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Traditional Finance and the Need for Crypto Regulation

This article is a full version of our latest series: “Traditional Finance and the Need for Crypto Regulation”

Last month in May 2022, the crypto industry experienced a shocking event that wiped out nearly $30 billion from the ecosystem, the Terra UST de-peg event. This event is fundamentally similar to a bank run which has happened numerous times historically and it is important to understand why bank runs happen and why regulations were created.

In this blog post, we will take a deep dive into historical bank run events and how regulators were instrumental in addressing the problems.

Depression-era bank runs occurred in a number of ways, but the most common was a sharp drop in investor confidence — as we might see with today’s algorithmic stablecoins.

Americans were understandably anxious about their money after the massive stock market crash of October 1929. The wealthy began shrinking their investments and consumer spending fell sharply. In 1929, some 650 US banks failed.

The next year the number doubled and confidence in US financial institutions collapsed. Finally, when a sizable number of depositors withdraw, or request to withdraw, their funds from the same bank around the same time, the financially devastating snowball has been kicked downhill.

Banks, let’s not forget, do not hold all of the deposits of all their clients in-house at any one time, but lend them out to borrowers or use them to build or buy assets. This brings to mind perhaps the best-known example of a bank run — which did not actually happen.

After a few sizable withdrawals, a bank might have limited reserves on hand. If a word starts to spread about the bank’s limited ability to pay out, anxiety is sure to follow, spurring still more withdrawal requests. Bank officials might then quickly move to recall loans and liquidate assets at emergency prices, but often there’s just not enough time. Amid high financial anxiety, the mere appearance of being unwilling to pay out can tip the scales.

The bank’s downfall likely began two years prior, in 1928, when it started selling shares to depositors to raise funds. Possibly taken in by the bank’s name, which suggested powerful backers, immigrants and working-class locals were the bank’s primary clients. Today, we might call them “the unbanked,” as most found it difficult to access financial services in New York City on their meager incomes and savings. Immigrants likely viewed an account at Bank of United States, not to mention stock holdings, as a step toward financial stability and respectability.

Few would view today’s crypto investors as akin to the immigrants and Jews of a century ago, who were among the more maligned minorities. Yet, it may not be much of a stretch to argue that the dominant traditional financial institutions of our era have a similar bias against crypto.

The up-and-comers not only pose a threat to their industry and status — a twist on replacement theory — but they tend to be seen as “new money” arrivistes, untrained in the ways of modern finance and undeserving of the riches so many of them flaunt. Thus, it would come as little surprise to learn that some of these institutions, hearing of their drowning crypto brethren, might have decided against throwing out a lifeline.

Rumors have swirled that a top investment firm, leading market maker and crypto exchange worked to precipitate the collapse. All of them have denied the charge, and we may never know exactly what happened with Terra. But whether or not the collapse was intentionally engineered is largely immaterial. What’s clear is that a major pull-out from Anchor shook investor confidence, kicking off a domino effect.

It’s largely about investor confidence, or the lack thereof, and regulatory support can provide a sturdy backbone. Without it, anxious investors might be left with nothing more than hopeful encouragement.

“We can get through this thing all right,” George Bailey urged the panicky crowd at the Building & Loan. “We’ve got to stick together, though. We’ve got to have faith in each other.”

Following the collapse of Bank of United States, similarly devastating bank runs continued into early 1933, when Franklin Roosevelt was inaugurated as president. He soon declared a national bank holiday, during which all banks would be closed until passing federal solvency inspection.

Roosevelt began his series of fireside chats that March with a solemn vow: “We do not want and will not have another epidemic of bank failures.” He called on Congress to devise banking legislation to support the country’s ailing financial institutions and, in June, signed the Banking Act of 1933 into law.

That landmark bit of legislation, also known as the Glass-Steagall Act, separated commercial and investment banking and created the Federal Deposit Insurance Corporation. Among other regulatory duties, the FDIC was tasked with insuring all deposits in eligible banks in the event of bank failure. Meant to end bank runs and restore financial confidence, the FDIC is widely considered a major success.

Twenty years before Bank of United States’ implosion, two Midwest banks merged in 1910 to form the Continental Illinois National Bank and Trust Company. Despite conservative roots, its management implemented a rapid-growth strategy in the 1970s, and by 1981 Continental had become the US’ largest commercial and industrial lender, with $40 billion in assets.

In the first quarter of 1984, the bank’s nonperforming loans jumped $400 million to $2.3 billion. On May 10, rumors of Continental’s insolvency sparked a massive run and depositors pulled out more than $10 billion. The next day the bank borrowed $3.6 billion from the Federal Reserve of Chicago. A few days later Continental accepted a $4.5 billion line of credit from a group of the US’ largest banks.

