BPInsights: November 19, 2022

Stories Driving the Week

FTX’s ‘Unprecedented’ Debacle: The Crypto Ledger

The fallout from FTX’s collapse continued to roil the crypto ecosystem this week in the wake of the exchange’s bankruptcy filing. FTX chief Sam Bankman-Fried sought a rescue, including from investing giants in Saudi Arabia and Japan, even as he revealed massive holes and entanglements in the firm’s books, Reuters reported. Another Reuters story reported how FTX “bought its way to become ‘the most regulated’ crypto exchange” through acquisitions. And FTX’s new CEO, John J. Ray, revealed the alarming extent of dysfunction at the crypto firm in a recent filing: Ray said FTX suffered a “complete failure of corporate controls” unprecedented in Ray’s decades-long career restructuring firms. Among the revelations in the filing: corporate funds used to buy homes for employees in the Bahamas, and Sam Bankman-Fried’s habit of communicating decisions to employees through messaging apps that auto-deleted statements. “From compromised systems integrity and faulty regulatory oversight abroad, to the concentration of control in the hands of a very small group of inexperienced, unsophisticated and potentially compromised individuals, this situation is unprecedented,” Ray said in the filing, covered by the Wall Street Journal.

  • Missing money: At least $1 billion of client funds is missing from FTX, Reuters reported this week. The exchange also may have been hacked soon after its bankruptcy filing.
  • Hidden and poorly labeled: A postmortem look at FTX’s balance sheet revealed major issues, according to the Financial Times. FTX held less than $1 billion in liquid assets against $9 billion in liabilities, and its balance sheet contained alarming elements like a negative $8 billion entry for “hidden, poorly internally labled [sic] ‘fiat@’ account”.
  • On the Hill: The FTX chaos is triggering new calls for crypto regulation and legislation on Capitol Hill. Both the House Financial Services Committee and Senate Banking Committee are planning FTX hearings. Lawmakers, including those on the Senate Agriculture Committee, are vying to craft a new framework for digital assets amid the vulnerability – but influence from Bankman-Fried may be a tricky piece of the puzzle: “[W]e took input from everybody involved who was interested in having a transparent system that provides accountability and regulation — so certainly we took his input,” Senate Agriculture Committee Chair Debbie Stabenow (D-MI) said in POLITICO.
  • SEC rule: Surveying the damage in FTX’s wake, Hal Scott and John Gulliver concluded in the Wall Street Journal that “[i]t didn’t have to be this way.” The crypto assets “should have been held, or ‘custodied,’ by regulated banks and broker-dealers, not by unregulated crypto exchanges,” but an SEC policy effectively precluding such activities “stood in the way,” the two wrote in an op-ed.
  • Worth noting: Wyoming crypto bank Custodia’s CEO called the FTX collapse “inevitable and foreseeable” in a recent interview – yet a senior executive from Custodia (formerly known as Avanti) sat on the board of FTX US Derivatives.

How a Regulatory Panel in Switzerland Quietly Shapes the Cost of Credit Around the World

The Basel Committee on Banking Supervision’s bank capital standards are non-binding, but its influence ripples throughout global banking. The Committee, whose members are not named publicly, formulates supervisory standards, guidelines and best practices that its members commit to promote. These standards and guidelines are not law, at least when they’re initially conceived, but they culminate in regulations that shape banks’ capital requirements and therefore the cost of credit to businesses and households. Despite the closed-door deliberations that form such standards, they end up exerting considerable force.

The Basel process is unique in American regulation – it has, in practice, the force and effect of a treaty, but has never been ratified by Congress, negotiated by the Administration or even approved by the banking agencies’ boards.

  • Local interpretation: Different jurisdictions, including the U.S. and the EU, implement Basel standards based on the requirements of each domestic political system. This has led to varying levels of willingness to deviate from the agreed standards across jurisdictions.
  • In the U.S.: Regulators in the U.S. implement Basel standards through notice-and-comment rulemaking, but their reluctance to deviate from the Basel standard creates tension with the Administrative Procedure Act, which aims to allow the public to participate in the rulemaking process. It’s highly unusual for the U.S. agencies to deviate from the Basel Accord except to make it more stringent.

Crypto Crash, Capital, Deposits: Bank Regulators on the Hill

Top banking regulators – Fed Vice Chair for Supervision Michael Barr, FDIC Acting Chairman Martin Gruenberg and Acting Comptroller Michael Hsu – answered questions on Capitol Hill this week at a pair of Congressional hearings. The regulators were joined by NCUA Chairman Todd Harper. Here are some key takeaways from their testimony.

