What impact and insights has the cleanup action of crypto-friendly banks in the United States brought to the crypto market?

Author: Daniel Li, CoinVoice

In the past week, frequent bank failures have once again made us feel the risks and destructive power of capital. While people are worried that the bankruptcy crisis of Lehman Brothers might repeat itself, the Federal Reserve and the Treasury's emergency intervention extinguished the fire that was about to ignite the global financial market. When we start to look back at the entire event, we find that the banks that failed this time were all involved in crypto business, which seems to be a targeted "cleanup" operation against crypto-friendly banks.

"Cleanup" Operation Against Crypto-Friendly Banks

2022 was the most tumultuous year for the crypto industry, with the frequent failures of several centralized crypto institutions making U.S. regulators realize that the risks of the crypto industry are not only confined to the industry itself but also pose threats to the banking sector closely associated with it. Especially after the FTX incident, U.S. regulators were determined to isolate the crypto industry from the banking system. By continuously pressuring banks, U.S. regulators forced them to abandon crypto business, thereby achieving the goal of isolating the crypto industry from the banking system.

To this end, in January of this year, three U.S. banking regulatory agencies—the Federal Reserve, the Office of the Comptroller of the Currency (OCC), and the Federal Deposit Insurance Corporation (FDIC)—jointly issued a statement urging banks not to engage in crypto-related businesses and to strictly review the compliance of various operations. By February, top U.S. banking regulators issued new warnings to banks, urging them to be vigilant against any liquidity risks from crypto-related clients, stating that some deposits from crypto-related clients could prove unstable. It is evident that the pressure on banks from the U.S. government is becoming increasingly apparent.

Against this backdrop, some banks have gradually chosen to exit the crypto market. For example, JPMorgan Chase announced in early March that it would sever ties with the cryptocurrency exchange Gemini, and Moonstone Bank also announced it would no longer provide services to the crypto industry, among others. The pressure from the U.S. government on banks has mostly remained at the warning level, and no clear legal regulations prohibiting banks from engaging in crypto business have been introduced yet, which has led some banks with a sense of complacency to continue their crypto operations. Additionally, some banks, like Silvergate, are deeply mired in the crypto market due to debt issues.

Silvergate's Struggles in Crypto

Silvergate Bank is a bank under Silvergate Capital (SI) and is one of the most crypto-friendly banks in the U.S. Silvergate not only accepts deposits from crypto trading platforms and traders but also established its own crypto settlement payment network—SEN (Silvergate Exchange Network). SEN is designed specifically for crypto trading platforms and investors, allowing investors to directly use U.S. dollars to purchase crypto assets and enabling efficient transactions among SEN participants around the clock. Due to its friendly stance towards the crypto market, Silvergate attracted a large amount of deposits from the crypto market over the past five years, and its stock doubled as a result.

However, the sudden collapse of FTX plunged Silvergate into a death spiral, causing over $8 billion in losses and triggering panic in the crypto market, leading a large number of crypto investment institutions and investors to rush to withdraw deposits from Silvergate. This quickly drained Silvergate's reserves, making it impossible to maintain normal operations. Furthermore, U.S. regulators have consistently insisted that banks should not engage in cryptocurrency business. After the FTX incident, the U.S. began a large-scale inspection of banks involved in crypto business, which put immense pressure on Silvergate, ultimately leading to its bankruptcy on March 8 due to the combined effects of these factors.

Signature Bank's Forceful Closure

Compared to Silvergate, Signature Bank (SBNY) had a relatively more conservative approach to the crypto market. If Silvergate Bank is considered the "bad student" with a high-risk appetite, then SBNY can be seen as the "good child" adhering to regulations. SBNY did not invest in, hold, or custody cryptocurrencies, nor did it provide loans secured by cryptocurrencies, only offering U.S. dollar deposit services. After U.S. regulators issued a statement advising banks not to engage in crypto business, SBNY's management actively worked to reduce the proportion of crypto deposits. According to SBNY's disclosed Q1 2023 financial data, total customer deposits were $826 million, with crypto user deposits amounting to approximately $144 million, accounting for only 17.43% of total deposits. Additionally, SBNY's short-term investments were $1.74 billion, making up 14.98%. Overall, even if all crypto deposits were withdrawn, SBNY would still have sufficient liquidity.

SBNY itself had a very low likelihood of facing a liquidity crisis due to the turmoil in the crypto market. However, the Silvergate incident has shown U.S. regulators the potential risks behind crypto-friendly banks. Especially in the context of continuous interest rate hikes, this potential risk could trigger a crisis in the entire financial market. Therefore, even if SBNY was unlikely to face a liquidity crisis, regulators decided to shut it down to prevent future issues, and the forced closure of SBNY undoubtedly demonstrated the U.S. regulators' determination to isolate banks from the crypto industry.