Still the run continued, and regulators began to fear a massive spillover if the country’s seventh-largest bank were to collapse. “The FDIC estimated that nearly 2,300 banks had invested in Continental Illinois, and nearly half had invested funds greater than $100,000, the deposit insurance limit,” says the Federal Reserve history.

On May 17, the FDIC gave the bank a $1.5 billion infusion of capital. The next day it announced that it would extend its support to depositors with funds beyond its $100,000 limit. Continental Illinois had become insolvent, the largest bank failure in US history up to that point, but governmental support, a sort of soft nationalization, enabled it to survive in a lesser form.

In July 1984 the FDIC said that it had failed to find a buyer and would provide permanent assistance, starting with the purchase of $4.5 billion of the bank’s bad loans. Stockholders were largely wiped out, but the FDIC protected bondholders and depositors, as promised. [The government pulled out of Continental Bank in 1991, and Bank of America purchased it in 1994.]

The larger the bank, the greater the risk of financial spillover, and thus the greater likelihood of significant governmental support. The problematic impact of this has been that financial institutions, grasping the advantages of size, will aim to grow as quickly as possible, potentially cutting corners and making more problematic investments en route. TBTF incentivizes over-sized banks, and possible risk-taking.

Congress sought to address this growth issue by limiting “too big to fail” rescues with the FDIC Improvement Act of 1991. The law limited the FDIC’s ability to protect creditors and the Fed’s ability to lend to troubled banks. Yet the other key issue raised by Continental’s failure — systemic risk, or the idea that one failure might ripple out, leading to other collapses and broader economic trouble — was left unaddressed for a quarter-century.

Enter Lehman Brothers, with $680 billion in assets, and its landmark bankruptcy filing in September 2008. Like Bank of United States and Continental, not to mention some crypto initiatives, Lehman embraced a high-risk model.

Relying on complicated financial products and presumed real estate growth, the firm needed to raise billions of dollars every day just to stay in business. It had invested heavily in subprime mortgages and, when these markets sagged, Lehman was unable to raise the necessary cash.

In March 2008, the US Treasury and Federal Reserve began looking for a buyer. Since it was an investment fund, the government could not nationalize Lehman as it done with Fannie Mae and Freddie Mac, not to mention Bank of United States. What’s more, Lehman lacked the assets to secure a massive government loan.

After Bank of America and Barclays pulled out of possible last-minute purchases, Lehman filed the largest bankruptcy proceeding in US history on September 15. The Dow Jones saw its worst one-day decline in seven years.

Two weeks later, after Congress rejected the Fed’s proposed $700 billion bail-out of troubled banks, the Dow experienced its largest-ever one-day decline to date. This came days after regulators had seized Washington Mutual (WaMu) and sold it to JPMorgan Chase for $1.9 billion. With $307 billion in assets, WaMu became the largest bank failure in US history, easily eclipsing Continental Illinois.

Lehman’s collapse also brought about the Dodd-Frank Wall Street Reform Act, the most far-reaching financial legislation since Glass-Steagall. Dodd-Frank, signed into law by Obama in July 2010, created the Financial Stability Oversight Council, which keeps an eye out for systemic risks.

To recap, the high-wire act of Bank of United States led to failure, spurring the creation of the US’ crucial financial oversight body, the FDIC; the problematic investments of Continental Illinois led to governmental stewardship, which created concerns about “too big to fail”; and the fall of Lehman and the resulting financial crisis paved the way for broader investor security and greater oversight of TBTF and systemic risk.

Each major collapse led to both broader economic difficulty and invaluable regulations. All of which brings us back to Luna, and the collapse that has shaken crypto.

Things may well get worse before they get better. But if history is any guide, it will be increased regulations that ensure a full recovery, and a bright future for crypto.

The FDIC is far from perfect, but it serves its purpose, providing a crucial safety net in choppy financial seas. That’s just one reason stablecoin issuers like GMO Trust keep 100 percent of their reserves in cash or cash equivalents.

Time for Crypto to Face the Music

About a year ago, US officials began laying out an aggressive approach to regulating cryptocurrency, starting with stablecoins. The market turmoil of recent weeks has accelerated these efforts, which is mainly a good thing for the industry.

The collapses of Luna and Celsius and the broader subsequent market trouble echo the bank runs and financial disasters of previous decades — and would, similarly, be best addressed via increased oversight and regulation. Once revealed, the problematic investments of Bank of United States and Continental Illinois made investors skittish and desperate to recoup their investments asap. Decades later, Lehman Brothers relied too heavily on subprime mortgages and its house of cards collapsed along with the housing market. In all three cases, regulatory responses added increased oversight, significantly reducing risk and increasing stability.