  • Crypto: Senate Banking Committee Ranking Member Pat Toomey (R-PA) questioned the OCC’s approach to banks holding digital assets in custody for customers. Toomey suggested that the OCC discourages banks from providing crypto custody services and that, in the context of FTX’s failure to segregate customer assets, customers “might be able to sleep more comfortably” if they had access to custody services by a regulated financial institution. Hsu responded that there are some underlying fundamental questions around what it means to own crypto through custody that “have not been fully worked out,” and that if banks can demonstrate they can handle such activities in a safe, sound, fair manner “we’re all ears.” Toomey called for clarity on the topic – without it, he said, “the result is not that the activity doesn’t occur, it’s just that it goes somewhere where the regulation is often lax.” Barr also said “it would be useful for us to provide guidance” to banks on how to safely custody crypto-assets. Separately, Sen. Cynthia Lummis (R-WY) said her legislation with Sen. Gillibrand (D-NY) on crypto would have prevented FTX’s bankruptcy.  At the House hearing, Barr said that crypto crises’ have had a “relatively muted” impact on the banking system overall, and that banks have been cautious about crypto activity. Regulators are not currently seeing systemic risk from crypto activity, he said. He called for regulators to use their existing authorities to oversee crypto, and that Congress should strengthen oversight if it steps into the crypto space.
  • Stablecoins: Barr said at the House hearing that it was “critically important” that any stablecoin legislation has a strong role for Federal Reserve approval, supervision and regulation. Stablecoin issuers should have strong prudential oversight and consumer protections in place so that “we don’t see the kind of shenanigans that we’ve witnessed in the crypto space in recent times,” he said.
  • Capital: Barr said at the Senate hearing that he had not reached a conclusion yet in his review of the capital framework, and previewed that he would have “more to say” in the first quarter of 2023. He said he was considering how regulators should set capital requirements across economic cycles and the right level of capital within the system. Barr received questions from Sen. Thom Tillis (R-NC) on higher capital requirements during an economic slowdown and from Sen. Mike Rounds (R-SD) on the SLR, CCyB, stress testing and GSIB surcharge in the Fed’s capital framework review. In response to Sen. Rounds, Barr said if the review requires the Fed to revise a rule like the eSLR, the CCyB or similar items, they would seek public comment as part of the process. He also said capital in the financial system today is strong, and the point of the holistic review is to assess how the capital rules are working together. “Saying something [is] strong doesn’t necessarily answer the question, ‘is it strong enough?’” he said.
  • Treasury market: House Financial Services Committee Ranking Member Patrick McHenry (R-NC) asked Barr about liquidity in the Treasury market and warned of the potential risks of the Fed having to intervene. Barr acknowledged volatility in that market and outlined steps that the Fed and SEC are taking to bolster liquidity, including the Fed’s two new standing repo facilities.  “It is my hope that you can address this before we have some unfortunate event that could have severe consequences,” McHenry said. Barr did not directly address a question from Rep. Ann Wagner (R-MO) on whether he agreed with Fed Governor Michelle Bowman that addressing leverage-ratio issues could improve market functioning and stability. At the House hearing, Barr reiterated that the Fed is looking at the eSLR, but said capital standards rank low on the list of reasons concerning liquidity constraints in the Treasury market.
  • CBDC: Barr said at the House hearing that a CBDC would require clear support from the executive and legislative branches, “and, ideally, that would be in the form of authorizing legislation.”
  • Climate: Barr noted at the House hearing that the Fed’s upcoming climate scenario analysis pilot does not have capital or supervisory implications.
  • Deposit insurance assessment rates: Sen. Rounds questioned the FDIC’s Martin Gruenberg about the agency’s decision to raise deposit insurance assessment rates until the deposit insurance fund reaches a designated reserve ratio of 2%. Rounds noted the potential harm, particularly to community banks, of that measure, and asked whether 2% was an arbitrary number. Gruenberg declined to address the 2% target, which is an internal FDIC target, and focused exclusively on defending the FDIC’s decision to increase assessments as necessary for the DIF to hit the statutory 1.35% minimum before 2028 (something Gruenberg said wouldn’t happen without the increase).  Many experts believe the FDIC’s projections are based on bad assumptions, and that the DIF could hit the 1.35% target as early as the first quarter of 2023, without the increase.  If this happens, it would call into question the underlying rationale for FDIC’s policy decision, described by Gruenberg this week as a “tricky call to make.”
  • FDIC supervisory appeals: Sen. Jerry Moran (R-KS) expressed consternation about the FDIC’s decision to replace the Office of Supervisory Appeals with the SARC, a less neutral alternative to hear bank appeals of examination-related determinations. Gruenberg noted that the FDIC has proposed some changes to the process including adding the ombudsman to the SARC as a nonvoting member. “It may not be fully satisfactory, but we’ve tried to take a balanced approach to this,” Gruenberg said in response to Sen. Moran.