Silicon Valley Bank's Liquidity Crisis Leading to Bankruptcy

Silicon Valley Bank was also a crypto-friendly bank, but unlike the reasons for the bankruptcy of the previous two banks (SBNY's closure), Silicon Valley Bank's bankruptcy was not directly related to the crypto market. The bank's failure was mainly due to its large-scale investment in long-term government bonds and MBS after the pandemic, which, coupled with the Federal Reserve's interest rate hikes, made it more difficult for depositors to raise funds and intensified withdrawal behaviors. The interest rate hike cycle also led to significant losses in its own securities investments, resulting in a liquidity crisis after depositors rushed to withdraw their funds.

The plight of Silicon Valley Bank is not an isolated case; many small and medium-sized banks in the U.S. are experiencing similar difficulties. On one hand, investment returns have sharply decreased against the backdrop of rising interest rates; on the other hand, it has become increasingly difficult for banks to attract deposits in an economic downturn, while also facing the risk of sudden large-scale bank runs. If a larger bank were to fail, it could trigger panic in the market, putting many small and medium-sized banks in the U.S. at risk of closure.

To avoid a potential widespread bank failure in the future, the U.S. government has conducted a preemptive cleanup of the potential risks within the banking system. Crypto banks connect traditional finance and the crypto market, and their vulnerabilities have been highlighted under the dual impact of the Federal Reserve's interest rate hikes and the crypto market's deleveraging. Therefore, these banks received special attention during the recent U.S. banking review actions. This is also why the three recently failed banks are all related to the crypto industry. It can be anticipated that for some time to come, banks involved in crypto business in the U.S. will face scrutiny from regulators, and any violations discovered could lead to the shutdown of their crypto-related operations. This poses a significant blow to the entire crypto market.

What Impact Has This Turmoil Brought to the Crypto Market?

In the week that Silicon Valley Bank and other crypto-friendly banks announced their closures, the liquidity crisis in banks caused by asset mismatches quickly spread to the entire crypto market, leading to a panic sell-off that mirrored the epic crash of March 12, with the total market capitalization falling below $1 trillion and Bitcoin (BTC) briefly dropping below $20,000. As one of the intersection points between the crypto market and traditional financial markets, the stablecoin market was the first to be affected, experiencing the most direct and severe impact.

Stablecoin Trust Crisis

Stablecoins are a type of cryptocurrency that can maintain a relatively stable price by pegging to fiat currencies. USDC, for instance, maintains its price stability by being pegged to the U.S. dollar at a 1:1 ratio, typically trading around $1. However, the recent failures of Silicon Valley Bank and other crypto-friendly banks have caused this stability to falter.

The stablecoin market has always been a key pillar of the crypto market, fully backed by cash reserves and short-term government bonds. As the issuer of the USDC stablecoin, Circle originally only needed to place U.S. dollars in interest-bearing accounts to ensure that people could redeem them at a 1:1 ratio. However, it deposited funds in Silicon Valley Bank, which became the source of the stablecoin crisis. According to Circle, $3.3 billion of its $40 billion USDC reserves were held in Silicon Valley Bank. Therefore, when news of the bank's bankruptcy broke, investors began to worry about USDC's stability, and as market panic escalated, USDC experienced a de-pegging, briefly dropping to the $0.98 range and further declining to $0.88, with a 24-hour drop exceeding 11.4%.

However, the stablecoin crisis triggered by the collapse of Silicon Valley Bank did not last long. With the implementation of the U.S. regulatory agencies' rescue measures, all depositors of Silicon Valley Bank were able to resume withdrawals. The price of USDC has also gradually recovered; as of now, CoinmarketCap shows 1 USDC = $0.9968, essentially restoring its peg to the U.S. dollar.

Crypto Industry Faces Fiat Liquidity Crisis

In the recent cleanup operation against crypto-friendly banks in the U.S., three banks have either failed or been shut down within just a week, including Silvergate and SBNY, which operated the Silvergate Exchange Network (SEN) and Signet network, respectively. These networks play a crucial role in connecting crypto business with the traditional banking system. Notably, the SEN trading network had a trading volume of nearly $800 billion throughout 2021, with almost all major U.S.-based cryptocurrency exchanges as clients of Silvergate. With the closure of these two banks, these vital networks for the crypto industry will also be shut down, which will undoubtedly have a significant impact on the fiat liquidity of the crypto industry.

Liquidity issues in the crypto industry have always been a challenge. The nature of cryptocurrency trading is P2P (peer-to-peer), unlike traditional financial markets that are centralized in one exchange. This means that trading volume may be dispersed across multiple markets, leading to limited liquidity, which can cause price volatility and increased trading costs. Therefore, the crypto industry needs to enhance its liquidity through external means, and banks are undoubtedly the most suitable choice. Funds from bank users can directly enter the crypto market, and this collaboration also brings funds and traffic to the banks, benefiting both parties. However, the current scrutiny by U.S. regulators on banks involved in crypto business is hindering this collaboration. On one hand, the number of crypto-friendly banks is gradually decreasing; on the other hand, developing new partnerships with banks is becoming increasingly difficult for the crypto industry. Until new banks enter the market, the fiat liquidity of the crypto industry will be severely restricted.

