Regulators have the power to determine crypto’s destiny in the US – and many suspect that  they’ll push it out of banking.

As tensions escalate between the US crypto industry and US regulators, crypto may have an entirely different future than some hope. 

Some crypto firms are attempting to connect to the traditional financial system, but the US Federal Reserve and other regulators are shunning them away.

In January, the Federal Reserve Board (FRB) decided to reject Custodia Bank, which focuses on crypto assets, from being a member. Experts say that this is an indication that federal regulators are coordinating on creating policy and attitudes that aim to create a barrier between crypto and the US’s wider banking system.

The rejection came soon after the Biden administration published a statement urging Congress to “step up its efforts” in regulating the crypto industry, with specific guidance to avoid “greenlighting mainstream institutions … to dive headlong into cryptocurrency markets,” in drafting new legislation. The statement from Congress also cautions regulators that if not handled their way, it would be a “grave mistake” that “deepens ties between cryptocurrencies and the broader financial system.”

Meanwhile, the Federal Reserve Bank of Kansas City also rejected Custodia Bank’s steps into the US banking system, denying its long-pending application for a master account.

Industry insiders have suspected that amongst Custodia’s rejections, and Congress’s warnings, more crypto banking crackdowns are to happen soon.

Last week, reports have surfaced that the Office of the Comptroller of the Currency (an  independent section of the US Treasury which oversees the US’s banking industry) is preparing to reject applications from two crypto companies who want to apply for a national trust bank charter.

This can mean danger for Paxos and Protego – which both have received conditional approval to convert into a nationally chartered trust bank back in 2021. However, the final status of their applications have been left on hold, longer than the 18-month deadline.

However, Paxos and Protego have denied such rumours, with a source at Paxos confirming that the firm had not been requested by the OCC to withdraw its application, and that the application had not been denied. But over last weekend, Paxos cooperated under the request of the New York Department of Financial Services where it would stop offering the Binance USD stablecoin.

Crypto antagonism from regulators

“Agencies have been pretty open about the fact that they are coordinating and working together on crypto and digital-assets issues,” said Grant Butler from law firm K&L Gates. “There’s a lot of caution and scepticism on the part of banking regulators around cryptocurrency and the exposure to that in the financial system,” adds Butler.

Butler points out that regulators would want to avoid crypto-focused banks with different charters or different primary regulators, as this makes their job more difficult in consistently tracking them in spotting potential problems that may rise up.

2022’s unfortunate events and bad press have created further anxiety about crypto, almost overriding efforts from crypto lobbyists and industry leaders who have been active in educating about the benefits and credibility of blockchain technology and digital assets to US lawmakers.

As a result of multiple meltdowns, numerous insolvencies, and high counts of fraud from the crypto industry, US regulators have been inclined to respond negatively to the industry, and are  about to take that into creating new policy.

“A lot of that is out the window, and it’s very frustrating,” said Georgia Quinn, general counsel for Anchorage Digital, says in response to recent moves made by US regulators. “I’m very disheartened by all of the recent statements and positions.”

Quinn however is still optimistic that crypto can find a way into the US banking system.

“I want more regulated institutions, not less,” she said. “You don’t address risks by pretending they don’t exist.”

Many proponents of crypto believe that for widespread, mainstream adoption of crypto and blockchain technology to happen, the crypto industry must keep up at the same pace as regulated US banking. If the crypto industry does so, the wider public may develop a better attitude towards crypto, adopting digital assets and smart contracts for use in everyday life. Integration between the public’s most trusted financial institutions should also happen to open up chances for more people to access this new technology.

Chris Odinet, a professor of commercial law at the University of Iowa College of Law says that banking regulators have been long suspicious of allowing such nontraditional activities into the banking system – and that it may give birth to risk, which can snowball even further. 

Joseph Lynack, a partner at Dorsey & Whitney agrees: “Considering that the crypto industry lost approximately $2 trillion in a few months last year, the federal agencies are correct in adopting a go-slow approach – or at least, it is understandable,” Lynack said. “Can you imagine what would happen to the banking system if banks lost a similar amount of capital in such a short period of time?”

Crypto’s new (outsider) future?

Banking experts say that they don’t see US regulators cutting crypto entirely out of the US’s banking system – instead, they believe that regulators are pushing for crypto to be driven to established banking institutions already heavily regulated.

“Banks are going to be able to offer traditional custody services and safekeeping services. Granted, they’re going to have to meet a very, very high bar on the safety and soundness around that [but] using a bank to custody [crypto] doesn’t seem foreclosed,” Butler said.

Butler expects that users wouldn’t be able to use a bank charter to link fiat to digital currencies until there’s more regulatory clarity.

While the US’s current crypto crackdown would impact the ability for the public to get these banking services, Butler believes that there will be other people working on making this happen for the crypto industry. “As far as doing it through a bank or being a novel bank that does this – no, I think it’s going to be pushed out of the banking sector.”

If crypto gets pushed outside of the banking industry entirely in the US, it can bring a severe blow to those hoping to bring crypto to the mainstream. Even if crypto were to be intensely regulated over time as the industry stabilises, there’ll still be ongoing tensions between crypto and banks.

But some suspect that regulators are seeing crypto as a rival financial system, with strong opinions on stablecoins as being dangerous.

In the case of Custodia’s string of rejections, theories have risen up that its stablecoin would compete with a future central bank digital currency (CBDC). However, Butler doesn’t really see that this is the case, but rather regulators being uncomfortable with stablecoins as they can pose a broader risk concern, in reference to past stablecoin collapses.

Meanwhile, some are hoping for clear regulations to happen to crypto, despite regulators trying to distance themselves from the industry.

“The regulators’ stiff-arming is a problem for crypto because being tied to banks would add legitimacy to crypto in the minds of ordinary Americans,” said Ian Katz, a banking policy expert at Capital Alpha.

Katz adds: “But for now it looks like regulators want to put a wall between crypto and banks. And that will probably contribute to the feeling among many consumers that crypto is too risky or niche for them to get involved with.”

As hysteria about crypto contagions continue to fester in Washington, DC, it may take an overwhelming effort to quell these anxieties for regulators and lawmakers.

Mick Mulvaney, a former acting White House chief of staff under former President Donald Trump, is still keeping watch on Capitol Hill after joining Swiss crypto startup Astra Protocol. Mulvaney believes that the US federal government won’t firm up their position yet.

“I don’t think it’s cast in stone,” said Mulvaney. “There’s a vibrant debate on the Hill right now.” According to Mulvaney, whoever has the most say in determining crypto’s future may be Congress, rather than regulators.