WE MUST PROTECT INVESTORS AND OUR BANKING SYSTEM FROM THE CRYPTO INDUSTRY.

• Author: Wilmarth, Arthur E., Jr.

ABSTRACT

The crypto boom and crash of 2020-22 demonstrated that (i) cryptocurrencies with fluctuating values are extremely risky and highly volatile assets and (ii) cryptocurrencies known as "stablecoins" are vulnerable to systemic runs whenever there are substantial doubts about the adequacy of reserves backing those stablecoins. Crypto firms amplified the crypto boom with aggressive and deceptive marketing campaigns that targeted unsophisticated retail investors. Scandalous failures ofprominent crypto firms accelerated the crypto crash by inflicting devastating losses on investors and undermining public confidence in crypto-assets.

Federal and state regulators allowed banks to become significantly involved in crypto-related activities. Several FDIC-insured banks that provided financial services to crypto firms experienced serious problems during the crypto crash. The failures of three of those banks in March 2023 threatened to unleash a systemic banking crisis. Meanwhile, stablecoins issued by nonbanks and uninsured depository institutions have become a hazardous new form of "shadow deposits," which could undermine the integrity of our banking system and require costly future bailouts.

This article presents a three-part plan for responding to the dangers posed by fluctuating-value cryptocurrencies and stablecoins. First, policymakers must protect investors by recognizing the Securities and Exchange Commission (SEC) as the primary federal regulator of most fluctuating-value cryptocurrencies. Federal securities laws provide a superior regime for regulating such cryptocurrencies. In particular, the SEC has broader powers, a more robust mandate to protect investors, and a stronger enforcement record than the Commodity Futures Trading Commission (CFTC).

Second, federal bank regulators must protect the banking system by prohibiting FDIC-insured banks and their affiliates from investing and trading in fluctuating-value cryptocurrencies, either on their own behalf or on behalf of others. In addition, federal bank regulators should bar FDIC-insured banks and their affiliates from providing financial services to crypto firms unless those firms are registered with and regulated by the SEC and/or the CFTC.

Third, Congress should mandate that all issuers and distributors of stablecoins must be FDIC-insured banks. That mandate would ensure that all providers of stablecoins must comply with the regulatory safeguards governing FDIC-insured banks and their parent companies and other affiliates. Those safeguards provide crucial protections for our banking system, our economy, and our society.

INTRODUCTION I. THE CRYPTO CRASH DEMONSTRATED THAT FLUCTUATING-VALUE CRYPTOCURRENCIES AND STABLECOINS POSE SEVERE RISKS TO INVESTORS AND OUR BANKING SYSTEM A. Fluctuating-Value Cryptocurrencies Inflicted Huge Losses on Investors During the Crypto Crash and Have Not Produced Meaningful Benefits B. Stablecoins Promise Stable Values but Are Highly Vulnerable to Investor Runs C. Aggressive Marketing Campaigns by Crypto Firms Intensified Crypto's Boom, While Scandalous Failures Accelerated Its Crash 1. Crypto Firms Magnified the Crypto Boom by Targeting Retail Investors 2. Scandalous Failures of Leading Crypto Firms Aggravated the Crypto Crash II. FEDERAL AND STATE REGULATORS ALLOWED BANKS TO BECOME SIGNIFICANTLY INVOLVED IN CRYPTO-RELATED ACTIVITIES, RESULTING IN THE CATASTROPHIC FAILURES OF THREE BANKS 268 A. Banks Established a Substantial Presence in Crypto Markets with the Approval or Acquiescence of Federal and State Regulators B. Several FDIC-Insured Banks Experienced Major Problems During the Crypto Crash, and the Failures of Three of Those Banks Threatened the Stability of the U.S. Banking System C. FDIC-Insured Banks Are Seeking to Develop New Payment Systems That Use Stablecoins and Tokenized Deposits III. POLICYMAKERS SHOULD ADOPT A THREE-PART PLAN TO PROTECT INVESTORS AND OUR BANKING SYSTEM FROM THE CRYPTO INDUSTRY A. Policymakers Should Affirm the SEC's Role as the Primary Federal Regulator of Most Fluctuating-Value Cryptocurrencies B. Federal Regulators Should Prohibit FDIC-Insured Banks and Their Affiliates from Investing and Trading in Fluctuating- Value Cryptocurrencies and from Providing Financial Services. to Crypto Firms That Are Not Regulated by the SEC or the CFTC C. Congress Should Mandate That All Providers of Stablecoins and Tokenized Deposits Must Be FDIC-Insured Banks 1. Providers of Stablecoins and Tokenized Deposits Should Comply with the Regulatory Safeguards Governing FDIC-Insured Banks 2. Congress Should Reject Proposals that Would Allow Nonbanks and Uninsured Depository Institutions to Issue or Distribute Tokenized Deposits and Stablecoins 3. Policymakers Should Not Apply the Regulatory Model for Money Market Funds to Nonbank Stablecoin Providers CONCLUSION INTRODUCTION

