U.S. Banking Collapse Doesn’t Necessarily Make Crypto Trustworthy

The world is saved in “Superman: The Movie” when (spoiler alert) our eponymous hero flies so quickly around the world that he turns back time and undoes a confluence of disastrous events where a nuclear missile detonated in the San Andreas Fault. (Wait, he could do that all along?)

This turn of events may have seemed familiar, as did our collective sigh of relief, when the Treasury Department, Federal Reserve and the Federal Deposit Insurance Corporation (FDIC) announced extraordinary measures on March 12, to “strengthen confidence in the U.S. banking system” following the dramatic closure of Silicon Valley Bank (SVB).

Jess Cheng is a partner in the New York office of Wilson Sonsini Goodrich & Rosati and former senior counsel at the Board of Governors of the Federal Reserve System in Washington, D.C. Amy Caiazza is a securities, fintech, and blockchain partner in Wilson Sonsini Goodrich & Rosati’s Washington, D.C. office.

Does such a deus ex machina of the crypto industry exist, or could it? Should it? The Silicon Valley Bank (SVB) headlines did not revolve around crypto. However, there are important lessons for the crypto community to consider, especially as the recent instabilities in the banking system have once again prompted cries that decentralized finance can solve many of the problems raised by traditional banking and incumbent financial systems.

SVB was closed March 10 by the California Department of Financial Protection and Innovation, with the FDIC appointed as receiver. Among the measures announced on Sunday were actions taken to enable the FDIC to complete its resolution of SVB in a manner that “fully protects all depositors [such that] depositors will have access to all of their money starting Monday, March 13” (emphasis added).

Even deposits over the $250,000 FDIC insurance limit would not take losses under this measure. Signature Bank, which was also closed that day by the New York Department of Financial Services with the FDIC appointed as receiver, received similar treatment, with all depositors to be made whole.

Any losses to the FDIC’s deposit insurance fund to cover these uninsured deposits would be recovered in a special assessment on banks. In other words, the cost of making SVB’s and Signature Bank’s customers whole has fallen directly on the banking industry as a whole: Not customers, and not taxpayers. Regulators have stepped in but they put the financial responsibility for protecting depositors firmly with the private sector.

Importantly, there was a second measure announced on Sunday. The Federal Reserve also created a new lending facility to help ensure banks have the ability to meet the needs of their depositors, with the Treasury Dept. making available up to $25 billion as a backstop. The facility offers loans for up to one year against certain securities – including long-term U.S. Treasury bonds and government-backed mortgage securities, whose market prices have plummeted as interest rates have soared. Importantly, those assets would be valued at par, not market value. As a result, a bank desperate for liquidity would not need to sell its portfolio of long-dated securities at a loss; it could pledge that collateral for a loan at par.

The Fed can stand up this liquidity facility because it is special. Like any balance sheet, the Fed’s consists of assets on one side and equal liabilities on the other – but the Fed can expand its balance sheet in ways that other entities can’t, and central bank money is unique in that it serves as the foundation for the safety and efficiency of the U.S. payment system as a whole.

It remains to be seen whether the measures announced on Sunday are enough to calm investors, depositors and the broader market. Just as the U.S. bank supervisory and regulatory framework may be at a crossroads, so too might the crypto community.

A challenge to consider: Can technology replicate, for the crypto markets, the effects of the Fed’s unique central bank powers, backed by the full faith and credit of the U.S. government?

Perhaps, to some degree. It doesn’t take a central bank or finance minister (or Superman) to develop clear, well-calibrated loss allocation schemes. As a point of comparison, the concept of loss-sharing is already a fundamental principle of payment systems in that the burden of unanticipated operational losses should rest with the providers of the payment system rather than with the users of the payment system. The crypto community might consider developing clear, enforceable legal terms or system rules that leverage this fundamental loss-spreading principle – beyond operational losses and on an industry-wide basis.

But, of course, that is not a deus ex machina of crypto, which would seem to be in philosophical tension with the decentralization goals of many in the blockchain and crypto industries. Ultimately, although crypto and traditional banking may be ostensibly competing in financial services, they are living in fundamentally different realities. In the wake of the Terra and FTX collapses, there was no Superman to swoop in and undo the calamitous ramifications.

The resulting cascade of losses has undermined trust in crypto outside the close-knit community. In response, this means the crypto community itself needs to be united, vigilant and disciplined – through rigorous rules, standards and protocols that protect customers and strengthen confidence. Only by rebuilding this trust can crypto have a chance at regaining its momentum and a shot at mainstream adoption.

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