Over the course of a single week we witnessed, in quick succession, the collapse of three of the most crypto-friendly banks in the U.S. – Silvergate, Silicon Valley Bank (SVB) and Signature. The failure of SVB represented the largest bank failure since the 2008 financial crisis. While U.S. regulators swiftly stepped in to guarantee deposits and avert an immediate banking crisis, the collapse of these three institutions has accelerated what is being called the “unbanking of crypto” in the U.S. While digital asset industry skeptics may view the past week as the final nail in the coffin for crypto, crypto lives on, with Bitcoin rallying to a 9-month high. As we take stock of this latest crisis, we unpack some of the implications for the U.S. digital economy.

The events 

Silvergate, Signature and SVB were considered to be crypto-friendly, although each had its own diverse depositor base that went far beyond the digital assets industry. In addition to banking many in the crypto ecosystem, Silvergate and Signature also provided important infrastructure supporting the digital asset industry in the form of the 24/7 SEN and Signet payment networks, and counted as clients major crypto firms, like Binance.US, Kraken, and Gemini. SVB was the primary bank for many venture capital, tech and digital assets firms, including Circle, Roku, BlockFi and Roblox.

The fates of these banks unravelled quickly: on Wednesday, March 8, Silvergate Capital announced that it would be winding down operations and liquidating its bank, after reporting that it would not be filing its annual report. On Friday, March 9, Silicon Valley Bank collapsed after depositors withdrew more than $42 billion following SVB’s statement on Wednesday that it needed to raise $2.25 billion to shore up its balance sheet. On Sunday, March 12, Signature Bank, which also had a strong crypto focus but was much larger than Silvergate, was seized unexpectedly by banking regulators. Crypto industry veteran Meltem Demirors (@Melt_Dem) tweeted “and just like that, crypto in America has been unbanked Silvergate. Silicon Valley Bank. Signature. in one week”. On Friday, March 17, SVB’s parent filed for a court-supervised reorganization under Chapter 11 bankruptcy protection to seek buyers for its assets.

The response

The rapid collapse of SVB – the second largest bank failure in U.S. history – was a major shock to the venture capital and start-up community. VCs, founders and other depositors faced extreme uncertainty about the fates of their bank accounts and business operations, including concerns about making payroll and having to furlough employees. Many expressed grave concerns about the likelihood of additional “digital bank runs” on Monday morning, while others cautioned about moral hazard – including the view that, if the government came to the rescue, it would be incentivizing and rewarding risk taking behaviors – thereby “privatizing wins and socializing losses.”

In the end, depositors won. Amid assurances that there would not be a “bailout” of the banks, the U.S. federal government swiftly stepped in to guarantee all deposits for both SVB and Signature depositors, adding confidence and sparking a small rally in the crypto markets. By helping the banks perform on their contracts and making depositors whole, a Lehman-type situation was averted and market confidence was at least somewhat restored. 

No taxpayer funders were used – instead, the Federal Deposit Insurance Corporation (FDIC) declared that it would create a "bridge bank" to protect SVB customers and another for Signature (typically FDIC insures all deposits up to $250,000 for individual bank customers and does not extend its protection to customers of crypto exchanges). Nevertheless, it is possible that bank depositors may bear additional expenses, such as increased fees, as a result of the backstop facilities.

Fractional reserve banking

Importantly, these events have focused the public’s attention on the risks of fractional reserve banking – a system in which only a fraction of bank deposits are required to be available for withdrawal – risks that, ironically, blockchain technology was designed to avoid. 

In a world in which bank customers no longer need to stand in lines at local branches to withdraw their funds and, instead, can move their funds in seconds using their phones – and where public sentiment can reach frenzied levels based on a Tweet – bank runs may occur more quickly and frequently than ever before. As bank customers realize, perhaps for the first time, that, if they are receiving yields on their deposited funds, those funds might not actually be sitting “at the bank,” available for withdrawal, many have begun to ask whether they could choose to pay a fee to a bank for the certainty that their respective deposits would be available. 

