Crypto crisis response must protect stability of traditional banking system
By Rebeca Romero Rainey
The latest crisis to emerge from the crypto sector this year — the collapse of the FTX cryptocurrency exchange — is not an aberration, but a predictable example of the serious risks that digital assets pose to consumers and the economy. While crypto’s pockets are deep enough to afford primetime Super Bowl ads, the latest in a long series of crypto failures validates what community banks have long warned — the crypto sector is fragile, prone to facilitating financial crime, entirely lacking in the protections available in the banking system, and ultimately a poor alternative to the unique and effective U.S. system of banking locally.
The FTX collapse, like the collapse of the TerraUSD stablecoin earlier this year, follows a familiar and disturbing pattern: holders of an overvalued asset become spooked about their investment, other companies are courted for a buyout to limit the damage, a selloff drains the entity of funds, contagion spreads the disturbance across the market, and failures bankrupt investors and threaten the economy. The results are generally the same: a ruinous decline in prices. Previous crises have led to new protections, such as federal deposit insurance, but the crypto sector remains a financial Wild West.
The current crypto unraveling has reinvigorated the debate over how Congress, the White House, and federal regulators should respond, and policymakers should ensure new policies directed at the crypto sector fully reflect its risks. FTX isn’t unique, and policymakers shouldn’t treat it as an isolated actor. Rather, Washington should honestly confront crypto’s embedded flaws before it inflicts further damage or contagion to the traditional financial sector.
Policymakers should start by focusing on the gravest risks posed by crypto: its role in facilitating financial crimes. Cryptocurrencies have a long history of being used for criminal and illicit activity and to undermine law enforcement, such as facilitating money laundering and terrorist financing, defrauding consumers and businesses, facilitating payments for illegal goods and services, and evading U.S. sanctions. Given the severity of these risks, protecting national security and implementing anti-crime measures should be primary drivers of cryptocurrency policymaking and regulation.
Similarly, policymakers should ensure the crypto response addresses decentralized finance, or DeFi, which presents new opportunities for bad actors to engage in illicit activities and avoid the scrutiny of traditional, regulated financial intermediaries. DeFi mixers — services that “mix” the cryptocurrency of multiple users to cloak the owners — intentionally complicate law enforcement efforts to stop cybercriminals and recover users’ stolen assets. Despite U.S. sanctions on Tornado Cash after the DeFi mixer was used to launder funds stolen by North Korea’s Lazarus group of hackers, bad actors still use it. In the case of FTX, hackers reportedly drained the company of digital assets worth hundreds of millions of dollars as it collapsed and used DeFi applications to launder the assets.
To avoid introducing these risks to the broader financial system and economy, policymakers should stand up a regulatory framework for crypto that ensures the traditional banking system continues to be a safe haven from the crypto sector’s instability. The commercial banking industry — with its alphabet soup of state and federal regulations on safety and soundness, consumer protection, and more — funds deposit insurance to ensure depositor funds are safe and protected by the FDIC, dollar-for-dollar up to the insurance limit. A broad swath of the banking system — community banks — are local institutions rooted in the communities in which their depositors live and work, ensuring these relationship-based institutions do right by their customers.
By contrast, crypto companies continuously seek to attract new sources of revenue to stay afloat — even encouraging bank depositors to pour their insured savings into highly volatile crypto investments. FTX itself was ordered by the FDIC in August to cease and desist falsely presenting its crypto products as FDIC insured. And top crypto exchange Binance has sought to assuage liquidity concerns by revealing its “reserves,” which are simply a collection of cryptocurrencies. Clearly, these companies have no place in the traditional banking system — including via master accounts at the Federal Reserve — which would only validate the crypto sector without preventing additional failures and financial fallout.
The crypto sector presents unique and outsized risks to financial stability and national security. Policymakers should ensure that bringing crypto into the regulatory perimeter means introducing a robust regulatory structure that shields consumers and institutions from the risks posed by the emerging and dangerous crypto sector.
Rebeca Romero Rainey is president and CEO of the Independent Community Bankers of America.
