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The spectacular failures of Silvergate Capital, Signature Bank, and Silicon Valley Bank have exposed weaknesses in the U.S. crypto banking sector, putting into question its future, and how the industry can grow domestically should this important infrastructure not be rebuilt. Since March, the risk appetite of banks and regulators to allow further crypto expansion into the larger U.S. financial system has greatly diminished.
Crypto got its break during the 2008 banking crisis. The failure of Lehman Brothers and other large institutions redirected regulatory attention to the too-big-to-fail banks, and away from the smaller banks. In January 2009, the first block of bitcoin traded. As awareness of crypto grew, trading expanded and prices soared, an infrastructure of exchanges and newly funded ventures arose. Flush with billions in cash, these crypto-focused ventures sought safe places to park funds. In 2014, Silvergate, filled this breach and became the first U.S. crypto bank. Initially, they reaped remarkable deposit and stock growth. By 2021, Silvergate had morphed from a sleepy, La Jolla, California-based community bank with just over $1 billion in deposits, to a $14 billion crypto-friendly financial institution. During this period, the San Francisco Federal Reserve, its primary regulator, appeared unconcerned about Silvergate’s hypergrowth and concentrated industry risk strategy. Other banks eager to bet on crypto also emerged. In 2018, New York-based Signature, entered crypto, quickly growing its digital assets deposits to 20% of its funding base ($20 billion). By 2022, Signature was the country’s largest crypto bank. Silicon Valley Bank, to a lesser extent, also banked crypto, including Boston-based Circle, the world’s second-largest stablecoin producer. This single customer parked over $3 billion of uninsured funds with them. Coinbase, the largest U.S.-based exchange was first banked by them too.
In addition to deposit, lending, and money transfer services, these banks also provided legitimacy. This was valuable to an industry that was not known for strong internal controls, adequate board oversight, or rigor in preventing money laundering. With this newly laid banking infrastructure, it appeared crypto was poised for sustained, rapid growth.
The collapse of scandal-ridden FTX in November 2022 set off a chain reaction and exposed the weak safety and soundness practices of these crypto banks. FTX had almost $1 billion on deposit with Silvergate, representing about 9% of the bank’s total funding. Once FTX failed, they withdrew all funds from Silvergate and Signature Bank. This fueled greater nervousness among remaining depositors and by the fourth quarter of 2022, these banks experienced significant depositor runs. Silvergate failed on Mar. 8, SVB on Mar. 10, and Signature on Mar. 12. In only four days, the central U.S. crypto banking sector was demolished. Other banks, including New Jersey-based Cross River Bank, continue to provide crypto services–but their scope and reach pale in comparison to the three financial institutions that failed.
These sudden failures and depositor runs extended to non-crypto banks including Credit Suisse and First Republic Bank, further heightening regulators’ concerns about the potential spillover effect crypto could have on the larger banking sector.
It would be naïve to say that the Silvergate-sparked bank run would have been muted if the crypto risk had been spread-out among more banks. On the contrary, more banks applying the same weak banking practices would have only amplified the systemic risk.
Even prior to these March failures, regulators were cooling to crypto banking. In January, the Fed issued a joint regulatory warning, outlining the risk to banks targeting digital asset customers. The SEC has also taken an increasingly anti-crypto stance, ramping up legal actions against Binance and Coinbase, the industry’s two largest exchanges.
Industry cooling is also reflected in the level of crypto venture funding: For the first half of 2023, VC funding has dropped by more than 90% and is not expected to come back anytime soon.
Crypto scandals, recent bank events, and tighter regulatory scrutiny have created a chokehold, that if not remedied, will impede the industry’s growth, limit innovation, and force businesses to move to more crypto-friendly territories, including Switzerland, Singapore, and Puerto Rico.
FinTech innovation, including blockchain technology, holds much promise in providing more secure ways to move and store value in a decentralized manner.
To grow, the crypto industry requires banks and funding. Yet the industry needs to better police itself internally and apply higher standards of conduct. Banks that enter this space also need to follow stronger risk management standards. The chokehold can be reduced when proper banking practices are applied to crypto. Once regulatory trust is regained, the regulatory freeze will thaw.
Mark T. Williams is on the finance faculty at Boston University Questrom School of Business, a former Federal Reserve Bank examiner, and currently serves as president of the Boston Economic Club.
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