The incredible boom in fintech and crypto banking is eroding long-standing protections for depositors and creating wider systemic risks.
Deposit insurance and depositor preference
If you deposit money in a bank, you are lending the bank your money. In other words, by placing the deposit, you become a creditor of the bank.
This arrangement is inherently unstable. Banks lend out much more than they take in as deposits. If too many of those loans go bad, depositors’ money is at risk. A bank run can easily result, causing wider panic and putting at risk even solvent institutions.
To reduce the likelihood of a run, most countries around the world operate deposit insurance schemes, underwritten by the public purse.
For example, the US Federal Deposit Insurance Corporation (FDIC) insures deposits up to $250,000 per person, per institution. In the European Union, individual governments insure deposits of up to €100,000 per person, per bank. In the UK it’s £85,000, calculated in the same way.
An additional safeguard is to treat depositors’ claims on a bank as senior to those of other creditors. This means that if the bank fails, the depositors get paid back first. Then what’s left over from the bank’s estate is divided up amongst the other creditors, depending on their order of seniority.
According to the IMF, this practice—called ‘depositor preference’—makes sense because banks have historically enjoyed a legal monopoly on collecting deposits. Why not protect those depositors in return, the argument goes.
In addition, says the IMF, retail depositors are not well placed to assess their risks arising from the insolvency of a bank, so it makes sense to treat their deposits as senior to other claims.
Some European countries balk at underwriting the deposits of others’ banks
Depositor preference could also facilitate access to deposits during the liquidation of a bank, the IMF goes on. The arrangement also helps insulate the payment system and could mitigate the wider economic impact of bank failures.
But deposit insurance—and depositor preference—are thorny subjects. Governments are wary of the open-ended commitment they take on by providing insurance, as well as the moral hazard they create. And the idea of treating some creditors preferentially also implies that others have to take their place further down the queue for repayment.
A European Union-wide deposit insurance scheme has never got off the ground, because some European countries balk at underwriting the deposits of others’ banks.
And there is no uniformity on depositor preference around the world: some countries, like Japan and South Korea, have deposit insurance schemes but no depositor preference, whereas for others it’s the reverse (for example, in Panama and Zambia).
The net result is that anyone depositing money at a bank—entering into a creditor relationship with it—has to pay careful attention to the legal framework within which it operates.
The rise of shadow banking
With the arrival of new financial intermediaries like financial technology (fintech) firms and cryptoasset lending platforms, the situation is getting even more complicated.
These new intermediaries are often referred to as shadow banks. They perform many of the functions of banks—deposit-taking and lending—but without being regulated in the same way.
The rewards on offer for beating the banks at their own game are huge
The rewards on offer for beating the banks at their own game are huge, especially in an era where technology allows new businesses to achieve scale very quickly. But so are the possible risks.
And, meanwhile, the opportunities for taking advantage of legal loopholes—so-called regulatory arbitrage—are growing.
Earlier this year, the head of the UK’s Financial Conduct Authority (FCA) reminded the public that money left with a payment firm or a so-called e-money institution is not protected in the same way as a deposit left at a bank.
The warning came after the June 2020 failure of Wirecard. The collapse of the German payments firm amidst allegations of fraud threw a spotlight on the risks of e-money.
Concerns over possible contagion effects also triggered a hurried rethink by the FCA of an earlier decision to shut down a UK-based Wirecard subsidiary.
Post-Wirecard, the FCA tightened up its requirements for payments and e-money firms looking after client money.
Cryptoasset firm deposit rates dwarf those of banks
In the last fifteen months activity in another less regulated segment of the deposit-taking business—run by cryptoasset firms—has exploded.
The crypto lending platforms are rocketing in size
Firms like BlockFi and Celsius Network allow clients to deposit both cryptocurrency and dollar-linked stablecoins and earn interest far in excess of the pitiful rates on offer at banks.
BlockFi, for example, currently pays annual interest of 8.25% on deposits of up to $40,000 of stablecoins tether (USDT), Circle (USDC) and Binance’s BUSD. Celsius, whose slogan is ‘unbank yourself’, pays 8.88% on deposits of the same dollar-linked tokens.
By comparison, a dollar savings account at JP Morgan Chase currently pays just 0.01% in annual interest.
The crypto lending platforms are rocketing in size. Celsius said in August it had grown its assets more than twenty-fold in just over a year, reaching over $20bn. BlockFi said it had over $10bn in client assets on its deposit platform at end-June.
