Lack of Crypto Regulation Limits Further U.S. Bank Participation

Fitch Ratings-New York/London-26 October 2022: In response to growing client interest, some U.S. banks are emerging to play important roles in digital assets and the distributed ledger technologies underpinning them, often referred to as blockchain. However, the lack of a federal regulatory framework will likely limit U.S. bank participation in the near term, as other jurisdictions outside the U.S. market finalize their regimes, Fitch Ratings says.

BNY Mellon recently began accepting bitcoin and ether from customers, becoming the first U.S. bank to store digital assets and traditional investments on the same custody and accounting platforms after receiving approval by the New York Department of Financial Services (NYDFS). U.S. banks have generally taken an asset-light approach to digital assets, offering custody and collateral settlement via blockchain networks and issuing stablecoin-based payment solutions, as finalized prudential requirements will result in punitive capital treatments for on-balance sheet exposures.

Growing tokenization of assets and the use of private distributed ledger technologies may enable fee-earning opportunities while reducing the transaction costs of intermediaries and accelerating the time to settlement for less liquid asset classes. Depending on the ultimate form of potential federal regulation, stable coins could allow for fractional reserving similar to deposits, which could create more profitable opportunities for stable coin issuers than if full reserving were required.

However, banks will likely tread cautiously until there is a comprehensive and ideally globally-coordinated regulatory framework given heightened fraud risk, cybersecurity concerns, and operational risks, as evidenced by several widely publicized crypto market failures such Celsius, Voyager, and algorithmic stable coin Terra/Luna. Traditional risks including market, regulatory, liquidity and counterparty risks also apply to digital asset participants but are exacerbated by extreme price volatility. The relative nascence of the asset class creates additional uncertainties that are difficult to assess under a traditional risk framework.

Although federal regulatory agencies have yet to coordinate and establish a robust framework for institutions operating in the digital asset ecosystem, market risks to be addressed by regulation include correlation risks and hedge effectiveness, and risks from overleveraged transactions that can amplify losses across the ecosystem. Regulators are also focused on investor and consumer protections and disclosures given the pervasiveness of fraud and potential for market manipulation in light of recent digital asset failures and bankruptcies.

Outstanding legal and accounting uncertainties include reserving and auditing requirements for assets backing stable coins, crypto asset classification and accounting treatment, segregation of digital assets in bankruptcy for custodians, asset/liability measurement and regulatory capital and financial disclosure requirements.

Increased visibility from regulation and the accounting classification of digital assets as securities could accelerate the growth of digital assets by attracting more investors. The tentative decision on Oct. 12 by the U.S. Financial Accounting Standards Board’s (FASB) that would permit the use of fair value accounting for crypto holdings could also result in wider institutional adoption of digital assets. The previous accounting treatment of classifying stable coins as intangible assets required firms to mark them on their balance sheets at their lowest price during a given reporting period, without the ability to re-mark the values up should the price increase.

The NYDFS has been at the forefront of U.S. regulation on digital assets through its Bitlicense as well as several other regulatory initiatives including guidance for stable coin issuers operating in the state. However, a comprehensive legislative framework for digital assets at the federal level will likely need to be initiated through Congress, which is not likely to occur until after the mid-term elections.