‘The Law and the Chain’: Why Crypto Rules May Never Contain the Chaos

The following excerpt from the Nov. 14, 2022, edition of Bloomberg’s Joe Weisenthal’s “Five Things to Know to Start Your Day” offers some of the clearest, most insightful commentary to date on crypto regulation and the FTX collapse. Read it below or here.

The collapse of FTX may accelerate efforts to come up with clearer and stronger crypto regulatory guidelines in the US. You could imagine greater transparency for companies that service the industry. Maybe minimum disclosure requirements for crypto projects listed on centralized exchanges and so on. But on some level it’s hard to imagine any of them being effective, for a variety of reasons.

Chief among them is the fact that crypto and the regulatory apparatus are like oil and water.

Currency (fiat currency, that is) is a creature of the law. The law governs what you can do with your money. Who has the money. What constitutes legitimate transactions. When a transaction is deemed illegitimate it can be reversed. When money is acquired illegally, it [sic] be be disgorged. Mistakes and errors and hacks happen in the traditional banking system, and then in theory legal authorities step in and clean things up.

But a cryptocurrency is not a creature of the law. The rules about who can own it, and what constitutes a legitimate transaction are governed by a separate system: the consensus mechanism of a given blockchain.

And so any given coin that’s held at a regulated entity is essentially governed by two different regulatory entities: the law and the chain.

We saw this vividly on Friday night, when there were hundreds of millions in unauthorized crypto withdrawals from FTX just hours after the company filed for bankruptcy.

Here you have a Chapter 11 bankruptcy, which prescribes rules about who can do what with a company’s assets while it goes through a legal restructuring. But then you have someone with access to the corporate’s wallets that can just ignore those rules entirely and operate by a separate set of rules: Those of the blockchain. The chain doesn’t know anything about Chapter 11. To the chain, those were just normal, rule-abiding transactions.

Now it’s possible that the coins can be traced in some way and returned. But it’s tricky. And by and large, irreversibility of transactions (settlement finality) is considered to be a feature, not a bug.

So there are theoretical safeguards that can be put in place to prevent unauthorized transactions and greater security and more transparency and so on. But fundamentally, what a blockchain does is attempt to recreate functions of government, by creating a new, decentralized approach to allocating property rights (Person A owns that. Person B owns this. They both owe debt to Person C). Governments do the same thing. And so the idea of regulated crypto may be an oxymoron, because it makes coins subject to two competing regulatory and legal systems at the same time.

New Industry Whitepaper Advances Debate on the Future of Money

This week, BPI welcomed the release of a new whitepaper aimed at advancing the policy debate regarding the future of money. The paper, published by a group of payments industry participants, outlines a distributed ledger technology solution called the Regulated Liability Network. The RLN presents one potential avenue for upgrading sovereign currency systems with shared ledger technology.

What BPI is saying:
“The RLN is an intriguing concept. It promises to bring potential efficiencies from distributed ledger technology to the world of payments, without creating the same financial stability and economic growth problems of a central bank digital currency. With RLN, commercial bank money and central bank money maintain their current roles, but both could transfer on a blockchain. As a result, they could displace other less regulated and less safe money-like instruments whose current selling point is 24*7 on-chain availability,” said Greg Baer, BPI president and CEO.

What’s at stake:
The future of money is often presented as a binary choice – a digital money exclusively issued by central banks (in the form of central bank digital currency) or by non-regulated issuers. The RLN demonstrates that shared ledger technology may be applied to all regulated monies (e.g., central bank money, commercial bank money and e-money) on a common platform.