Regulators scramble to catch up
Regulators are now scrambling to catch up with the sector and, in some cases, have sought to block crypto lenders’ expansion.
In the US, state securities regulators in New Jersey and Kentucky have issued BlockFi with ‘cease and desist’ orders, while regulators in another three states have requested further information on its activities. Celsius has been hit with similar orders in Texas, New Jersey, Alabama and Kentucky.
But the bans haven’t stopped the lenders from growing their valuations as rapidly as their assets.
Yesterday, Celsius said it had raised $400m in a new fundraising round, valuing the firm at $3bn, 2,400 percent higher than during a first equity round conducted last year.
The new fundraising was led by equity firm WestCap and Caisse de dépôt et placement du Québec (CDPQ), Canada’s second largest pension fund and the manager of several public sector retirement schemes.
Risks at crypto lenders
But depositors with firms like BlockFi and Celsius are taking risks with their money—albeit ones that are hard to quantify.
In its July ‘cease and desist’ order against BlockFi, the New Jersey securities regulator warned that depositors handing their cryptoassets to the firm were giving up control of their assets, were not covered by FDIC insurance and had little or visibility into how the crypto lender makes its money.
depositors handing their cryptoassets to the firm were giving up control of their assets
While BlockFi lends client money to third parties and uses it to make trades for its own account, said Christopher Gerold, the head of New Jersey’s Bureau of Securities.
However, Gerold said, BlockFi does not disclose to investors how much it invests in different asset classes, the nature and creditworthiness of its borrowers, the identity of those borrowers, the terms and duration of its loans, the types of equities, options and futures it trades, nor the profits or losses derived from these activities.
Earlier this year Max Boonen, CEO of crypto trading firm B2C2, told New Money Review that BlockFi has used a temporary arbitrage opportunity involving bitcoin investment trust GBTC to help fund its business.
For its part, Celsius makes it clear in its terms and conditions that anyone transferring cryptoassets to it is relinquishing ownership of those assets.
Celsius goes on to say it may “lend, sell, pledge, hypothecate, assign, invest, use, commingle or otherwise dispose of assets to counterparties, using our best commercial and operational efforts to prevent losses”.
While the crypto lending firms make it clear that clients’ deposits are not covered by insurance, there is also no system of depositor preference to ensure preferential treatment in the case of a bankruptcy.
For example, Celsius registered a $150m charge in favour of WestCap in September. A Twitter-based investigator called ‘intel_jakal’ pointed out that the legal documents contain a negative pledge in favour of the lender.
While a negative pledge is a standard provision in commercial loan and bond documents, it also has the effect of pushing other creditors, such as the clients of Celsius’s interest programme, further down the repayment queue in the case of the firm’s insolvency.
Averting an accident
According to Bill Nelson, chief economist at the Bank Policy Institute, the emergence of fintechs and crypto lenders threaten a repeat of the mistakes that led to the 2008 financial crisis.
“There is always an incentive for maturity and liquidity transformation to take place outside of regulated, federally insured banks,” Nelson wrote in a recent blog.
“But when that happens, the result is always increased instability in the financial system,” he said.
“What I missed was that crypto peeps would beat the big banks to it”
Nelson still believes that another system-wide crash can be averted. All the US financial regulators are already deeply concerned about the financial stability and other risks that are building, he says.
These concerns are now echoed worldwide. The G20 Financial Stability Board is now coordinating work on the regulation of stablecoins. And last week the Bank for International Settlements (BIS) and the International Organization of Securities Commissions (IOSCO), said that the operators of systemically important stablecoins, such as the $69bn Tether and the $30bn USDC, must follow the 2012 Principles for Financial Market Infrastructures (PFMI).
These set stringent transparency, credit and liquidity requirements for entities like payment systems, central securities depositories, securities settlement systems, central counterparties and trade repositories.
But are they enough to head off a future run? Even some long-standing supporters of the crypto market now sound concerned about the wildfire growth of lending and deposit schemes.
“Leverage-based financialisation in cryptocurrency markets is not happening yet,” Caitlin Long, a former Wall Street banker and now head of Wyoming-based Avanti Bank, said in 2018.
But by last week Long had changed her tune.
“When I started writing in 2016 about the dangers of leverage…in bitcoin markets, I was worried about Wall Street banks bringing it,” Long tweeted.
“What I missed was that crypto peeps would beat the big banks to it—and would do it MUCH bigger,” she said.
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