In a pivotal move this week, the Federal Reserve rolled out sweeping regulations for the U.S. banking sector, focusing on stablecoins and banking facilities extended to businesses engaged in ‘crypto-asset activities’. The element of surprise was the direct issuance of these directives from the Federal Reserve without any legislative intervention from Congress. Interestingly, this decision was timed alongside PayPal’s unveiling of its stablecoin, PYUSD.

The Federal Reserve has initiated a ‘Novel Activities Supervision Program,’ specifically for banking organizations engaging in activity “related to crypto-assets, distributed ledger technology (DLT), and complex, technology-driven partnerships with nonbanks to deliver financial services to customers.” Essentially it means that no regulated banking organization can begin to offer these services without prior approval from the Fed.

While the knee-jerk reaction of many has been to label this initiative as anti-crypto, it is instead the Federal Reserve fulfilling its mandate to safeguard the banking sector amidst the crypto industry’s noticeable void in self-regulation. A testimony to the Federal Reserve’s comprehensive strategy is its scrutiny not merely of stablecoins but the broader ecosystem encompassing banks partnering with crypto projects, custodians, and exchanges.

The Fed’s concern with stablecoins is undoubtedly based on the collapse of Luna’s stablecoin UST, which caused an estimated loss of $40-$45 billion in days. Their concern over banks offering financial services to the crypto industry is most likely related to the failure of Silvergate Bank and Silicon Valley Bank, which caused further failures across the banking system.

To many, this may have the hallmarks of a bearish stance. However, when viewed through the prism of the Federal Reserve’s liability for every regulated bank’s downfall, their proactive stance is defensible and timely.

Before 2023, the Federal Deposit Insurance Corporation (FDIC) had a cap on payouts in the event of bank failures — $250,000 per account. But the unraveling of Silvergate and Silicon Valley Bank led the FDIC to a paradigm shift, pledging to cover losses without ceilings.

In the aftermath of the first two bank failures, Treasury Secretary Janet Yellen said, “Our intervention was crucial in fortifying the broader U.S. banking infrastructure. We’ll not hesitate to take analogous steps if smaller entities grapple with deposit challenges that threaten systemic stability.” This year alone has seen the folding of five U.S. banks, with the most recent in July.

Observers examining the crypto sector’s trajectory in recent times might harbor serious reservations about its self-regulation efficacy. This is especially true given the spate of dubious memecoin launches and rug pulls, which are eerily reminiscent of Ponzi schemes rather than technological innovations.

While the Fed’s new program will add some friction to the present relationship between legacy banking and crypto services, they take pains to point out that banks are obliged to offer services to all clients and have the freedom to choose whether to integrate stablecoins. The concept of the program is to add a layer of checks and balances before regulated banks take the plunge.

The Federal Reserve’s monitoring will primarily focus on operational, cybersecurity, liquidity, illicit finance, and consumer compliance risks. In an ideal scenario, this could encourage banks’ foray into crypto. Conversely, the approval process could deter many.

Regardless of the aftermath, one thing is clear: this new oversight is a testament to the banking sector’s acknowledgment of crypto’s potential, signaling safeguards that could accelerate its mainstream adoption. What remains in the offing is the crypto industry’s ability to elevate its offerings and rebuild some of its damaged credibility.