One potential solution:
Blockchain technology has created a wave of innovation at the edge of the regulatory perimeter. The RLN whitepaper is written in support of sovereign currencies and might point the way to a more functionally rich financial system that is still compliant with all existing laws and regulations. The whitepaper doesn’t present the RLN as the only answer; rather, it seeks to offer one potential alternative that fits between CBDC and stablecoin proposals.

The objective:
As the policy debate around the future of money continues to take shape, the RLN seeks to offer a potential solution that helps ensure the supremacy of the sovereign currency system and confront potential challenges from the growth of non-regulated, non-sovereign currencies.

Financial Trades Call for Accessible, Functional and Simple cyber Incident Reporting Rules

BPI, the American Bankers Association, Institute of International Bankers and the Securities Industry and Financial Markets Association responded this week to a Cybersecurity and Infrastructure Security Agency (CISA) request for information on new cyber incident reporting requirements, established by the Cyber Incident Reporting for Critical Infrastructure Act of 2022 (CIRCIA). The associations urged CISA to prioritize reporting requirements that are accessible, functional and simple and to carefully weigh the type and volume of data collected so that it remains useful to prevent systemic vulnerabilities and combat bad actors.

“Effective visibility, awareness and coordinated information sharing between the public and private sectors are critical during a cyber incident, and reasonable incident reporting to government entities can help disrupt attackers and assist affected firms with protection, mitigation and response,” the associations wrote. “We urge CISA to recognize this as an opportunity to demonstrate needed leadership and ensure that where there are requirements for incident reporting, they are simple, tied to an actionable purpose and bidirectionally useful.”

To learn more, click here.

In Case You Missed It

Treasury Calls for Fintech Oversight, Secure Data Sharing in New Report

A new Treasury Department report outlines the risks and benefits of fintech and Big Tech in consumer financial services. The report lays out the landscape of a financial services market where nonbank firms have made significant inroads – nonbanks’ large market share in residential mortgages, for example. While the report notes potential benefits of tech involvement in consumer finance, it also calls for caution on topics such as financial inclusion: “The entrance of non-bank firms into consumer finance … has often come under the banner of expanding access and inclusion. These claims need to be scrutinized to understand the extent to which these firms may actually be serving financially excluded consumers,” the report says. Here are other noteworthy highlights.

  • Competition: The report describes the potential for Big Tech firms to become entrenched in financial services markets and harm competition. It also notes that consumer financial markets have transformed since the DOJ’s 1995 Bank Merger Review Guidelines, and expresses support for a review of bank merger oversight policies. Traditional measures of bank concentration may not capture the market share and competitive effects of nonbank firms, the report notes. The prevalence of online services has also complicated how some banking products are categorized geographically.
  • Regulatory gaps: The report expresses concern about regulatory arbitrage by nonbank firms, such as tech firms seeking ILC charters that threaten to mix banking and commerce. Fintech firms could exploit the difference in regulatory scrutiny between banks and nonbanks, and such regulatory gaps pose risks.  
  • Bank-fintech relationships: The federal banking regulators should implement a clear and consistent supervisory framework for bank-fintech relationships, the report says. Such partnerships have grown in recent years, according to a citation in the report.
  • Data sharing: The federal banking agencies and CFPB should promote a more unified approach to overseeing consumer-authorized data sharing, the report recommends. The CFPB’s Section 1033 rulemaking on the topic could “resolve a number of open policy questions regarding consumer financial data access and data sharing.” The report also noted concern about the growing stores of data held by data aggregators who are generally not subject to supervision of their data practices.

NY Fed Staff Report Notes Banks’ Strength, Resilience

A recent New York Fed staff report illustrates banks’ high resilience on multiple measures. “Overall, the banking system shows historically low vulnerability according to our four measures, reflecting historically high capital ratios and liquid assets related to post-crisis capital and liquidity regulations and to Federal Reserve balance sheet policy,” the report notes. The report measured banks’ resilience according to several capital and liquidity metrics.

Treasury to Propose Public Disclosure of Some Treasury Market Trade Data

The Treasury Department will propose that transaction data for the most widely traded Treasuries – “on-the-run” bonds – be released daily starting early next year, according to the Financial Times. There will likely be some limits on reporting based on trade size, according to the article. Under Secretary for Domestic Finance Nellie Liang said Treasury would consider, in the future, releasing data about other bonds and requiring reporting of transactions within an hour rather than by the end of the day. “The work to improve data quality and availability in the Treasury market was developed to support the official sector’s ability to assess market conditions and preparedness to respond to market stresses, and also to provide transparency that fosters public confidence, fair trading, and a market ecosystem that provides for more resilient and elastic liquidity,” Liang said.

