects for cryptocurrency. Weeks and two congressional hearings later, distrust of traditional finance is fueling conspiratorial whispers and a truckload of unanswered questions about the future of crypto.

These collapses are the latest storm clouds for the industry. Earlier this month, the SEC issued an investor alert urging extreme caution when investing in crypto asset securities, calling them “exceptionally volatile and speculative” and citing a possible lack of compliance with laws like FINRA. The agency followed up with a warning to major crypto exchange Coinbase last week about potential enforcement actions.

During a Senate Banking Committee hearing Tuesday, FDIC chair Martin Gruenberg cited mismanagement of traditional banking risks like lack of diversification and aggressive growth and detailed the role of digital assets in each bank’s decision-making and subsequent downfall. In a recent House Financial Services Committee (HFSC) hearing, Republican lawmakers seemed to question and potentially blame regulators’ response to troubling signs at the bank while acknowledging that risk mismanagement at the banks was clear. Rep. Patrick McHenry (R-NC), who chairs the committee, said any solution requires “competent financial supervisors” while vice chair Rep. French Hill (R-AR) said the response looked like “a lack of supervisory urgency.”

The bank failures followed an announcement the week prior from Silvergate Capital, a major crypto-friendly lender, that it would liquidate its assets and wind down operations. Silvergate and Signature were considered the main banking options for the crypto industry, while SVB held deposits from nearly half of all U.S. startups backed by venture capital funds, many with strong ties to cryptocurrency startups. In an industry with greater need for liquidity and regulatory uncertainty, this trifecta of closures severely reduces banking options for cryptocurrency and adjacent companies. The optics alone also leave questions about how regulators will respond to an already-disruptive industry and how consumers will respond to the perception of risk as it stands now—especially in light of the explosive downfall of major crypto exchange FTX in November and the ongoing criminal trial of its founder and CEO, Sam Bankman-Fried.

The FDIC’s Gruenberg cited Silvergate’s closing, largely sparked by FTX’s bankruptcy, as the start of the banking troubles that culminated in mid-March. Even though FTX only represented 10% of Silvergate’s deposits, it lost a total of 68% of its deposits in the FTX aftermath and set off a series of panicked domino effects impacting the crypto-friendly SVB and Signature Bank. Gruenberg also mentioned Silvergate and Signature’s use of digital platforms for round-the-clock dealing and trading, “the only two known platforms of this type within U.S. insured institutions,” he said. This meant that as panic started to spread through Twitter and other direct messaging apps, it created a rush to pull deposits in an urgency and convenience that is different from the proverbial stand-at-a-teller-window bank liquidations of the past.

The short-term impacts are already coalescing. The federal government stepped in to make SVB and Signature depositors whole, even though most accounts exceeded the $250,000 FDIC insurance threshold. Crypto values also rallied while stablecoins were able to regain their pegs after some ripples in the market. Evidence of risk aversion may have surfaced in an industry-specific trend even if dedication to cryptocurrency generally remains high: Self-custody of Bitcoin surged to a six-month high point after the collapse. Self-custody is when a user takes full control of their crypto wallet instead of entrusting an exchange, removing third-party involvement.

Although the backstop will inoculate the financial system from further hits generally, the bank failures have already created more challenges for the crypto industry’s critical infrastructure. Signature Bank’s collapse took down its Signet interbank transfer system with it, one of a few options left after Silvergate discontinued its SEN service as part of its wind-down. Fewer options for crypto holders to send funds for trading have already impacted liquidity and may make digital assets more volatile. Coinbase was also reportedly reaching out to institutional clients and causing whispers about a potential trading platform overseas as the U.S. market and regulatory environment continue to turn on crypto. With the SEC’s most recent action against another crypto exchange Beaxy, other platforms are considering moves abroad.