Regulators Prepare

In November, the US President’s Working Group on Financial Markets published a report on stablecoins that highlighted risks to market integrity and investor protection, including possible fraud, terrorist financing and money laundering, and trading misconduct such as market manipulation, insider trading and front running, as well as risks to the broader financial system. “If stablecoin issuers do not honor a request to redeem a stablecoin, or if users lose confidence in a stablecoin issuer’s ability to honor such a request, runs on the arrangement could occur that may result in harm to users and the broader financial system,” argued the report, peering successfully into the near future. The Working Group, the FDIC, and the Office of the Comptroller of the Currency (OCC) went on to jointly “recommend that Congress act promptly to enact legislation to ensure that payment stablecoins and payment stablecoin arrangements are subject to a federal prudential framework on a consistent and comprehensive basis.”

The report also encouraged legislation to be flexible yet comprehensive and complement existing authorities while aiming to minimize stablecoin user risk by requiring stablecoin issuers and any holding company or parent to: be insured depository institutions subject to supervision and regulation; require wallet providers to be subject to federal oversight; and enable the federal supervisor of stablecoins to require that any entities critical to the functioning of a stablecoin to meet certain risk management standards.

In March, President Joe Biden issued an executive order on ensuring the responsible development of digital assets. The order highlighted the remarkable growth of digital asset markets (from $14B to $3T in five years ending Nov 2021) and the implications for consumers, investors and businesses and risks to financial stability. “We must take strong steps to reduce the risks that digital assets could pose to consumers, investors, and business protections; financial stability and financial system integrity…US should ensure that safeguards are in place and promote the responsible development of digital assets to protect consumers, investors, and businesses.”

Biden also went into illicit finance and crime, including fraud, money laundering, terror financing, as well as the underbanked and privacy. The issue of money laundering has become more urgent for policymakers in the wake of Russia’s invasion of Ukraine, with officials fearing that Russia could use stablecoin and crypto tools to evade sanctions. This is an important concern, yet it’s largely beyond the scope of this post, which is focused on stablecoins and regulations that might limit the risks they pose to users, investors, businesses and the financial system. On that last issue, Biden smartly added that “We must reinforce United States leadership in the global financial system and in technological and economic competitiveness, including through the responsible development of payment innovations and digital assets.” Thus, smart, effective regulation for crypto will not only stabilize the industry but also help keep the US at the forefront of digital innovation.

Biden went on to outline his stance on a Central Bank digital currency. “My Administration places the highest urgency on research and development efforts into the potential design and deployment options of a United States CBDC.” Such a currency could strengthen the dollar and solidify its international position, which would in turn strengthen stablecoins linked to the dollar. As part of a “whole of government” approach to crypto, Biden’s Executive Order urged the Federal Reserve to outline a plan and required most government bodies — Treasury, State, Attorney General, Commerce, Homeland Security, Office of Management and Budget, National Intelligence and “other relevant agencies” — to submit, by September, a report on money and payment systems, digital assets, likely impact of a CBDC, the implications for the US financial system, and more.

Crypto’s Response

Balancing DeFi and TradFi

Presumably, under pressure from their investors, major crypto firms like Coinbase, BlockFi, and Crypto.com have announced big layoffs, blaming it on a looming recession. But these moves are less about a recession than about earlier bets placed on hypergrowth that has suddenly vanished. The risk now is that many tokens could be delisted, which would dam the revenue stream for many companies just as looming regulations mean that many will need a lot of cash on hand for attorney fees. As part of a massive conglomerate of more than 100 companies, GMO Trust is largely free from these concerns.

Due to the stringency of AML and KYC standards, regulators will likely never accept the permissionless aspect of crypto trading — or not at least until they are confident that the industry’s infrastructure is solid and secure. Crypto players will in the meantime have to sacrifice the competitive advantage of anonymity and begin to identify users in order to enter the mainstream economy. Questions remain, however, about the use of avatars and handles and whether many of the more advanced crypto users could still evade identification even within a permissioned protocol like Aave Arc.

Regulators, too, should also aim to strike a balance between protecting retail customers and stifling innovation. The question is whether they will be able to appreciate that meaningful innovation in crypto mainly occurs within the rubric of “what we can’t get away with within traditional finance”. “The new and unique uses and functions that digital assets can facilitate may create additional economic and financial risks requiring an evolution to a regulatory approach that adequately addresses those risks,” Biden said in his executive order. We are still finding our way to the appropriate legislative and regulatory measures, the optimal forms of oversight and compliance enforcement.

Want to read more? Check out our blog for more stories.

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