US crypto exchange, Coinbase, is facing regulatory scrutiny in the wake of financial contagion in the crypto industry – following the collapse of US crypto exchange FTX and crypto lending bank Silvergate.

Today’s (23rd March) warning by the US Securities and Exchange Commission (SEC) identified potential violations of US securities law, demonstrating a commitment to greater regulation of the largely unregulated crypto industry.

In January 2023, US federal agencies – including the US Federal Reserve – issued a warning to banks, dissuading them from serving crypto customers. And in February, The SEC issued a warning to stablecoin, Paxos, further demonstrating that crypto businesses are firmly on regulators’ radar.

FTX’s collapse, in November 2022, revealed a catastrophic failure of risk management and alleged fraud, which served as a wake-up call to other crypto businesses and policy makers alike. The ripple effects of FTX’s collapse were far reaching, including the liquidation US crypto lender, Silvergate bank.

GlobalData consultant analyst, Niklas Nilsson, says Silvergate’s problem was a classic case of poor risk management. “If Silvergate had held $13.3bn in cash, instead of in demand deposits, (deposited funds that can be withdrawn without advance notice) the bank run wouldn’t have impaired its capital,” explains Nilsson.

Like the financial institutions that collapsed in 2008, the centralised crypto exchanges and platforms that have collapsed in the past year have had an economic incentive to under-collateralise and take risks with user funds, says Nilsson.

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By GlobalData

Ideally, the financial contagion within the crypto industry will force crypto companies to manage their risk more effectively, says GlobalData analyst, Suneet Muru. “It’s highly likely we’ll see fiat-backed stablecoin companies putting a bigger proportion of their reserves into short-dated treasury bills for the time being, to limit exposure to banks,” says Muru.

But Muru doesn’t believe stabilising crypto banking services will be enough to end the crypto’s problems any time soon. “Crypto has too many of its own problems right now on the regulatory side,” he says adding that it will take a lot for investors to “wash the taste of FTX out of their mouths”.

Increased regulatory scrutiny will bring the demand deposit risk faced by crypto companies into sharp relief. Muru cites crypto company Circle’s fiat-back stablecoin USDC as an example. The company has a reserve split of roughly a quarter cash in banks and three-quarters short-term demand deposits, according to Muru.

Circle had around $3.3bn invested with Silicon Valley Bank when the bank collapsed (10th March 2023), which at the time was around 8% of their total reserves. In theory, if they were to lose all $3.3bn of this – which they won’t – it would value their stablecoin on paper as 1 USDC = $0.92 USD which is well below its purported pegging to the dollar.

Increased regulatory clarity would require crypto companies to provide greater transparency of liquidity and provide a framework for risk management. Industry insiders have been calling on policy-makers to fill crypto’s regulatory void for some time, with the rationale that the industry cannot grow without such oversight. Had FTX been required to disclose its liquidity to regulators, the crypto exchange would not have been allowed to operate in the way it did.

However, Varun Paul, market infrastructure director at blockchain company, Fireblocks, says that while transparency can help rebuild trust, crypto companies may need to be more open about their liabilities as much as their assets.

“The weakest institutions will remain at risk, and institutions that demonstrate sound risk management will be able to set themselves apart from the crowd. In periods of heightened uncertainty and anxiety, where deposits are flighty, there is a premium placed on liquidity. The asset base may need to be more liquid than in steady state, even if it yields a lower return.

Right now, everyone, everywhere in financial services, is laser-focused on risk management. That’s just as true for crypto as it is for traditional finance, and quite rightly so. Interest rate risk has come to the fore, and nobody wants to be the next Silicon Valley Bank,” says Paul.