Going forward, it may be significantly more difficult for smaller crypto startups to find banking relationships, possibly resulting in more consolidation when only the largest and most successful crypto players can remain banked. Initial reports indicated that the agreement to sell Signature Bank’s assets specifically excluded its crypto-related assets, meaning the FDIC may have conditioned approval of the sale on leaving the crypto industry in the dark.

The teetering divide between cryptocurrency and traditional finance may be wider than ever, but partisan splits and tensions among policymakers and legislators make the regulatory landscape even less clear. Even after the collapse of FTX, Republicans have been critical of SEC Chairman Gary Gensler and his agency’s attempts to crack down on crypto but have also agreed that some form of regulation of the industry is necessary. Even among reform-minded Democrats, there may not be consensus. Former Rep. Barney Frank, from his unique perch as a primary architect of the post-2008 Dodd-Frank Act banking reforms and a board member for the recently seized Signature Bank, has largely blamed crypto’s volatility for the most recent banking failures. In stark contrast, Sen. Elizabeth Warren (D-MA)—a Frank ally who crafted the watershed consumer protection reforms included in the 2010 law—blamed a Trump-era rollback of certain regulations.

Lawmakers have been grappling with which federal agencies are best suited to regulate blockchain and digital assets, including enforcement measures over how crypto companies calculate risks. At the outset of this Congress after taking the gavel, HFSC Chairman McHenry identified creating digital assets legislation as a top priority, even creating a new subcommittee focused on the topic. After the events in California, the HFSC has now pivoted its focus for the next several weeks to determine what went wrong and what must be done to prevent any further damage. It is not yet completely clear how this impacts the HFSC digital assets agenda, but it is very likely changes the scope and focus of some of that work for the remainder of the year.

In February, the SEC also recently proposed a change to its custody rule requiring investment advisers to custody digital assets with qualified custodians. A qualified custodian is generally a bank or broker-dealer and they are required to keep separate accounts and not commingle client assets. The custody rule proposal will bring needed oversight and structure for custodians of digital assets. However, qualified custodian options are currently limited for investment advisers offering advice on digital assets.

USDC issuer Circle—which had assets at SVB and saw its valuation fall after the collapse—called on Congress to pass stablecoin legislation, although that is unlikely to happen anytime soon. The Federal Reserve has explored a Central Bank Digital Currency, virtual money endorsed and issued by a central bank, but has made no decision in lieu of congressional action. A CBDC is similar to cryptocurrencies except its value is fixed by a central bank and is essentially a digital equivalent to the country’s flat currency, although anonymized transactions may not be possible—a central feature of cryptocurrencies.

As far as the prospects for such a bill, HFSC chair McHenry is committed to moving stablecoin legislation through the House, which will likely include a federal oversight component given the criticism of state regulatory failures in the wake of SVB. This has not been a top priority for Senate Banking Committee chair Sen. Sherrod Brown. So to have a chance in the Senate, McHenry would need to keep working on a bipartisan basis with Rep. Maxine Waters, the HSFC ranking member. A bipartisan House bill was held up in the last Congress over some policy disagreements and the impending election, but Waters said most of those tensions had been resolved and a bill could come out of the HSFC sooner rather than later.

The next few months will be critical for the industry. More high-profile collapses and closures may lead to increased scrutiny. Likewise, the SEC is seeking a $200 million budgetary increase to bolster its enforcement ranks to aid what Chair Gensler described as a team that is spread too thin with its crypto enforcement actions. Whether Congress provides the SEC these requested resources remains to be seen and will have a significant impact on the agency’s aggressiveness going forward.

This document is intended to provide you with general information regarding cryptocurrency policy. The contents of this document are not intended to provide specific legal advice. If you have any questions about the contents of this document or if you need legal advice as to an issue, please contact the attorneys listed or your regular Brownstein Hyatt Farber Schreck, LLP attorney. This communication may be considered advertising in some jurisdictions. The information in this article is accurate as of the publication date. Because the law in this area is changing rapidly, and insights are not automatically updated, continued accuracy cannot be guaranteed.

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