In February 2023, the US federal banking regulators released guidance on liquidity risks associated with banks receiving certain types of funding from crypto-asset-related entities (“Liquidity Guidance”).1 The Liquidity Guidance reemphasizes the skepticism that the federal banking regulators have expressed toward 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 background on liquidity risk and discuss what the Liquidity Guidance means for banks and the crypto sector.
Liquidity is a bank’s capacity to meet its cash and collateral obligations at a reasonable cost.2 Liquidity risk is the risk that a bank’s financial condition or overall safety and soundness is 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 prudently manage their liquidity risk.
Liquidity risk has long been recognized as one of the top-tier risks that a bank faces.3 However, prior to the 2008 financial crisis, much of the supervisory focus of banking regulators was on other top-tier risks, such as credit and market risks. As a consequence of the 2008 financial crisis, regulators began to focus on liquidity risk as both a regulatory and a supervisory priority.4
Crypto-assets are a new and rapidly evolving asset class that present new risks, as well as old risks in new ways. The Liquidity Guidance focuses on the liquidity risks presented by certain sources of funding from crypto-asset-related entities.
Two Situations with Heightened Risk
In particular, it highlights two situations that the regulators believe create heightened liquidity risk for banks:
- Deposits placed at a bank by a crypto-asset-related entity that are for the benefit of the crypto-asset-related entity’s customers. While brokered and other pass-through deposit accounts are common (the FDIC recognizes at least 13 types of brokered deposits5), the regulators believe that deposits placed by a crypto-asset-related entity present heightened risk from the combination of the unpredictable behavior of the crypto-asset-related entity’s customers and the volatility of crypto-asset sector’s dynamics. This rapid, large-scale conduct can lead to bank runs where a crypto-asset-related entity’s customers rapidly deposit or withdraw funds.
- Stablecoin deposits. Risk is heightened because the stability of stablecoin deposits may be linked to the demand for stablecoins, the confidence of stablecoin holders in the stablecoin arrangement, and the stablecoin issuer’s reserve management practices. As with customer deposits, rapid redemption of stablecoins that are driven by factors exogenous to the bank can lead to a bank run.
The Liquidity Guidance states that banks should use existing risk management principles to prudently manage the liquidity risks of crypto-asset activities. It also provides examples of how banks might apply four risk management principles to crypto-asset-related entity customers:
- Understanding the direct and indirect drivers of potential behavior of deposits from crypto-asset-related entities and the extent to which those deposits are susceptible to unpredictable volatility.
- Assessing potential concentration or interconnectedness across deposits from crypto-asset-related entities and the associated liquidity risks.
- Incorporating the liquidity risks or funding volatility associated with crypto-asset-related deposits into contingency funding planning, including liquidity stress testing and, as appropriate, other asset-liability governance and risk management processes.
- Performing robust due diligence and ongoing monitoring of crypto-asset-related entities that establish deposit accounts, including assessing the representations made by those crypto-asset-related entities to their end customers about these deposit accounts that, if inaccurate, could lead to rapid outflows of these deposits.
There are few banks engaged in crypto-asset activities of any type, although presumably more are engaged in banking crypto-asset entities.6 The Liquidity Guidance may cause these banks to look more closely at their crypto-asset customers to understand the liquidity risks presented by their accounts. At a minimum, these banks should expect greater supervisory scrutiny of these banking relationships.
The Liquidity Guidance emphasizes that banks are “neither prohibited nor discouraged from providing banking services to customers of any specific class or type, as permitted by law or regulation.” However, there already are public reports of banks exiting relationships with crypto-asset-related entities.7 This type of behavior is likely to continue as banks weigh the cost of regulatory scrutiny and heightened risk management expectations against the low margins of deposit banking. Therefore, crypto-asset-related entities should expect to encounter difficulty in opening and maintaining bank accounts for the foreseeable future.
1 Press Release, Agencies issue joint statement on liquidity risks resulting from crypto-asset market vulnerabilities (Feb. 23, 2023), https://www.federalreserve.gov/newsevents/pressreleases/bcreg20230223a.htm.
2 See OCC, Liquidity Handbook at 3 (Aug. 16, 2021); Federal Reserve, BHC Supervision Manual § 1060.20.1 (Feb. 2023).
3 See, e.g., OCC, NR 1996-2 (Jan. 4, 1996); see also BPI, Is It Time For a Holistic Review of Liquidity Requirements? (Feb. 23, 2023).
4 E.g., Daniel Tarullo, Liquidity Regulation (Nov. 20, 2014) (“prior to the crisis there was very little use of quantitative liquidity regulation”); Jeremy Stein, Liquidity Regulation and Central Banking (Apr. 19, 2013) (“Liquidity regulation is a relatively new, post-crisis addition”).
5 Interestingly, the Liquidity Guidance also mentions the importance of banks correctly identifying and reporting brokered deposits. It is unclear if this is in response to a specific issue that regulators have identified or is merely a general caution.
6 BCBS, Basel III Monitoring Report (Feb. 28, 2023) (indicating that 17 of 181 internationally active banks have cryptoasset exposures or cryptoassets under custody).
7 Rachel Louise Ensign, Banks Are Breaking Up With Crypto During Regulatory Crackdown, WSJ (Feb. 16, 2023).