US Fed, other regulators jointly warn banks of liquidity risks from crypto-related assets

The board of governors of the Federal Reserve System (Federal Reserve), the Federal Deposit Insurance Corporation (FDIC), and the Office of the Comptroller of the Currency (OCC) (collectively, the agencies) issued a statement about the liquidity risks presented by certain sources of funding from crypto-asset-related entities, and some effective practices to manage such risks.

In the statement, the regulators reminded banking organizations to apply existing risk management principles — which means it does not create new risk management principles.

However, banking organizations are neither prohibited nor discouraged from providing banking services to customers of any specific class or type, as permitted by law or regulation.

Jointly, the regulators highlighted key liquidity risks associated with crypto-assets and crypto-asset sector participants which banks should be aware of.

Firstly, it would be deposits placed by a crypto-asset-related entity that is for the benefit of the crypto-asset-related entity’s customers (end customers).

The regulators said, the stability of such deposits may be driven by the behaviour of the end customer or crypto-asset sector dynamics, and not solely by the crypto-asset-related entity itself, which is the banking organization’s direct counterparty.

Also, the stability of deposits can be influenced for example by periods of stress, market volatility, and related vulnerabilities in the crypto-asset sector — which may or may not be specific to the crypto-asset-related entity.

“Such deposits can be susceptible to large and rapid inflows as well as outflows when end customers react to crypto-asset-sector-related market events, media reports, and uncertainty,” the regulators added.

Further, they said, this uncertainty and resulting deposit volatility can be exacerbated by end-customer confusion related to inaccurate or misleading representations of deposit insurance by a crypto-asset-related entity.

Second would be the deposits that constitute stablecoin-related reserves. As per the regulators, the stability of such deposits can be linked to demand for stablecoins, the confidence of stablecoin holders in the stablecoin arrangement, and the stablecoin issuer’s reserve management practices.

On this, they said, “such deposits can be susceptible to large and rapid outflows stemming from, for example, unanticipated stablecoin redemptions or dislocations in crypto-asset markets.”

In a broader spectrum, the regulators also said, when a banking organization’s deposit funding base is concentrated in crypto-asset-related entities that are highly interconnected or share similar risk profiles, deposit fluctuations may also be correlated, and liquidity risk therefore may be further heightened.

Hence, the regulators’ direct banks to actively monitor the liquidity risks inherent in such funding sources and establish and maintain effective risk management and controls commensurate with the level of liquidity risks from such funding sources.

Some of the practices that the banks could use as per the regulators are:

– Understanding the direct and indirect drivers of the potential behaviour 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 such deposit accounts that, if inaccurate, could lead to rapid outflows of such deposits.

Lastly, the regulators asked banks to comply with applicable laws and regulations.

The year 2022 has gone down the history with bitter shocks for crypto markets with the collapse of major stablecoins, illiquidity, bankruptcies of leading crypto exchanges, free fall in trading volumes, and extreme volatility among others. The latest bankruptcy that has rocked the crypto market would be of FTX Group.