  • Context: The Treasury market has experienced notable liquidity pressures recently, partly due to regulatory factors such as the supplementary leverage ratio that inhibit large banks’ ability to make markets in Treasuries. The Treasury Department, SEC and other agencies are looking at ways to bolster the market’s liquidity, but one solution that would be powerful and could be implemented relatively quickly would be to overhaul the SLR and certain other banking regulations to enhance bank-affiliated primary dealers’ market-making capacity.

CFPB Bids for Supreme Court Review of Funding Structure Case

The CFPB and U.S. Solicitor General this week petitioned the Supreme Court for a writ of certiorari to review the Fifth Circuit decision that ruled the Bureau’s funding structure unconstitutional. The agency requested that the Court consider the petition at its Jan. 6, 2023 conference and hear the case during its April 2023 sitting. The CFPB argued that the Fifth Circuit erred in declaring the CFPB’s funding mechanism unconstitutional because “text, history and precedent” establish the constitutionality of the CFPB’s funding structure.  The petition also urged the Court to review the circuit court ruling because of its “enormous legal and practical consequences” that complicate the Bureau’s enforcement actions. “New challenges to the Bureau’s rules and other actions can be expected to multiply in the weeks and months to come, and will presumably be filed in the Fifth Circuit whenever possible,” the CFPB and Solicitor General wrote. “Those legal consequences have major practical effects. The CFPB’s critical work administering and enforcing consumer financial protection laws will be frustrated. And because the decision below vacates a past agency action based on the purported Appropriations Clause violation, the decision threatens the validity of all past CFPB actions as well.”

BPI’s Nelson Speaks on Financial Stability Panel

On Thursday, BPI’s Chief Economist, Bill Nelson, spoke on a panel about Macroprudential and Monetary Policy at the Cleveland Fed and OFR’s annual conference on financial stability.  Nelson presented his recent note “Bank Examiner Preferences are Obstructing Monetary Policy,” described how a strong and liquid banking system helped the Fed keep the severe financial shock from COVID from becoming another multiyear financial crisis (see here), and summarized a recent BPI panel discussion about how the outlook for QT depends on the outlook for the ON RRP facility (see “How the Overnight Reverse Repurchase Agreement Facility Could Derail the Fed’s Path to Getting Smaller”). 

What’s in the Fed’s Supervision and Regulation Report

The Federal Reserve released its latest semi-annual Supervision and Regulation Report. Here are some key takeaways.

  • Robust banks: The vast majority of banks remain sound and resilient, the report noted. The banking industry demonstrates capital and liquidity above regulatory minimums, loan growth and higher interest rates are boosting net interest margins and bad loans remain low, according to the report.
  • Barr’s regulatory agenda:  The Fed has taken several actions since its last report was published in May including guidance on crypto-related activities.  The report reiterates new Vice Chair for Supervision Michael Barr’s top priorities going forward, such as capital, bank merger policy review, resolution planning, stablecoins and crypto, CRA and climate-related financial risk.
  • Supervisory priorities for large banks:  Supervisors are focused on matters such as remediation of previously identified findings and risks from changing economic conditions.  Supervisory priorities for large banks in 2023 include: financial risks affected by changing economic conditions, including interest rate risk and credit risk, asset/liability management and stress testing, operational resilience, third-party risk management, firm remediation efforts on previously identified MRAs, and resolution planning, among other topics.
  • LIBOR: Fed supervisors continue to monitor banks’ efforts to transition away from LIBOR, the report says, noting “substantial progress” in updating contracts with new alternative benchmark rates but cautioning that the volume of legacy U.S. dollar LIBOR contracts remains high.
  • Climate: The Fed plans to work with the OCC and FDIC to propose interagency guidance on climate risk for large banks to help them incorporate such risk into their risk management frameworks, the report noted. The report also flagged the upcoming climate scenario analysis pilot exercise forthcoming in 2023 with six large banks participating.

Wells Fargo Launches ‘Flex Loan’ Small-Dollar Product

Wells Fargo this week announced the launch of a new small-dollar loan option. The “Flex Loan” product offers millions of eligible customers the flexibility to meet short-term cash needs.

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The views expressed do not necessarily reflect those of the Bank Policy Institute’s member banks, and are not intended to be, and should not be construed as, legal advice of any kind.