Mankiw Research | The Dilemma of Debanking: Does the encryption Industry Need to Break Away from TradFi?

According to a report by Fox News journalist Eleanor Terrett on January 25, the US Senate Banking Committee announced that it will hold a hearing on February 5 (US time) to discuss the ‘de-banking’ phenomenon of banks on Crypto Assets companies. Earlier, the US House Committee on Oversight and Government Reform had already sent letters to several encryption company executives asking for explanations on this issue. In recent years, ‘de-banking’ has gradually become a key feature of the encryption industry. From payment interruptions to financing bottlenecks, and then to the transformation of custody services, in the current rift between traditional financial institutions and the Web3 industry, encryption companies are also trying to take a path to ‘break away’ from traditional finance and complete decentralization. However, is de-banking really an inevitable trend? Or is it just a short-term response to traditional financial regulatory pressure? More importantly, what impact does this trend have on the development prospects of the encryption industry? Lawyer Mankun will explore the current regulatory policies of representative countries and regions around the world in this article. What is decentralization? In the encryption industry, banks, as an important pillar of traditional financial institutions, have long maintained close ties with the development of the encryption industry. For example, in the early days of the encryption industry, banks ensured the flow of encryption assets and fiat currencies by providing fiat deposit channels; in the process of institutional development, banks also played the role of custodians, providing asset security and credit endorsement for encryption companies; even in some cutting-edge technology collaborations, banks actively participated in blockchain application experiments to empower encryption technology. However, in recent years, this cooperative relationship is undergoing subtle changes. As the regulatory environment continues to tighten, the relationship between banks and the encryption industry is gradually becoming tense. On the one hand, the anonymity and cross-border liquidity of the encryption industry are putting banks under higher compliance pressure. The requirements of Anti-Money Laundering (AML) and Know Your Customer (KYC) regulations require banks to invest significant resources when cooperating with encryption companies, and these high compliance costs make some banks hesitate. On the other hand, the extreme price volatility of encryption assets further deepens banks’ concerns about market risks. Traditional financial institutions believe that the high-risk nature of the encryption industry may pose a threat to its stability. In addition, the continuous changes in the policy environment have exacerbated the cautious attitude of banks. Regulatory authorities in some countries have frequently pressured banks to restrict or terminate services to encryption companies, while certain opaque projects and fund flows have raised banks’ awareness of potential illegal activities. More importantly, with the rise of stablecoins and decentralized finance (DeFi) technologies, traditional banks also need to face competition pressure from the encryption industry, which has further reduced some banks’ willingness to cooperate with the encryption industry. Under the combined effect of these factors, some countries represented by the United States have seen the phenomenon of “debanking” in the encryption industry: payment channels are closed, accounts are frozen, traditional banks are gradually exiting the encryption asset custody market, and some banks even explicitly state that they will no longer provide services to encryption companies. Interestingly, the move towards de-banking is not solely driven by banks, but the encryption industry is also actively seeking alternative solutions, striving to reduce reliance on traditional banks. In the payment field, stablecoins and on-chain payment protocols are gradually replacing bank accounts and payment networks, becoming the primary payment tools for the encryption industry; in the custody service sector, native encryption companies such as Fireblocks and Anchorage not only provide compliant custody services but also incorporate technologies like secure multi-party computation (MPC) to fill the gaps in traditional bank custody services; in terms of financing, the rise of DeFi protocols enables encryption companies to directly raise funds through on-chain tools, completely bypassing the restrictions of the banking system. However, alternative solutions in the encryption industry cannot completely replace the key role of traditional banks. The challenge of de-banking While the trend towards de-banking seems to provide an opportunity for the Crypto Assets industry to bypass the traditional financial system, Man Kun, a lawyer, believes that this trend also brings undeniable challenges. These challenges may not only hinder the development of the Crypto Assets industry but also weaken its influence on traditional financial markets to some extent. Trust Crisis Banks, as the core institutions in the traditional financial system, their credit endorsement cannot be easily replaced by the encryption industry. Transactions conducted through bank accounts are generally considered legitimate and compliant, while completely bypassing banks with decentralized operations may undermine public and institutional trust in the encryption industry. For example, stablecoins, although capable of partially replacing bank payment networks, may face doubts about the value support if their underlying reserve assets are not custodied by banks. In addition, in the absence of bank intervention, the encryption industry needs to bear higher compliance costs, such as independently establishing anti-money laundering (AML) and know your customer (KYC) systems, while the standardization and credibility of these systems are still to be strengthened. Asset Security Traditional banks’ experience and security capabilities in the asset custody field, Crypto Assets industry’s current alternative solutions are hard to match. While some native encryption enterprises have provided innovative custody services, these services still face potential threats such as technical vulnerabilities, smart contract risks, and hacker attacks. More importantly, after decentralization, the credibility of custody services may be challenged, especially for traditional institutional investors, the lack of bank-level protection may reduce their willingness to invest in encryption assets. Financial Isolation The de-banking process is gradually distancing the payment network of the encryption industry from the traditional financial system. Although this improves the efficiency of on-chain payments, it may also lead to financial island effects. The payment and financing networks within the encryption industry may not be seamlessly connected to traditional financial markets, thereby limiting the mainstream application of encryption assets. For example, if certain large multinational corporations cannot connect to encryption payment networks through bank accounts, their