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Navigating the Risks of Crypto-Assets in the Banking Sector

Derek Wolfe

Updated: January 9, 2023

Crypto-assets
Editor’s Note:

EDITOR'S NOTE: The crypto space was bound for a “winter” as any bubbling asset market is destined for some kind of a correction or crash. It just so happens that SBF’s (and FTX’s) reckoning brought the winter chill to a negative freeze, transforming what would have been a seasonal drop in temperature into a systemic ice age. Regulators are now warning that the crypto debacle may contaminate the banking system, as all crypto assets, no matter how legitimate or fake, are linked to monetary assets. So what’s the likelihood of contagion, and how bad might it affect the financial system? Which banks are likely to fail due to the crypto collapse? Here’s what some analysts are thinking. Needless to say, “real assets” like physical gold and silver are immune to this contagion; fiat-based assets, unfortunately, are not. 

Only a couple of smaller banks have significant exposure to cryptos, and their shares have collapsed.

Following a series of bankruptcies of crypto companies, and following the total collapse of some stablecoins, and following the general collapse of crypto prices, and following revelations of all kinds of imaginable and previously unimaginable shenanigans, scams, and frauds in the entire crypto and DeFi space, the US banking regulators today issued a warning to banks about the crypto and DeFi space, amid fears of contagion to the banking sector.

So far, crypto has been like a giant videogame where nothing is really illegal because it’s just a videogame, and where players are having lots of fun clicking on buttons and watching flashing screens while scamming and defrauding each other, a videogame where people in the end lose all their money if they don’t get out in time. And no big deal because it’s just a videogame, with no real consequences on the economy, other than a profuse waste of energy, because there is nothing crypto is actually needed for outside of the videogame.

But contagion spreading from the beloved and fun crypto videogame to the despicable fractional-reserve fiat banking system could be a real mess.

So the Federal Reserve, the FDIC, and the Office of the Comptroller of the Currency (OCC) – the three banking regulators in the US – issued a joint-warning today to banks, with a laundry list of “key risks” associated with cryptos – in effect, enumerating sordid stuff that is standard practice in the crypto videogame, and why banks need to protect themselves.

This is their laundry list of stuff that’s going on in the crypto videogame that banks “should be aware of,” quoted verbatim from their joint statement:

  • Risk of fraud and scams among crypto-asset sector participants.
  • Legal uncertainties related to custody practices, redemptions, and ownership rights, some of which are currently the subject of legal processes and proceedings.
  • Inaccurate or misleading representations and disclosures by crypto-asset companies, including misrepresentations regarding federal deposit insurance, and other practices that may be unfair, deceptive, or abusive, contributing to significant harm to retail and institutional investors, customers, and counterparties [for example, now-bankrupt Voyager was advertising that customer deposits were covered by the FDIC!]
  • Significant volatility in crypto-asset markets, the effects of which include potential impacts on deposit flows associated with crypto-asset companies.
  • Susceptibility of stablecoins to run risk, creating potential deposit outflows for banking organizations that hold stablecoin reserves [remember stablecoin Terra Luna, which collapsed to nothing in no time when there was a run on the stablecoin].
  • Contagion risk within the crypto-asset sector resulting from interconnections among certain crypto-asset participants, including through opaque lending, investing, funding, service, and operational arrangements. These interconnections may also present concentration risks for banking organizations with exposures to the crypto-asset sector.
  • Risk management and governance practices in the crypto-asset sector exhibiting a lack of maturity and robustness.
  • Heightened risks associated with open, public, and/or decentralized networks, or similar systems, including, but not limited to, the lack of governance mechanisms establishing oversight of the system; the absence of contracts or standards to clearly establish roles, responsibilities, and liabilities; and vulnerabilities related to cyber-attacks, outages, lost or trapped assets, and illicit finance.

And the joint statement added 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.”

And the statement said that the bank regulators “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.”

I get the message that it’s OK for the videogame players to lose all their money on this stuff; but that it’s not OK for banks to lose all their money on this stuff.

No major US bank has picked up life-threating exposure to crypto, but some small banks have in a videogame-like effort to become a big bank in no time, and their stocks soared while what I call consensual hallucination still reigned as the Fed’s money printing was turning investors’ brains to mush.

But since November 2021, the Fed has been talking about, and then started doing, some real tightening, and the party was over, and cryptos crashed, and everything around them crashed, and the banks that dealt with cryptos, their stocks crashed too. Here are the two main ones:

Silvergate Capital [SI], which had gone public via a classic IPO in November 2019, became a poster girl of the principle of consensual hallucination. It owns Silvergate Bank, “the leading provider of innovative financial infrastructure solutions and services to participants in the nascent and expanding digital currency industry,” it said at the time.

Its shares started spiking in October 2020, from around $15, and a year later, by November 2021, had multiplied by a factor of 15, to $220. Then they kathoomphed, became a hero in my pantheon of Imploded Stocks, and today closed at $17.27, down by 92.8% from their November 2021 high:

Source: Wolf Street

Signature Bank [SBNY] made a genius Wall Street move. It was just a small bank until it tied its fortunes to cryptos, and its shares spiked from around $120 a share at the end of 2019 to $374 on January 18, 2022. On the very day that its shares peaked, it sold an additional 2.1 million shares at $352 a share, extracting $739 million from folks that bought those shares in a final paroxysm of consensual hallucination. Those folks got instantly crushed, and at today’s closing price of $113.17 are down 68.9% in ten months. Crypto hype-and-hoopla just keeps on giving.

Since the intraday peak of January 18, shares are down 69.8%, and there’s a spot for them in my pantheon of Imploded Stocks (minimum requirement: -70% from peak):

Source: Wolf Street

 

Originally published by Wolf Richter at Wolf Street

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