Should Crypto Investors Get Ready To Celebrate Regulatory Involvement?

The primary banking regulators of the United States waited three days after New Year’s Eve to send up a firework, and their news release could mark the start of an exciting new phase in the evolution of the digital asset market.

The big three banking regulators are Board of Governors of the Federal Reserve System (Federal Reserve), the Federal Deposit Insurance Corporation (FDIC), and the Office of the Comptroller of the Currency (OCC). According to their statement, “It is important that risks related to the crypto-asset sector that cannot be mitigated or controlled do not migrate to the banking system.”

This release is an important milestone in that the banking regulators have accepted digital assets as worthy of recognition and that the industry is still immature. Recognizing and enumerating the risks from digital assets is the important first step in preparing for an effective regulatory environment.

The key risks highlighted in the report could have been pulled from the headlines of any major publication any time in the past several months and represent a good summary of the current deficiencies within the industry. From another perspective, the list also provides a roadmap for how to overcome current problems to realize the benefits and promise of digital assets.

Roughly half of the risks are related to the conduct of the current industry participants. Concern about shady and non-standard practices is certainly warranted, and if judging solely by the bad actors in the space, perhaps the list can be taken at face value as an indictment of the industry.

However, such a simple analysis ignores the reputable operators. Within the digital asset industry there are participants who seek to do the right thing and who wish to operate in accordance with financial industry standards. The headlines are filled with the salacious details of those who do bad things, but what about those who believe in the future and are building solid businesses?

The regulator’s statement should provide hope to fair operators and industry participants. Clearly now the authorities are aware of the problems and are working their way through analysis towards solutions.

The banking regulators cautioned that “issuing or holding as principal crypto-assets… is highly likely to be inconsistent with safe and sound banking practices.” This seemingly simple sentence carries considerable weight – far more than appears at face value.

Banks must operate in a “safe and sound” manner and, therefore, through this release, issuing or owning crypto-assets is essentially a prohibited activity. Banks should not own Bitcoin
BTC
or other forms digital assets.

Whereas this in itself is consistent with existing regulations that restrict bank ownership of volatile investments such as common equities, it does mean that not all commodities are alike. Bitcoin and the euro are both accepted as commodities, and both are the currency of sovereign nations. Banks can own euros, but banks cannot own Bitcoin, the legal tender of El Salvador. So perhaps as their analysis evolves the banking regulators will consider that ownership of designated commodities have different risk characteristics than other digital assets, and adjust the rules.

Another area for further development is stablecoins. In November 2021 the President’s Working Group on Financial Markets, the FDIC, and the OCC issued a report on stablecoins wherein they recommended that stablecoins be issued by insured depository institutions, also known as banks. What has changed such that the recommendation for issuance by banks has changed to a prohibition?

It is evident that stablecoins that are not backed 1:1 are not stable. Clearly market participants and U.S. regulators should not trust entities other than well-managed issuers with audited balance sheets, or certainly not coins issued through unregulated foreign entities. What, then, is the recommended path forward for stablecoins? Perhaps in their next release the regulatory agencies will address the issue.

If the existing digital asset industry is a mess, and the banking regulators certainly believe this to be the case, then perhaps an optimal solution is to migrate some of the activity inside the perimeter of well-regulated financial institutions. For the commodity digital assets how about adopting a similar arrangement to that seen with foreign exchange products where the banks and Commodity Futures Trading Commission (CFTC) work together?

Who better to take the lead for digital asset commodities than banks that know how to comply with financial rules and regulations? Plus, banks in the U.S. are well supervised by multiple regulatory agencies and the U.S. has a well-deserved reputation for safety. Investors and the industry participants would benefit from the banking regulators taking a strong lead in the space.

Digital assets are not going away, and the sector still has robust activity despite a full year of failures and scandals. Longer term planning is clearly appropriate. The banking regulators are looking at the industry, and participants should be grateful for their attention.

The U.S. financial system is the envy of the world because it benefits from a solid regulatory framework. Perhaps the joint statement from the banking regulators was their signal that they are preparing to bring forth a solid regulatory regime for the digital asset class. Exciting to see if the banking regulators have more fireworks in store for the digital asset community.