Crypto Liquidity Guidance Released by US Federal Banking Regulators | Insights and Events

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In February 2023, US federal banking regulators issued guidance on the liquidity risks associated with banks receiving certain types of funding from crypto-asset-related entities (“Liquidity Guidance”).1 The Liquidity Guidance again underscores the skepticism expressed by federal banking regulators towards the crypto-asset sector and may make it even more difficult for crypto-asset-related entities to open bank accounts.

In this legal update, we provide information on liquidity risk and discuss what the Liquidity Guidance means for banks and the crypto industry.

Background

Liquidity is the ability of a bank to honor its cash and collateral obligations at a reasonable cost2. Liquidity risk is the risk that a bank’s financial condition or overall safety and soundness will be adversely affected by an inability (or perceived inability) to meet its obligations. For some banks there are quantitative liquidity risk management requirements, but all banks are expected to manage their liquidity risk prudently.

Liquidity risk has long been recognized as one of the main risks facing a bank3. However, prior to the 2008 financial crisis, much of the oversight of banking regulators focused on other high profile risks, such as credit and market risk. risks. Following the 2008 financial crisis, regulators began to focus on liquidity risk as both a regulatory and prudential priority4.

Liquidity advice

Crypto-assets are a new and rapidly evolving asset class that presents new risks, as well as old risks in new ways. The Liquidity Guidance focuses on the liquidity risks presented by certain funding sources from crypto-asset related entities.

Two heightened risk situations

In particular, it highlights two situations that regulators believe create increased liquidity risk for banks:

Deposits placed with a bank by a crypto-asset-related entity for the benefit of the crypto-asset-related entity’s customers. Although traded deposit accounts and other transfer deposit accounts are common (the FDIC recognizes at least 13 types of traded deposits5), regulators believe that deposits placed by an entity related to cryptoassets present an increased risk because the combination of the unpredictable customer behavior of crypto-asset related entities and the volatility of the dynamics of the crypto-asset industry. This rapid and large-scale conduct can lead to bank runs where customers of a crypto-asset-related entity rapidly deposit or withdraw funds. Stablecoin repositories. The risk is increased because the stability of stablecoin deposits may be related to the demand for stablecoins, the confidence of stablecoin holders in the stablecoin arrangement, and the reserve management practices of the coin issuer stable. As with customer deposits, rapid redemption of stablecoins that are driven by factors exogenous to the bank can lead to a bank run.

Risk management

The Liquidity Guidance states that banks should use existing risk management principles to prudently manage the liquidity risks of crypto-asset business. It also provides examples of how banks can apply four risk management principles to customers of crypto-asset related entities:

Understand the direct and indirect drivers of the potential behavior of cryptoasset-related entity deposits and the extent to which these deposits are susceptible to unpredictable volatility. Assess potential concentration or interconnection between deposits of crypto-asset related entities and associated liquidity risks. Incorporate liquidity risks or funding volatility associated with crypto-asset-linked deposits into contingency funding planning, including liquidity stress testing and, where appropriate, other asset-governance processes liabilities and risk management. Perform robust due diligence and ongoing monitoring of crypto-asset-related entities that establish depository accounts, including evaluating statements made by such crypto-asset-related entities to their end customers about such depository accounts which, if inaccurate, could lead to rapid outflows from these deposits.

To take with

There are few banks engaged in crypto-asset business of any type, although more are likely to be engaged in crypto-asset banking entities6. The Liquidity Guidance may lead these banks to take a closer look at their crypto-asset clients to understand the liquidity risks presented. through their accounts. At a minimum, these banks should expect increased prudential scrutiny of these banking relationships.

The Liquidity Guidance stresses that banks are “neither prohibited nor discouraged from providing banking services to customers of a specific category or type, to the extent permitted by law or regulation”. However, there are already public reports of banks ending their relationships with crypto-asset-related entities.7 This type of behavior is likely to continue as banks weigh the cost of regulatory oversight and heightened expectations in risk management in relation to the low margins of the depository bank. Therefore, entities related to crypto-assets should expect to encounter difficulties in opening and maintaining bank accounts for the foreseeable future.

1 News Release, Agencies Issue Joint Statement on Liquidity Risks Arising from Crypto-Asset Market Vulnerabilities (February 23, 2023), https://www.federalreserve.gov/newsevents/pressreleases/bcreg20230223a.htm.

2 See OCC, Liquidity Handbook at 3 (August 16, 2021); Federal Reserve, BHC Supervision Manual § 1060.20.1 (February 2023).

3 See, for example, OCC, NR 1996-2 (January 4, 1996); see also BPI, Is It Time For a Holistic Review of Liquidity Requirements? (February 23, 2023).

4 For example, Daniel Tarullo, Liquidity Regulation (20 November 2014) (“before the crisis, quantitative regulation of liquidity was very little used”); Jeremy Stein, Liquidity Regulation and Central Banking (April 19, 2013) (“Liquidity regulation is a relatively new, post-crisis addition”).

5 Interestingly, the Liquidity Guidance also mentions the importance for banks to correctly identify and report traded deposits. It’s unclear if this is a response to a specific issue identified by regulators or just a general warning.

6 BCBS, Basel III Monitoring Report (February 28, 2023) (stating that 17 out of 181 internationally active banks have crypto-asset exposures or crypto-assets under custody).

7 Rachel Louise Ensign, Banks break from crypto during regulatory crackdown, WSJ (February 16, 2023).

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