WASHINGTON — A trio of regulators, including the Federal Reserve, warned banks to be aware of liquidity risks associated with cryptocurrencies, the latest move by US officials to limit the economy’s vulnerability to the tumultuous market.
The Fed, Office of the Comptroller of the Currency and Federal Deposit Insurance Corp. said in a joint statement Thursday that banks should practice effective risk management when handling deposits linked to crypto entities. These include robust due diligence and monitoring of crypto entities opening deposit accounts, as well as incorporating the potential volatility of those deposits into routine stress testing.
A regulatory crackdown on crypto — fueled in part by the collapse of trading firm FTX in November — has scared some banks away from doing business with the sector. The latest statement comes after a warning in January in which the three regulators said certain types of crypto-related activities are “highly likely to violate safe and sound banking practices.”
That has led to fears in the crypto industry that US regulators could cut off crypto companies’ access to the banking system – a potential death knell that would limit investors’ ability to exchange assets like bitcoin for dollars.
“I think the effect of all the recent guidance will be that some banks will be more cautious about entering this space,” said Alison Hashmall, an attorney in the financial institutions and banking practice of Debevoise & Plimpton LLP. However, she noted that regulators have not explicitly banned or discouraged banks from serving customers in crypto.
Crypto imploded in 2022, as investors lost confidence in digital assets and the industry was plagued by crisis. But unlike other collapses, it has largely avoided rippling into other markets. WSJ explains how crypto became so interconnected. Illustration: Mallory Brangan
Regulators on Thursday flagged two types of bank deposits that they said could be susceptible to unpredictable “large and rapid inflows and outflows.”
The former are deposits placed by crypto companies for the benefit of their clients, who may react quickly to market events, media reports and uncertainty. As a result, the stability of these deposits may not be dictated by the company alone, especially during times of stress or market volatility, regulators said.
The second type of deposits flagged by regulators is related to stablecoins, a class of cryptocurrencies that seek to maintain a 1:1 parity with the dollar or other official currencies. Stablecoin issuers typically ensure this parity by holding reserves in the form of bank deposits and highly liquid treasury bills.
However, the stability of these deposits cannot be taken for granted for banks, the regulators warned. They said stablecoin reserves “could be susceptible to large and rapid outflows” if stablecoin holders decide to exchange the assets for cash, if broader crypto markets are in turmoil, or if confidence in the stablecoin issuer declines.
Because stablecoin issuers often maintain wafer-thin buffers against potential losses, regulators have long warned of stability risks. Large-scale redemptions could force issuers to unload reserves in a fire sale, potentially resulting not only in losses for stablecoin investors, but also a fall in Treasury bill prices.
Also on Thursday, the Fed rejected a request from Custodia Bank Inc. to reconsider its rejection last month of Custodia’s application to be under central bank supervision. Custodia, chartered in Wyoming, had proposed centering its business model around crypto. That created “significant safety and soundness risks,” the Fed said.
Write to Paul Kiernan at paul.kiernan@wsj.com
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Appeared in the February 24, 2023 print edition as “Banks Warned of Risk in Digital Currency Deposits.”
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