US Federal Reserve, FDIC warn banks against crypto risks

The US Federal Reserve, Federal Deposit Insurance Corporation (FDIC), and the Office of the Comptroller of the Currency (OCC) warned banks about the risks involved with crypto in a joint statement on Jan. 3.

The statement noted that the past year saw high volatility in crypto prices and exposed vulnerabilities in the sector. Therefore, the regulatory authorities highlighted some key risks banks should be wary of while dealing with crypto.

The authorities noted that the risk of fraud and scams among crypto firms could potentially affect banks dealing with such companies. In addition, the latest bankruptcy of FTX and fraud allegations against its founder Sam Bankman-Fried (SBF), could have potentially motivated the regulators to warn banks against such risks.

The statement said that banks should also beware of risks arising from legal uncertainty around crypto custody services, redemptions, and ownership rights.

The regulators warned that crypto firms might provide fraudulent disclosures and representations to banks. This could include misrepresentations about federal deposit insurance and other “unfair, deceptive, or abusive” practices that can harm consumers.

The regulators were referring to defunct crypto exchange Voyager Digital’s misleading statements about FDIC coverage. As a result, on July 28, 2022, FDIC warned Voyager Digital to cease misrepresenting facts about FDIC insurance coverage of user funds.

At the time of bankruptcy filing, Voyager had assured users would get back the USD that Voyager deposited with the FDIC-insured Metropolitan Commercial Bank. However, the bank later clarified that the user deposits are FDIC-insured, but the insurance does not protect customers in the case of Voyager’s bankruptcy.

In the joint statement, regulators cited the significant volatility of crypto markets, which can impact the deposit flows of crypto firms, as a risk for banks. Additionally, the statement warned that banks holding stablecoin reserves might face significant deposit outflows in case of bank runs on the stablecoin.

Furthermore, the federal regulators warned against contagion risk in the crypto sector. The contagion risk arises from the interconnectedness of crypto firms “through opaque lending, investing, funding, service, and operational arrangements,” the regulators said.

The domino effect observed after the Terra-LUNA fiasco, which caused a series of bankruptcies starting with hedge fund Three Arrows Capital, proved that crypto firms are intricately connected. This was again highlighted after FTX and Alameda Research’s collapse, after which Genesis and its parent company Digital Currency Group landed in hot water.

According to the regulatory bodies, this interconnectedness presents “concentration risks” for banks exposed to cryptocurrencies.

Furthermore, the statement noted that the crypto sector’s risk management and governance practices are in their infancy and lack “maturity and robustness.” Besides, decentralized networks lack governance mechanisms, an oversight system, and contracts and standards that establish roles, responsibilities, and liabilities.

Moreover, decentralized systems are vulnerable to hacks and cyber-attacks, outages, and present risk of illicit finance, the authorities warned, adding:

“It is important that risks related to the crypto-asset sector that cannot be mitigated or controlled do not migrate to the banking system.”

The federal agencies further stated that they are evaluating any proposals from banks to engage in crypto-related activities. They are also closely supervising banks with crypto exposure. The agencies added:

“Given the significant risks highlighted by recent failures of several large crypto-asset companies, the agencies continue to take a careful and cautious approach related to current or proposed crypto-asset-related activities and exposures at each banking organization.”

However, the statement clarified that banks are neither “prohibited nor discouraged” to provide services to any specific type of companies, including crypto-related businesses.

Federal agencies continue to evaluate whether or how banks can conduct crypto-related activities. According to the statement, their main concern is that such activities should adequately address “safety and soundness, consumer protection, legal permissibility, and compliance with applicable laws and regulations.” This would include banks adhering to money laundering, illicit finance, and consumer protection laws while engaging in crypto-related activities.

The agencies further noted:

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