Crypto's terrible, horrible, no good, very bad year

January 1, 2023 9:00 PM

At the beginning of 2022, the Biden administration didn't know what tack it was going to take in regards to regulating cryptocurrency.

Is crypto providing a boon to minority communities by expanding financial access? Is it a dangerous new technology that needs to be curtailed? Probably somewhere in between?

By the end of the year, the administration had its answer. The Biden administration's tone sharpened significantly, and banks looking to dip their toes in the water have largely been warned off pursuing crypto-related business lines.

That shift sets up a volatile situation for 2023. Some banks, like Bank of New York Mellon, are moving ahead with their efforts to custody crypto without regulators' enthusiastic support. Other banks that have made crypto partnerships a cornerstone of their business models are facing harsher market conditions.

Meanwhile, regulators and lawmakers are looking for their pound of flesh after the spectacular collapse of crypto exchange FTX and its founder Sam Bankman-Fried.

What follows is a look back at crypto policymaking in 2022.

The Biden administration starts to show its cards

Andrew Harrer/Bloomberg

In March, the White House made its first significant move into cryptocurrency policy: An executive order.

The order mostly asked various regulators to assess the pitfalls and opportunities posed by cryptocurrency, and attempted to tie together what had been disparate strategies by different agencies on digital assets.

Crypto advocates were largely happy with the executive order. Instead of solely focusing on risks, the order also acknowledged what it described as cryptocurrency's potential, quelling some fears.

And by and large, the executive order elicited a positive reaction from banking groups in Washington. The Bank Policy Institute lauded the "clarity" that more federal action on crypto would bring, as well as the idea of bringing crypto and fintech startups into a regulatory scheme, noting that regulated financial institutions had been waiting for "further regulatory action before expanding their digital offerings."

By September, when the various regulators' reports came out, the administration's tone had shifted. The Treasury Department, for example, urged regulators to continue acting vigilantly with respect to cryptocurrency transactions.

"We've seen in recent months substantial turmoil in cryptocurrency markets, and these events really highlight how without proper oversight cryptocurrencies risk harming everyday Americans, financial stability and our national security," Brian Deese, director of the National Economic Council, said at the time.

Bank regulators take a tougher stance

Bloomberg News

Throughout the year, bank regulators considered how much involvement banks should have in the crypto world.

The Federal Deposit Insurance Corp. and the Office of the Comptroller of the Currency announced in April that banks need to check in with their regulators before pursuing any crypto projects.

Both agencies took stronger stances on the topic later in the year. The FDIC issued an advisory in July saying that it's "concerned about the risks of consumer confusion or harm" arising from digital assets that are offered in connection with an insured depository institution.

In October, acting Comptroller of the Currency Michael Hsu warned against crypto firms integrating with the traditional financial system, saying that crypto companies often "disguise" their products as being similar to banking ones.

Hsu also expressed caution about regulating digital assets, suggesting that bringing crypto into the regulatory perimeter might or might not help tame the risks, depending "on whose terms it is brought in."

"Using the familiar to introduce something novel can downplay or mask the risks involved and establish false expectations," Hsu said. "In time, people get hurt."

The SEC complicates banks’ plans

Joshua Roberts/Bloomberg News

One of the most aggressive regulators when it comes to policing digital assets has been the Securities and Exchange Commission.

While the SEC doesn't typically influence bank policy beyond what it does for other publicly traded companies, crypto was a big exception in 2022.

For months, banks awaited their regulators' promised guidance on how to hold virtual assets on behalf of clients — but that conversation was turned on its head by the SEC. An accounting bulletin issued in March requires most SEC registrants that hold crypto assets for their clients to record that risk on their balance sheets as a liability.

That accounting treatment makes it uneconomical for many banks to hold crypto on their balance sheets.

While the SEC's de facto capital requirements hurt banks' ability to generate revenue from custodying crypto, some institutions may forgo a return on investment in the short term in favor of a longer-term plan to meet growing investor interest.

After the SEC released its guidance, BNY Mellon announced that it has gone live with its crypto custody service for investors.

Deposit-insurance claims face scrutiny

Voyager Seeks Bankruptcy As Crypto Mogul's Lifeline Fails

Gabby Jones/Bloomberg

Cryptocurrency challenged the very fundamentals at one of the major U.S. bank regulators: The FDIC.

The FDIC's primary job is to make sure that customers get back money, up to a certain point, that they have deposited at a failed bank. So they take the legalities of FDIC deposit insurance very, very seriously.

When the crypto firm Voyager went bankrupt, some customers were unable to get their USD deposits back from the company. They were confused, regulators said, about the claims Voyager made about deposit insurance.

While the funds were technically FDIC insured, they were insured in the case of the partner bank's failure, not Voyager's. The FDIC and the Federal Reserve issued a cease-and-desist order to Voyager, and the bankruptcy case continues to play out.

But that was far from the end of the story.

The FDIC later issued five cease-and-desist letters, including one to a now-familiar name — FTX — telling them to stop making false and misleading statements about the availability of deposit insurance for their customers.

In December, the agency proposed a rule to further crack down on misrepresentations of FDIC-insured accounts by crypto companies.

Under the proposal, depository institutions would be required to display a new digital FDIC sign to customers across all online channels, just as they have long been required to display at a physical branch.

The proposed rules also state that depository institutions must provide signs that distinguish insured deposits from nondeposit products and inform consumers that "certain financial products are not insured by the FDIC, are not deposits, and may lose value" where applicable.

FTX comes crashing down

Bankman-Fried Released on $250 Million Bond in FTX Fraud Case

Stephanie Keith/Bloomberg

The dramatic downfall of crypto exchange FTX was a told-you-so moment for bank regulators — and the impetus for a number of rewritten pieces of legislation on digital asset regulation.

While crypto legislation was already in the works, FTX's collapse reshuffled the deck to a certain extent, and made it more likely that meaningful reform will emerge from Congress on digital assets.

Only hours after former FTX Chief Executive Sam Bankman-Fried's arrest for money laundering and fraud, the company's new CEO told the House Financial Services Committee that the actions around the crypto company's collapse amounted to "plain old embezzlement."

Bankman-Fried planned to testify at the hearing, and would have appeared virtually, but was arrested the evening before in the Bahamas. Instead, new CEO John J. Ray — a lawyer specializing in bankruptcies who most famously managed Enron through its accounting scandal — appeared alone, telling the panel that FTX's shoddy accounting practices have made the bankruptcy proceedings uniquely difficult.

Bank regulators are also considering the fallout. The FDIC and the Fed are "looking closely" at Farmington State Bank, a small bank connected to FTX, according to FDIC Chairman Martin Gruenberg.

FTX's bankruptcy documents have revealed that Alameda Research, a hedge fund affiliated with the failed crypto exchange, invested $11.5 million in the tiny Farmington State, which does business as Moonstone Bank in Washington State.

That's a significant sum for the bank, which had about $21.7 million of assets as of the second quarter, and has only had about $10 million of deposits for most of the past decade.