Federal Reserve Issues Warning on ‘Crypto-Asset Risks to Banking Organizations’

The Federal Reserve joined with other federal banking regulators to issue a joint statement highlighting the critical risks to banks associated with crypto assets and the entire cryptocurrency industry.

The statement comes amidst regulators' failure to issue uniform guidance or rules on cryptocurrency, even as banks have expressed a desire for more clarity. It, however, doesn't extend any new policies about how traditional lenders should deal with digital assets.

US banking regulators warned financial institutions on Tuesday that dealing with crypto subjects them to several risks they need to be aware of, including scams, fraud, legal uncertainties, and deceptive disclosures.

“It is important that risks related to the crypto-asset sector that cannot be mitigated or controlled do not migrate to the banking system,” the agencies said in their first joint statement on crypto.

The regulators also said they're still figuring out how to deal with banks and cryptocurrency. Currently, they're working on a case-by-case basis while regulators build their understanding of the risks crypto may pose to banking organizations, their customers, and the broader US financial system.

As such, they're being “careful and cautious” and will issue further statements on banks' crypto-related activities as warranted. They also said they'd continue to work with other agencies on crypto issues.

Call for More Clarity

The joint statement came at a time when US policymakers have been pressing regulators for greater transparency in the cryptocurrency sector following the high-profile November crash of the crypto exchange FTX.

The statement actually came just minutes before Sam Bankman-Fried (SBF), co-founder and former CEO of failed crypto exchange FTX, pleaded not guilty to the eight counts of criminal charges, including wire fraud, securities fraud, money laundering, and conspiracy. SBF faces up to 115 years in prison for his alleged role in the FTX collapse.

The former crypto billionaire appeared in a New York City courtroom nearly two months after his crypto trading platform FTX declared bankruptcy, which sent shockwaves through the industry.

Now, billions of dollars from investors and customers are missing, and the Department of Justice (DOJ), US Securities and Exchange Commission (SEC), and Commodity Futures Trading Commission (CFTC) have all accused FTX of operating a fraud from the very start.

SBF was arrested in the Bahamas last month before being extradited to the US to face criminal charges. He is currently living with his parents while free on a $250 million bail. Meanwhile, two of his associates, Caroline Ellison, former CEO of FTX's sister company Alameda Research, and FTX co-founder Gary Wang had already pleaded guilty and were cooperating with the prosecutors, as per the authorities.

US District Judge Lewis Kaplan has tentatively set a start date for the trial on October 2nd and has added a new bail condition, saying that SBF is not allowed to access FTX or Alameda assets.

Key Risks Associated with Crypto

Now, at the start of the New Year, on January 3rd, the Joint Statement on Crypto-Asset Risks to Banking Organizations was issued by federal bank regulators, highlighting risks to bank organizations related to the crypto sector.

The regulators in question included the Board of Governors of the Federal Reserve System, the Federal Deposit Insurance Corporation (FDIC), and the Office of the Comptroller of the Currency (OCC).

The trifecta of regulators warned banks of a litany of risks related to cryptocurrencies, including shoddy risk management and governance practices at crypto firms.

Banks were also warned to watch for concentration risks, given how interconnected the crypto sector has proven to be, and protect against contagion risks more generally.

Other risks identified include fraud risks to participants in the cryptocurrency assets sector, legal uncertainties related to custodial practices, redeemability, and property rights; significant volatility in crypto markets, which impacts deposit flows of companies; and stablecoins vulnerability to bank runs.

The statement also stated heightened risks associated with open, public, and decentralized networks, including the lack of governance mechanisms establishing oversight of the system; the absence of standards to establish roles clearly; and vulnerabilities related to outages, cyber-attacks, lost or trapped assets, and illicit finance.

The agencies further listed risks associated with inaccurate or misleading statements and disclosures from companies engaged in crypto, including false statements regarding Federal Deposit Insurance, as well as other practices that may be deceptive, unfair, or abusive, resulting in substantial losses for retail and institutional investors, customers, and counterparties, that banking organizations should be aware of.

Additionally, crypto companies issuing digital tokens or holding them on their own balance sheets “is highly likely to be inconsistent with safe and sound banking practices,” the agencies argued. The regulators said they have “significant safety and soundness concerns with business models concentrated in crypto-asset-related activities.”

Guidance to Banks

This first joint statement of 2023 follows a year filled with digital assets scandals and bankruptcies. The group of powerful bank regulators said that the recent failures of major crypto firms led them to exercise caution in reviewing banks' proposals to engage with the market.

This year we saw the crash of the Terra USD algorithmic stablecoin, questionable deposit insurance application by cryptocurrency company Voyager, and the most recent collapse of the crypto exchange FTX.

The three US agencies said that although banks are not prohibited or deterred from providing banking services to the extent permitted by law or regulations to cryptocurrency customers, they strongly urge banks to think carefully before getting involved in the space. Also, agencies are considering how crypto-related activities might proceed.

According to the joint statement, US regulators are monitoring banks that might be exposed to risks related to crypto and are closely scrutinizing banks' proposals for engaging in crypto activities.

The Fed, the FDIC, and OCC have also said that they are considering proposed activities related to cryptocurrencies within each banking entity in a manner that adequately addresses safety and soundness to provide the greatest consumer protections and ensure adequate crypto compliance in line with existing laws.

Before engaging in crypto-related activities, a regulated bank entity must evaluate whether an activity is permitted; determine if it is required to file reports pursuant to applicable federal or state laws; and establish appropriate systems and controls in place to operate such activities safely and appropriately, in accordance with any applicable laws.

The agencies also encouraged banks to implement proper risk management, with appropriate policies and monitoring in place to mitigate and detect risks.

They further encouraged banks to monitor the evolving legal requirements to offer custody services for digital assets and be aware of the governance mechanisms – or lack of them – in crypto platforms with which they hoped to cooperate.

Cooperation among Agencies

This new statement from regulators is much stronger than previous ones from the agencies with a focus on risks from crypto. For instance, back in November 2021, they announced an initiative to clarify regulations around crypto where its major focus was ensuring that banks didn't process crypto for criminals.

While the US banking regulators remain cautious, they've allowed some custody operations among lenders. The OCC also briefly extended provisional charters to crypto trust banks. But the rules at the agencies now hold that a lender must get approval in advance before getting into any new business involving the crypto sector.

Last month, the heads of the three agencies agreed with the Financial Stability Oversight Council to include crypto as a danger area in the group's annual report that flags risks to the financial system.

A few bills have been proposed in Congress to regulate crypto, but it will take some time for the legislation to make its way through before it becomes law.

For now, the report calls on agencies to issue guidance and regulations to work together to address both ongoing and emerging risks within the digital assets ecosystem.