Examining the intersection of cryptocurrency and government

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Welcome to State of Crypto. Here’s what’s important in policy news this week:

Silvergate Bank had a really rough week, to the point where a not-insignificant number of people were waiting for the Federal Deposit Insurance Corporation (FDIC) to announce the bank had entered receivership after close of business Friday. 

— Nikhilesh De

(Tim Grist Photography/GettyImages)

Silvergate Bank announced last week it had to delay filing its annual 10-K form because of questions it received from its independent auditors. In the same form, under the “forward looking statements” section, Silvergate announced it was facing bank regulator inquiries, a U.S. Department of Justice investigation, congressional scrutiny and concerns about its ability to be a “going concern” over the next year. Generally speaking, these are all bad signs.

Silvergate is (was?) the bank in crypto. It counted some of the industry’s biggest firms (in the U.S.) as its clients. The fact it’s now in a position where it may soon fold is not a good signal for the rest of the industry, and gives regulators a prime example of what happens if the banking sector gets too close to crypto. 

Silvergate had a really bad week. Its stock is down 61% over the past week, with the bulk of that fall coming last Thursday, dropping its stock (SI) to $5.41. It’s actually down 94% over the past year, and obviously a bit lower than its all-time high of $212.

It’s not inconceivable the bank will have to enter receivership in the near future. It may still recover – the bank may have more capital than we realize, or it may receive a rescue package from an investor – but a lot of its most prominent crypto clients have already left, and the bank shut down its most attractive product, the Silvergate Exchange Network, last Friday. 

Silvergate appears to have sold off billions of dollars worth of bonds at a market loss to keep up with withdrawals, which in turn meant it no longer met certain regulatory requirements that indicated it was perfectly fine.

Bloomberg’s Matt Levine explains it much more clearly in a newsletter from last week. Elizabeth Lopatto over at The Verge explains both what happened and some of the impacts to businesses. 

The main result is that crypto firms are going to have to look for other banks. Some companies will find this easier than others. The established titans of this industry will, I imagine, not have too many difficulties. If you’re a company with a history of operating without major issues, you’ll probably be able to convince a bank that what happened to Silvergate wasn’t your fault (and in a sense, it wasn’t). 

If you’re starting an enterprise, it may be more difficult. Startups in this industry have traditionally had difficulty gaining banking services, and that won’t be made easier by federal bank regulators warning financial institutions under their charge that they need to be careful, or maybe need permission, when dealing with crypto. 

On Monday, White House Press Secretary Karine Jean-Pierre said the Biden administration was monitoring the situation, and that U.S. President Joe Biden would continue to call on Congress to do something. This isn’t likely to reassure banks either, to the extent they may want to wait for Congress to act. 

Banking services like deposits aside, companies may also have issues with accessing payment services, at least in the short term. Circle, for example, has already cut off its ACH support, at least temporarily. 

A spokesperson pointed to Silvergate. “Amid growing concerns about Silvergate Bank, Circle has accelerated plans to deprecate some services and transition others to additional banking partners, completing a process that began last year to reduce risk to our customers, our business and USDC. We are communicating with customers and have taken steps to ensure access to customer funds via alternative payment and redemption channels,” the spokesperson said in a statement. 

All of this will become a backdrop to the regulatory response. Bank regulators have already gone out of their way to warn about crypto. But beyond that we’ve already heard from officials such as Acting Comptroller of the Currency Michael Hsu, who warned months ago there may be “contagion risk.” Just this week Hsu gave another speech, where he said last year’s FTX collapse reminded him of a major bank failure, Bank of Credit and Commerce International (BCCI). 

To date, despite the fall of FTX and the dozen or so bankruptcy filings last year, there hasn’t been a huge risk of contagion from crypto to the traditional financial sector. That may finally be changing. 

