How contagious is Circle’s USDC contagion: Will US Fed bail out crypto-friendly banks?

US financial regulators’ crackdown on stablecoins, issuers and cryptocurrency exchanges took a new turn in 2023 with lawsuits alleging “Ethereum is a security.” A large part of the DeFi ecosystem relies on Ethereum and stablecoins like Circle’s USDC, therefore it has resulted in widespread FUD and panic in the crypto community. 

The voluntary liquidation of crypto-friendly Silvergate bank and Silicon Valley Bank’s collapse have added to the uncertainty. Market participants are keen to know whether the US Federal Reserve will consider bailing out these banks in crisis amidst rising inflationary pressures. 

Also read: Where does Vitalik Buterin’s allegiance lie: RAI or Circle’s stablecoin USDC?

What’s the macroeconomic outlook, will regulation crush crypto innovation?

US Federal Reserve Chair Jerome Powell testified at a hearing before the Senate Banking Committee last week, stating that the Fed does not want to stifle innovation. Powell argued that there has been a remarkable set of events in the crypto space, noting there’s been “quite a lot of turmoil” in the past year, with companies collapsing and high-profile fraud being revealed. 

Powell was quoted as saying:

We see in crypto activity lots of things that suggest that regulated financial institutions should be quite cautious in doing things in the crypto space.

US financial regulators have repeatedly issued statements and policy interpretations that dampen the sentiment among crypto traders. New York Attorney General Letitia James recently filed a suit against KuCoin exchange, citing Ethereum as a security. 

Suit filed by AG Letitia James

The change in the regulators’ stance on cryptocurrencies like Ethereum and stablecoins has caused a rise in uncertainty in the crypto ecosystem. 

What happens when Ethereum drops to $350: Citron Research

Ethereum is one of the key components of the DeFi ecosystem. As of November 2022, Ethereum accounts for upwards of 58% of DeFi, based on data from Statista.

Ethereum in DeFi ecosystem 

Since a large part of the DeFi ecosystem revolves around Ethereum and its utility as a smart contract blockchain, if Ether is deemed a security it would negatively impact the entire ecosystem.

Citron Research, a stock research firm recently published a tweet stating the case for Ether’s price drop to $350. The firm cited Ether being considered a security since its migration to Proof-of-Stake and its current market capitalization. 

Will Silicon Valley Bank get bailed out?

Silicon Valley Bank, considered a tech-friendly financial institution recently witnessed a collapse. The Federal Deposit Insurance Corporation (FDIC) shut down the SVB after its stock crashed nearly 60%. 

Danny Fortson, correspondent for The Sunday Times told CNBC that there is market-wide fear with bank stocks crashing. Market participants are awaiting a bailout of the SVB bank. If the FDIC could find a buyer, it could reinstate depositor’s confidence in financial institutions. 

Fortson argued that SVB markets itself as a startup-friendly bank with 50% of their clients being startups. SVB therefore exposed itself to a unique risk, with rising interest rates, declining bond rates and clients pulling their funds out.

Since the SVB has less individual clients and more institutions as its customers, it makes for a unique scenario. SVB has less than 40,000 commercial customers. The bank suffered a liquidity crunch and a bailout could help accounts be recovered on a one-to-one basis. 

Experts believe SVB’s crisis may not be systemic as of now, leaving room for possible bailout. This could bring relief to market participants and crypto traders alike.