Moreover, if the U.S. scrutiny of banks involved in crypto business becomes a long-term trend, then in the future, users in the U.S. market may only be able to purchase cryptocurrencies through OTC (over-the-counter) transactions. Without banks as intermediaries, this undoubtedly shifts the risk onto users, and the associated risks and complexities may lead some users to choose to forgo entering the crypto market, further impacting the liquidity of the crypto market.

How Will the Crypto Industry Develop After This Crisis?

Every crisis presents an opportunity for the industry to identify its problems and address its shortcomings. The recent wave of failures among crypto-friendly banks is a moment of reflection for both traditional banking and the crypto industry.

Establishing Regulatory Policies and Crisis Management Mechanisms for the Industry

This crisis has shown us that the traditional banking system, protected by regulatory oversight, can minimize losses during a crisis. For instance, Silicon Valley Bank, ranked 16th in the U.S., was able to quickly regain control within a week after the crisis erupted due to the U.S. government's support policies, preventing a spillover effect on the entire banking system. Conversely, if a similar situation occurs in the crypto industry, the outcome is starkly different. The crypto industry lacks any experience or regulatory policies, and once a crisis occurs, everyone tends to look out for themselves. Without unified regulatory policies and crisis management measures, the crypto industry becomes more vulnerable to risks.

Therefore, through this crisis, the crypto industry should strive to establish its own industry standards and crisis management mechanisms as soon as possible to ensure market stability and sustainable development, enhance the industry's risk resistance capabilities, and protect investors' interests. This requires collaboration between the crypto industry and government regulatory agencies to jointly promote the establishment of a sound regulatory system and crisis management mechanisms.

The Crypto Industry Needs to Establish True Stablecoins

Stablecoins can be categorized into centralized and decentralized stablecoins. In the incident where the collapse of Silicon Valley Bank led to the temporary de-pegging of USDC, USDC is a centralized stablecoin. Historically, centralized stablecoins have also experienced de-pegging from the U.S. dollar multiple times, including the leading stablecoin USDT. Therefore, when similar events occur again, decentralized stablecoins, which rely less on external dependencies, gain renewed attention.

Centralized stablecoins typically choose to peg to fiat currencies by depositing a certain amount of legal tender in banks to ensure the price stability of their stablecoins. Thus, centralized stablecoins need to collaborate with banks, and the recent scrutiny of crypto-friendly banks in the U.S. undoubtedly casts a shadow over the development of centralized stablecoins. Although USDC has returned to normal after a brief de-pegging, as long as the U.S. continues its scrutiny of crypto-friendly banks, the risk of USDC de-pegging will likely reoccur.

In contrast to centralized stablecoins, decentralized stablecoins do not need to be tied to banks because they are built on blockchain technology and do not have the support of central banks or governments, nor do they involve traditional financial institutions. These stablecoins typically use algorithms or collateralization with other cryptocurrencies to maintain price stability. Additionally, compared to centralized stablecoins that rely on fiat currency credit and bank stability, decentralized stablecoins excel in asset transparency and design flexibility. Their minimal external dependencies and maximum transparency make decentralized stablecoins more attractive in the current context.

Decentralized stablecoins have many advantages, but they also have a fatal flaw: over-collateralization leads to significantly lower capital efficiency compared to centralized stablecoins. Furthermore, there are certain gaps in scalability and security compared to centralized stablecoins. However, after the recent wave of failures among U.S. crypto-friendly banks, it is believed that as more institutions begin to focus on the development of decentralized stablecoins, these issues will be resolved quickly, and the crypto industry will welcome its own true stablecoins.

Conclusion

Since the FTX incident, U.S. regulators have been emphasizing the risks that the crypto industry poses to the banking sector and have thus launched a series of reviews targeting banks involved in crypto business, hoping to isolate the crypto industry from the traditional banking system. However, the de-pegging of USDC has demonstrated the crises caused by banks' own asset mismatches and financial opacity, which have spilled over into the crypto industry. Therefore, not all crypto businesses are high-risk, and the banking sector also has its own problems and limitations.

The scrutiny of crypto-friendly banks by U.S. regulators will not only have a negative impact on the crypto industry but, more critically, will hinder traditional banks from exploring innovative fields. The traditional banking sector needs more exploration and innovation to better adapt to the ever-changing market environment and improve its mechanisms. Therefore, regulatory agencies should not completely deny crypto-friendly banks but should instead create safer and more robust crypto-friendly banks through policy guidance.