To be clear, Silvergate didn’t fail merely because it banked crypto. But if crypto companies rushing to withdraw their funds – creating a bank run – led to Silvergate needing to sell off its bonds, which in turn led to it being under-capitalized, which has now led to the bank coming close to receivership, then this was another victim of last year’s massive failures and evidence of that contagion risk. 

Regulators are likely to continue warning that crypto is fraught with danger, and have a perfectly primed example to point to. 

It remains to be seen if Silvergate really does fail or if it finds a path to survival. It also remains to be seen just who will pick up its former clients – Signature Bank, the next-friendliest bank to crypto, or another of the myriad institutions out there or even a crypto-native company that has successfully run the gauntlet of the Federal Reserve Board application process.

Grayscale Investments has finally had its chance to argue the U.S. Securities and Exchange Commission has no choice but to allow it to convert its Grayscale Bitcoin Trust (GBTC) product into an exchange-traded fund (ETF).

To recap: In June the SEC rejected Grayscale’s bid to convert GBTC to an ETF, citing common refrains about a lack of a robust surveillance-sharing agreement with a national securities exchange, the potential for market manipulation. Hours later, Grayscale appealed the decision, filing suit in the D.C. Circuit Court of Appeals in Washington, D.C. 

Disclosure: Grayscale is a subsidiary of Digital Currency Group, the parent company to CoinDesk. 

Grayscale received support in the form of five different amicus (friend of the court) briefs, signed by The Blockchain Association, Chamber of Digital Commerce, Coin Center and the Chamber of Progress; Coinbase; the Chamber of Commerce; NYSE Arca; and a group of individuals. 

Grayscale’s main argument seems pretty straightforward: It’s arguing the SEC’s decision to disapprove its GBTC conversion – or indeed, any spot bitcoin exchange-traded product – despite its past approvals of bitcoin futures ETFs is “arbitrary to its core.” 

“Its central premise – that the Exchange’s surveillance-sharing agreement with the CME provides adequate protection against fraud and manipulation in the bitcoin futures market but not the spot bitcoin market – is illogical. Any fraud or manipulation in the spot market would necessarily affect the price of bitcoin futures, thereby affecting the net asset value of an [exchange-traded product] holding either spot bitcoin or bitcoin futures as well as the price investors pay for such an ETP’s shares. Either CME surveillance can detect spot-market fraud that affects both futures and spot ETPs, or that surveillance cannot do so for either type of ETP,” the company said in its summary. 

The company also argued the SEC was inconsistent about how it approached futures markets. 

For its part, the SEC argued that futures-based ETFs and spot ETFs “are fundamentally different products,” with different surveillance-sharing agreements and oversight mechanisms. 

In a brief, the SEC tried to draw a clear distinction between bitcoin futures and spot bitcoin markets, saying the futures products it regulates hold underlying assets that either trade only on CME – namely, cash-settled bitcoin futures – or cash and cash equivalents. Grayscale’s proposed ETF would be based on actual bitcoin, which could trade on any crypto exchange, including those overseas. 

Similarly, for futures products, CME has surveillance-sharing agreements with NYSE Arca and Nasdaq, the SEC said, once again noting that CME is where the actual bitcoin futures contracts trade. 

“Because of CME’s comprehensive surveillance measures and the one-to-one relationship between the regulated market (the CME) and the underlying assets (CME-tradable bitcoin futures), the Commission concluded that CME’s surveillance ‘can reasonably be relied upon’ to capture the effect of attempts ‘to manipulate the proposed futures ETP by manipulating the price of CME bitcoin futures contracts, whether that attempt is made by directly trading on the CME bitcoin futures market or indirectly by trading outside of the CME bitcoin futures market,’” the SEC’s filing said. 

The judges seemed largely skeptical of the SEC’s arguments.

If you’ve got thoughts or questions on what I should discuss next week or any other feedback you’d like to share, feel free to email me at nik@coindesk.com or find me on Twitter @nikhileshde. 

You can also join the group conversation on Telegram. 

See ya’ll next week!

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