Moonstone, formerly Farmington State Bank, once served local farmers in Washington state. However, over the last few years, the bank has expanded its services into cryptocurrencies.
When Sam Bankman-Fried’s crypto trading firm, Alameda Research LLC, purchased a stake of $11.5 million in the bank in March 2022 — at 37 times the price someone else had purchased the bank for only 18 months prior — Moonstone’s valuation shot up to around $115 million, according to the Wall Street Journal. Though Moonstone’s ventures into high-risk cryptocurrency industries were purportedly intended to appeal to a new target customer, it reflects the larger problem of banks intentionally taking advantage of uninformed consumers. It also threatens to destabilize the entire financial system due to its attempt to circumvent Securities and Exchange Commission regulations.
Part of the promise of Moonstone’s expansion into the crypto industry was the opportunity to offer interest-bearing cryptocurrency accounts, which enable customers to deposit their digital assets at Moonstone. The bank could then use those assets for other investing activities. In exchange for depositing their assets, consumers would receive a variable monthly interest payment. Interest rates for these investments, generally called “crypto-yield” programs, are higher than traditional bank account interest rates, so customers can theoretically make much more money by depositing their money into CYPs than if they had just put it into a savings account.
For CYPs to operate properly, consumers’ deposited digital assets — usually cryptocurrencies — must functionally act as securities like stocks or bonds. That way, banks can allow investors to earn interest from their assets upon depositing them in a common pool, which can then be lent out by the bank to borrowers. These borrowers are typically sophisticated crypto trading firms like Alameda, and they borrow cryptocurrency so they can in turn trade the assets as if they were their own in an attempt to earn an even greater profit. The idea is they can make a big enough return from trading to cover the interest on their loan to the bank, which in turn covers the bank’s interest payment to the original depositor. As you can see, there’s a lot of risky moving parts here.
Current SEC rules for ordinary banks are designed to “limit the amount of risk that banks and credit unions are allowed to take with your deposited funds [in order] to decrease the possibility that your bank or credit union becomes insolvent and unable to provide you your funds when you want to withdraw [them].” In contrast, the cryptocurrency market is one of the least regulated. In particular, a specific regulatory exemption that neglects digital exchanges and cryptocurrencies means that CYPs aren’t even regulated as securities. These high-risk investments can therefore spread like wildfire because it allows banks like Moonstone to bypass SEC regulations designed to prevent dangerously risky behavior in the traditional market.
If the intent to avoid regulation wasn’t alarming enough, the structure of CYPs is strikingly similar to the bundling practices of investment banks during the 2008 financial crisis. Calls for deregulation in the early 2000s increased the popularity of financial assets called derivatives — a type of security — that allowed for similar circumvention of risk-profiling processes. This enabled Wall Street to take risky wagers without reasonable limits.
In the period leading up to the 2008 market collapse, traditional banks would sell mortgages to investment banks. These firms then combined thousands of mortgages and other forms of debt together into a collateralized debt obligation, which was considered a complex derivative. Investment banks would then sell these CDOs as financial packages in which customers could invest — and, in order to fetch a higher price, investment banks would pay rating firms to rate CDOs as a low-risk investment, even though they weren’t.
Worryingly, the current architecture of CYPs closely resembles the fundamental interactions evident in the 2008 system. The basic logic goes that individual assets are combined and sold to a large firm, which then repackages those assets in order to convert it into an investment that earns regular income. In 2008, those assets were mortgages. Today, it’s crypto.
Not only has this lending-investing structure led to historic market collapse, but there is also the impact on the consumer. In 2008, investment banks were able to borrow immense sums of money to buy massive quantities of CDOs, inflating the proportion of their portfolio made up by them. This increased the perceived “investability” of CDOs by making them appear mainstream. Uninformed consumers could thus be led astray into a volatile and much more risky investment without recognizing the structural problems.
Moonstone, Alameda and FTX — the latter being Alameda’s sister company, also founded by Sam Bankman-Fried — operated in a similar manner. We know that circular reinvestment, as with what occurred within the 2008 financial system, artificially inflates the value of whatever is being invested in. After Alameda’s initial investment, deposits increased sevenfold and assets as a whole grew from $18 million to $99 million over the same period. On the surface, these numbers might indicate that CYPs are a promising, lucrative and secure investment. However, regulatory filings reveal that 77% of total deposits were from a subsidiary of FTX.
The collapse of the financial market in 2008 wasn’t just because of CDOs themselves. It was also because stakeholders in the system were rewarded for success but not held liable for any mistakes. CDOs simply compounded existing incentives for taking dangerous risks. Whereas banks were bailed out following the market crash, with crypto exchanges and the emphasis on decentralization, — the idea that financial interactions are non-custodial and therefore need not go through a regulatory intermediary — bailouts are not a plausible option. Moreover, the risk falls directly onto the consumers. Because of decentralization, individual consumers, not large banks, are the ones engaging in these types of behaviors.
I want to clarify that I am not explicitly opposed to crypto-yield programs. I am, however, opposed to uninformed or misinformed investing practices. If the basis of our market economy is each individual actor, what happens when too many people place their money in a program that collapses and can’t pay them back?
The silver lining is that, at the start of this year, the Board of Governors of the Federal Reserve, the Federal Deposit Insurance Corporation and the Office of the Comptroller of the Currency issued a joint statement highlighting the risks that crypto-assets pose to banks’ stability. Moreover, the SEC recently reached a cease-and-desist settlement against BlockFi — which ran similar crypto-lending programs to Moonstone — on the grounds that these programs incorporate unregistered securities. Is this enough, though? Given the recent collapse of FTX, I don’t think so.
Decentralized exchange platforms like FTX can remain decentralized but still be subject to fundamental regulation that treats packaged digital financial assets as securities. In the case of crypto-yield programs, this means treating them like securities. In addition, consumers should be made fully aware of the risks of using CYPs and recognize the potential losses that could arise. These two safeguards might just prevent 2008 from happening all over again.