willingness to use encryption assets as a payment method will also decrease. Regulatory Pressure Complete de-banking operations may trigger greater regulatory pressure. In recent years, governments around the world have been continuously strengthening regulations on the encryption industry. Debanking may be seen as a strategy for the encryption industry to evade traditional financial regulations, leading to more scrutiny and restrictions. For example, the EU’s MiCA regulations require stablecoin issuers to store some reserve assets in banks to ensure value support, while the trend of debanking directly contradicts this requirement. Similar policy contradictions may intensify friction between the encryption industry and regulatory authorities, and even trigger more restrictive policies. Industry fragmentation The process of decentralization is not balanced, with large encryption enterprises often having more resources to seek alternative solutions, while small and medium-sized enterprises may face greater challenges. For example, large enterprises can establish internal compliance systems and engage in direct dialogue with regulatory agencies, but small and medium-sized enterprises may struggle with compliance due to lack of resources. In the long run, this imbalance may lead to further differentiation within the industry, exacerbating the trend of resources concentrating towards leading enterprises, which is not conducive to the diversified development of the industry. Global regulatory banks In the previous section, Lawyer Mankiw mentioned that the EU MiCA regulation on stablecoins requires issuers to comply with strict reserve requirements, with at least 30% of the reserve assets stored in the form of legal tender in EU-authorized banks to ensure that the value of stablecoins remains pegged to the underlying assets. At the same time, the MiCA regulation also sets out compliance requirements for custodians and encryption service providers, requiring them to fulfill anti-money laundering (AML) and know-your-customer (KYC) obligations. Especially in the custodial field, MiCA aims to enhance asset security by authorizing custodian banks, which to some extent offsets the impact of the trend towards bankless transactions. This regulatory logic that rebinds banks with the encryption industry is not only present in the EU, but also reflected in the regulatory frameworks of other countries and regions such as Singapore and Hong Kong. In Singapore, the Payment Services Act (PSA) requires digital payment token (DPT) service providers, including stablecoins, to obtain a license from the Monetary Authority of Singapore (MAS). This not only imposes requirements on payment services and trading platforms but also emphasizes that stablecoin issuers must collaborate with local banks to ensure the compliance of reserve management and payment clearing. Similarly, Hong Kong’s regulatory policies also follow a similar approach. According to the latest guidance from the Securities and Futures Commission (SFC) of Hong Kong, stablecoin issuers are required to hold asset proof from regulated banks or trust companies. In addition, Hong Kong has raised the bar for exchanges and custodians, requiring them to establish effective internal control measures to prevent fund abuse and provide higher security guarantees for market participants. These requirements not only reflect a focus on user protection but also demonstrate the regulatory authority’s emphasis on the essential role of banks in the compliance chain. It can be seen that, whether in the European Union, Asia or other regions, the global trend of encryption regulation does not fully support “debanking”. Instead, regulatory agencies around the world are incorporating banks into the core of the encryption ecosystem through regulatory design, in order to ensure industry development while reducing potential systemic risks. Summary by Mandel Lawyer The phenomenon of de-banking reveals the efforts of the encryption industry to break free from traditional financial constraints, and also reflects the pains of the global financial system in the face of technological changes. The core role of traditional banks in payment clearing, asset custody, and credit endorsement is still the foundation that the encryption industry currently cannot completely replace. Although the encryption industry has demonstrated great potential for technological innovation in the payment and financing fields, lack of trust, regulatory friction, and technological risks still constrain its further development. Therefore, complete de-banking is not a realistic path, and the current de-banking is more like a catalyst for promoting the encryption industry to find a new balance with traditional finance, rather than a simple separation. More importantly, this phenomenon also provides an opportunity for reflection and adjustment for the global financial system. De-banking should not be seen as a unilateral experiment of the encryption industry, but as the beginning of traditional finance and emerging technology working together to explore future financial models. As advocated by Lawyer Mankiw, justice and regulation should not be in opposition to technology, but should seek breakthroughs in integration. In the future, only driven by innovation and compliance, de-banking can not only avoid differentiation and contradictions, but also become a key driving force in building a new financial ecosystem. This is not only a key link in the self-evolution of the encryption industry, but also a historical node that may reshape the global financial order.

It is worth noting that, as of the time of writing, the US hearing on Debanking has been successfully held, focusing on the impact of bank account closures and financial service restrictions on businesses and individuals. During the meeting, several witnesses pointed out that regulatory pressure on banks has led to the termination of business relationships between banks and cryptocurrency-related companies, which not only affects the normal operation of the industry but also weakens the US competitiveness in the global digital economy. Meanwhile, the Federal Deposit Insurance Corporation (FDIC) has released a 790-page document, acknowledging that its past regulatory measures towards the encryption industry have been overly strict, and stating that it will reassess the related policies. FDIC acting head Travis Hill further committed during the hearing to provide banks with clearer regulatory guidance to ensure that they can engage in blockchain and cryptocurrency-related businesses within a legal and compliant framework. The hearing and the FDIC’s change in attitude indicate a possible relaxation of US regulatory policies towards the encryption industry. However, this does not mean that the traditional financial system will completely open its doors to encryption enterprises, but rather a recalibration of regulation between policy and market demand. The relationship between banks and the encryption industry may be entering a period of easing, but the real market changes still depend on the pace and intensity of regulatory implementation. But at least, the first step of integration has been taken. / END. This article is written by Iris and Liu Honglin