Political drivers

An intense blame game has been unfolding in the media, with some arguing – not for the first time – that crypto needs to “stay out of” big banks. Questions also remain about the extent to which bank regulators were motivated by that very goal. For example, in the search for a buyer to purchase SVB, it was rumored that at least one GSIB (globally systemically important bank) had been prevented from bidding. 

Former Congressman, Barney Frank, an architect of the Dodd-Frank Act (and a member of Signature’s board of directors), has suggested publicly that New York regulators targeted Signature to convey an “anti-crypto message.” Yet according to Reuters, the New York Division of Financial Services (NY DFS) said that its decision was based on “a significant crisis of confidence in the bank’s leadership,” with a spokesperson asserting, “[t]he decisions made over the weekend had nothing to do with crypto. Signature was a traditional commercial bank with a wide range of activities and customers” and emphasizing, “[NY] DFS has been facilitating well-regulated crypto activities for several years and is a national model for regulating the space.”

Reuters also described reports that the FDIC had included a crypto-specific condition on bidders for Signature, requiring that “….any buyer of Signature Bank must agree to give up all the crypto business at the bank….” While the FDIC has denied this, it would not be the first time that a U.S federal regulator required a would-be buyer to discontinue digital asset-related activities as a condition to purchasing a bank (for example, when SoFi Technologies, which engaged in some digital asset-related activities, acquired a national bank).

Regulatory drivers

There certainly appear to be a number of regulatory drivers restricting the extent to which banks can participate in crypto markets. As demonstrated in the SoFi acquisition, the OCC confirmed that national banks and federal savings associations “must demonstrate that they have adequate controls in place before they can engage in certain cryptocurrency, distributed ledger, and stablecoin activities,” noting further that a bank “….should not engage in the activity until it receives a non-objection from its supervisory office.” 

In addition, a new Fed rule, which “presumptively prohibits” member banks from holding certain crypto assets, calls into question whether banks will be able to serve as “qualified custodians” for purposes of the SEC’s “custody rule,” under the Investment Adviser Act of 1940, as amended. This new Fed rule has been announced relatively contemporaneously with the SEC’s proposed expansion of the “custody rule” into a “safekeeping rule” – requiring the use of a qualified custodian for all customer assets (including, explicitly, digital assets), rather than only for customer assets that constitute “customer securities” or “customer funds.” 

While banks otherwise might be considered the natural players to serve as “qualified custodians,” constraints exist on their ability to engage in digital asset-related activities. Some have expressed concerns that adoption of the proposed “safekeeping rule,” without clear guidance about which entities constitute “qualified custodians,” may, effectively, result in a ban on crypto VC investments.

Impact on policy

Federal bank interest rate hikes last year may well have a been a factor in last week’s events. Increased interest rates caused the value of fixed-income bonds, like those in which SVB was reported to have invested, to dip, while arguably increasing depositors’ needs to access their funds. This created a negative feedback loop, with banks forced to sell their long-term bond holdings into a down market to meet customer withdrawal demands. 

Some also believe that Jerome Powell’s statements, suggesting an additional 50 basis point rate hike, contributed to the public’s crisis of confidence in SVB and Signature. Now, it appears that a 50 basis point increase is off of the table, with some predicting a 25 basis point increase, or no increase at all.

The bank failures also have spurred suggestions to increase the FDIC guarantee limit above $250,000 – the FDIC limit previously has been raised 7 times – and implement for regional banks new reserve and stress-testing requirements. 

Impact on stablecoins

Circle (issuer of the USDC stablecoin) also was affected by SVB’s collapse. When Circle disclosed its exposure to SVB, USDC, the world’s second “largest” stablecoin, temporarily lost its peg to the U.S. dollar, sinking to an all-time low of 88 cents. Circle’s disclosure appeared to be clear and timely, explaining where Circle held its funds and its go-forward plan and identifying potential challenges. Although the market’s response to such transparency appeared to be negative, the depegging ultimately was resolved. Unlike last year’s Terra/Luna unravelling, which involved an unbacked algorithmic stablecoin, the U.S. dollar reserve backing USDC always existed in the account, and the “loss” was never realized.