An enormous speculative boom occurred in markets for crypto-assets (1) between April 2020 and November 2021, followed by a catastrophic bust that continued through the end of 2022. The crypto crash inflicted huge losses on investors and generated serious concerns about the dangers that crypto-assets pose to our financial system. In March 2023, those dangers were highlighted by the failures of three U.S. banks with significant exposures to crypto-related activities. In view of the extreme risks of crypto-assets and their lack of demonstrated benefits, Congress and federal regulators must take decisive measures to protect investors and our banking system from the crypto industry.

During the crypto boom, the total market capitalization of crypto-assets soared from about $200 billion in April 2020 to almost $3 trillion in November 2021. (2) Prices for the two largest cryptocurrencies--Bitcoin and Ethereum (3)--rose dramatically during the same period. (4) In the autumn of 2021, "Bitcoin and Ether ranked among the world's top 20 traded assets, competing with the market capitalization of some of the world's largest companies." (5)

The crypto crash began in late 2021 and became a prolonged "crypto winter," as the total market capitalization of cryptocurrencies fell by over $2 trillion between November 2021 and the end of 2022. (6) Prices for Bitcoin and Ethereum declined by more than 70% during the same period. (7) A staff study issued by the Bank for International Settlements (BIS) estimated that about three-quarters of individual investors who purchased Bitcoin between 2015 and 2022 suffered losses on their investments. (8) The magnitude of the crypto crash caused significant concerns among U.S. and international officials about the risks that crypto-assets posed to the banking system and financial markets. (9)

The most widely used crypto-assets are cryptocurrencies. The term "cryptocurrencies," as used in this article, refers to digital assets that are created and traded on blockchains or other privately created distributed ledgers. (10) Most cryptocurrencies fall into two general categories: (i) cryptocurrencies with fluctuating values, like Bitcoin and Ethereum, and (ii) "stablecoins," which seek to maintain parity with a designated fiat currency or other referenced asset or group of assets. (11) The term "cryptocurrencies," as used here, does not include digital ("tokenized") representations of traditional financial assets such as stocks, bonds, bank deposits, and fiat currencies. (12)

In December 2022, the Basel Committee on Banking Supervision (Basel Committee) issued prudential standards for bank exposures to crypto-assets. As further discussed below, the Basel Committee's standards distinguish between (i) "Group 1" crypto-assets, which include tokenized traditional financial assets and stablecoins that satisfy prescribed standards, and (ii) "Group 2" crypto-assets, which do not meet "Group 1" criteria, such as cryptocurrencies with fluctuating values. (13) This article, like the Basel Committee's standards, excludes tokenized traditional financial assets from treatment as cryptocurrencies and also contends that "Group 1" stablecoins should be regulated differently from "Group 2" cryptocurrencies with fluctuating values.

Part I of this article provides an overview of the crypto boom and crash. As described in Part I.A, the crypto boom and crash demonstrated that cryptocurrencies with fluctuating values are extremely risky and highly volatile assets that are strongly correlated with each other. Fluctuating-value cryptocurrencies rose in tandem during the boom and collapsed together during the bust. Those cryptocurrencies did not provide hedging or diversification benefits and inflicted very severe losses on investors. In addition, fluctuating-value cryptocurrencies have not produced meaningful benefits for our financial system or the broader economy.

As discussed in Part I.B, stablecoins are the most widely used form of payment for investing and trading in cryptocurrencies and are also pledged as collateral for borrowing and lending cryptocurrencies. Stablecoins provide the primary link between traditional financial markets and cryptocurrency markets because most investors convert their fiat currencies into stablecoins before engaging in cryptocurrency transactions. The crypto crash revealed that, despite their promise of stability, stablecoins are vulnerable to investor runs whenever there are serious doubts about the adequacy of their reserves.

As explained in Part I.C, the crypto boom was fueled by huge fiscal stimulus programs and expansive monetary policies that governments and central banks adopted during the Covid-19 pandemic crisis. Crypto firms amplified the boom with aggressive and deceptive marketing campaigns that targeted unsophisticated retail investors. The crypto crash began in late 2021, as governments reduced their fiscal stimulus programs and central banks began to tighten their monetary policies in response to rising inflation. A series of failures among leading crypto firms intensified the crypto crash...