Regulatory authorities like the Basel Committee on Banking Supervision (BCBS) have already signalled their worries that crypto assets might adversely impact banks’ liquidity and risk — market, credit, operational, legal, and reputational — and, consequently, the stability of the entire financial system – according to a recent Arthur D Little report on crypto.
Headlines such as “How $60 Billion in Terra Coins Went Up in Algorithmic Smoke” do little other than create a sense that cryptocurrencies are built on shaky ground.
The International Monetary Fund (IMF) has commented that: “Crypto-assets are potentially changing the international monetary and financial system in profound ways.”
US Federal Reserve Vice Chair Lael Brainard is someone who has voiced concerns when she said: “It is important that the foundations for sound regulation of the crypto financial system be established now before the crypto ecosystem becomes so large or interconnected that it might pose risks to the stability of the broader financial system.”
Crypto regulation
And this takes us to the centre of the crypto conundrum: regulation. And, most particularly, how much there should be and what form it should take.
Rather than banning crypto, most countries are taking a more pragmatic view by seeking to find ways to better manage its impact.
So, driven by Europe (and in particular the MiCA regulation), efforts have begun to develop a globally coordinated regulatory approach to crypto assets, improve levels of transparency, and establish new codes of conduct and standards for disclosure and reporting.
The Financial Stability Board (FSB), the Basel Committee on Banking Supervision (BCBS), the Committee on Payments and Market Infrastructures (CPMI), the Financial Action Task Force (FATF), and Germany’s Federal Financial Supervisory Authority (BaFin) are some of the key authorities working on the effort.
Should banks mainline on crypto?
So how should financial institutions position themselves in this new environment where crypto is increasingly legitimate, and in what areas should a bank choose to play?
That is very much down to the individual institution, its appetite for risk, and its specific take on the market’s point of arrival.
It could, for instance, eschew this whole area and remain outside the crypto playing field altogether, leaving others to serve the market.
If the market doesn’t stabilise and crypto’s reputation continues to be trashed by highly volatile price swings, then this principled approach may be a sensible one. However, it does seem to cut across the direction of travel.
Or an institution can assume that it will enter the market at some point, just not right now. Playing the “wait and see” game is a pragmatic solution, though it could leave one having to play catch-up in a fast-moving marketplace.
Alternatively, financial players could dip test the waters by providing a limited range of crypto services, enabling their customers to participate in the market without actively engaging themselves.
They might, for instance, provide crypto custody services to store digital assets and digital wallets that have a shareable public address, like the IBAN of a bank account, with a private digital key used by the account holder to control access.
Cryptocurrency custody has become a highly active area, with 73 new services launched in 2021. Players in this segment now include US Bancorp, Bank of New York Mellon, Deutsche Bank, BNP Paribas, JPMorgan Chase, and HSBC.
Crypto risk
However, offering a cryptocurrency custody service is not without risk.
While providing offline “cold” wallets, where assets are merely stored is one thing, any bank offering a “hot” wallet that is connected to the Internet and used for trading or payments has to be strongly secured against high-level hacks and thefts.
The recent illegal siphoning of $190 million in cryptocurrencies from US crypto firm Nomad clearly demonstrates what can happen, especially when you are the target of well-organized bad actors.
North Korea, for example, has made stealing cryptocurrency part of its strategy to mitigate the country’s financial isolation.
In H1 2022, crypto-research firm Chainalysis calculated the regime had already stolen over $840 million, mainly from decentralized financial platforms.
There are also unpredictable risks over which you have little influence, such as a bug in a layer 1 protocol (the blockchain layer), which then disrupts the cryptocurrencies and smart contracts that are built on it.
If that were not enough, there are decisions to be made about which cryptocurrencies to support, because that will have a big impact on the IT infrastructure required.
If you don’t want to have to change that infrastructure too frequently, you need to be picking “crypto winners.” And that is not easy to do — an infrastructure that would have supported the top 10 cryptocurrencies five years ago would only be capable of supporting three of them today.
Because of this volatile market situation, any organization offering crypto-related products or services must have an IT infrastructure that can react fast and respond flexibly to market changes.