Many regard USDC (backed by real assets like U.S. Treasuries and cash) as a stablecoin with good transparency; its issuer, Circle, is regulated by NY DFS. While Circle held USDC reserves in bank accounts and appears to have provided the public with the types of meaningful disclosure that regulators seek, some wonder whether such frankness, in a real-time, social media-driven world, may have increased the market’s skittishness.

Interestingly, despite all of the market turmoil, Tether’s stablecoin, USDT, never lost its $1 peg. Certain U.S. regulators have criticized USDT (which, as of March 9, reportedly exceeded 54% of the market share among stablecoins), expressing concerns about a relative lack of transparency concerning USDT’s reserves (much of which appears to be held in the form of less-liquid commercial paper) and the potential for systemic risk. It may be a fluke that holding stablecoin reserves in a more opaque way resulted in a more stable situation/price. Yet, some suggest that SVB’s very transparency to the market about SVB’s situation may have contributed to the bank run. 

Circle’s experience also may affect future U.S. federal regulation. In the wake of collapses of previously high-flying digital asset-related players like FTX, Celsius, Genesis, BlockFi, Three Arrows Capital and Voyager, some believe that the digital asset-related federal legislation most likely to be passed first would focus on stablecoins, instituting requirements relating to reserves (perhaps requiring fiat-backing), disclosures and reporting, similar to NY DFS’s existing rules. USDC’s depegging may affect the terms of any such federal legislation, including whether such stablecoin reserves should be held in smaller amounts spread across multiple banks – or whether they should be held in banks at all. Interestingly, some accused banks of introducing risks to crypto.

Impact on crypto liquidity

In addition to drawing regulatory attention, Silvergate’s, SVB’s and Signature’s failures have increased market focus on stablecoins and what backs them, the potential knock-on effects for structures that rely on stablecoins (notably, DeFi and collateral arrangements) and the availability of stablecoins themselves. 

Indeed, the disappearance of both the SEN and Signet real-time payment platforms is significant, because they provided the fiat-to-crypto “on ramps” and “off ramps” – 24 hours a day, seven days a week – via their respective instant settlement services. Although Circle reported having previously discontinued use of SEN, it relied on Signet for purposes of USDC minting and redemptions. 

While Circle swiftly found replacement banking partners, in the forms of BNY Mellon – an established “safe” name – for settlements, and Cross River Bank for USDC minting and redemptions, Circle disclosed that, for the time being, USDC minting and redeeming only could be effected during “business hours” – nearly a foreign concept for a digital assets industry accustomed to 24/7 trading. It remains to be seen what the move from a 24-hour market to a business hours market will mean for crypto liquidity. Some have suggested that so-called challenger banks may step-in to try to bridge the gap in 24/7 services. 

Crypto lives on

With the unforeseen failure of three key banks, and reported moves to separate digital assets from Globally Systemically Important Banks – and, perhaps, banks in general – where do we go from here? Many wonder whether the crypto industry will be pushed further and further offshore. It is, however, important to remember that crypto was not to blame for this crisis – arguably, fractional reserve banking was. SVB was not a crypto bank, and although Silvergate and Signature provided crypto payment settlement systems, both were smaller than SVB and also had many non-digital asset-related depositors. 

Indeed, Bitcoin was created in response to the last financial crisis, with a goal to avoid situations and risks posed by fractional reserve lending. Perhaps in response to uncertainties in the traditional financial sector, Bitcoin this week reached a 9-month high. Despite some calling the current banking crisis a death knell for crypto, others predict that it is Bitcoin’s moment to shine. In any event, one thing is clear: crypto lives on.

Hear more on this topic and the Digital Economy from our key Fintech voices in the U.S.: The Unbanking of Crypto // Fintech | The Linklaters Podcast (podbean.com)