And to do this, organizations must be aware of not just factors that impact them directly, but also events and circumstances affecting others they may be connected with.
An investment in or collaboration with company A, for instance, could leave you unexpectedly exposed if you are unaware they are heavily invested in Bitcoin, and the crypto market turns.
The situation becomes even more opaque if company A is involved with company B, which also has cryptocurrency holdings. Such interconnectedness means additional due diligence is required to identify potential risks.
And unlike most other digital transactions between banks, cryptocurrency transactions are nonreversible, which means that often very little can be done to recover any money.
We may have a wealth of knowledge about how to protect physical assets, but measures to keep cryptocurrencies secure are still in their infancy.
Besides crypto custody, more banks are beginning to expand their portfolio of services to include crypto-asset trading.
Goldman Sachs was one of the first major US banks to offer OTC trades, while Citigroup is looking to offer Bitcoin futures trading for some institutional clients, dependent on regulatory approval.
Even those considered traditional banks are becoming involved.
Italy’s Banca Generali, for example, has teamed up with Italian-American cryptocurrency exchange Banca Generali Conio, enabling customers to use an app to buy cryptocurrencies through their regular banking account.
And French FinTech Lydia has partnered with the Austrian investment start-up Bitpanda so that its 5.5 million users can now invest in cryptocurrencies, while Revolut has set up an in-house crypto-exchange platform and launch its own token.
Infrastructure requirements
Financial institutions that decide to hold cryptocurrencies as assets, provide crypto-based products, or offer crypto-custody services to other institutions will need to revise their operating model to meet regulatory requirements.
Institutions offering cryptocurrency as an asset will need to ensure they have sufficient liquidity and are able to store and transfer assets safely.
As a digital custodian, they will also need to be confident that their current AML and KYC capabilities remain compliant for cryptocurrencies. They may have to modify their software ecosystem and processes accordingly.
The illustration of a target operating model of a crypto bank below shows that the main architectural changes required will revolve around connectivity to public or permissioned blockchains, and to other services such as crypto exchanges, as well as crypto brokers and issuers.
Further key, critical changes will be needed to core banking software, where additional applications will be required for functions such as digital custody and tokenization.
There are also potential opportunities in crypto lending and borrowing.
Under a crypto-lending model, private investors receive interest payments for allowing lenders to use their cryptocurrency to make loans to institutional and corporate borrowers.
Though interest rates vary widely between lending platforms, with each lender having different rates for different coins, typically these fall between 3% to 8%.
However, rates for stablecoins are generally higher, at between 10% and 18%.
This is a very fast means of financing — transactions happen within a matter of hours — with much potential for customization of terms.
On the flip side, by crypto borrowing, private investors can take out a loan secured against their crypto holdings, usually capped at 50% of asset value.
And since professional investors and high-net-worth individuals hold almost two-thirds of the Bitcoin supply, providing a wealth management service that encompasses crypto assets would be of obvious benefit to banks.
However, their wildly deviating prices mean cryptocurrencies must be regarded as a high-risk investment that much like commodities needs to be actively traded, rather than considered a stable store of value that just needs to be managed.
Is their a future for crypto?
Even as the market undergoes a crypto winter, venture capitalists (VCs) are looking to pour money into digital currency and blockchain start-ups.
Data from PitchBook shows that VCs invested $17.5 billion in such firms during H1 2022, which means that the $26.9 billion raised in the whole of last year is likely to be surpassed.
North America has been a particular hotspot, where in contrast to the downturn in VC activity generally, in the six months to June 2022 about $11.4 billion flowed into crypto-related start-ups, not far behind the $15.6 billion for the whole of 2021.
VC investment is also strong in Europe, with $2.2 billion in funds raised in H1.
The financial services sector is increasingly enthusiastic about cryptocurrency applications and the blockchain technology that underpins them — some estimate that around 30% of investment banks’ infrastructure costs could be stripped out by using blockchain.
The market for blockchain in banking and financial services is expected to reach $12.39 billion in 2026, up from $1.17 billion in 2021, a CAGR of around 60%.
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