Blockchain and Banking: Opportunities and Risks With Digital Assets

In the 12 years that have passed since the world’s first Bitcoin transaction, digital payment systems have come a long way. Crypto and digital assets such as Bitcoin, Ethereum and Ripple make the headlines almost daily and account for more than a million transactions every day.

With more customers holding crypto and digital assets, banks can no longer afford to dismiss the crypto trend and must find ways to address those customers’ needs. The potential benefits extend beyond customer retention. Engaging with crypto and digital assets can provide banks with opportunities to reach out to new customers, differentiate themselves from competitors and find new sources of noninterest income.

As the scope of the crypto landscape has expanded, the debate over the banking industry’s place in it has intensified. Because of its historical role as a cornerstone of the broader financial system, many industry leaders contend that the banking sector has a logical role to play in bringing order and stability to the world of crypto transactions.

This contention is bolstered by the advent of stablecoins, which have values pegged to some other asset such as a fiat currency or a commodity. This feature seeks to reduce price volatility and enable more confident valuations so that stablecoins can be treated more like other intangible assets.

Proponents also note that banks clearly are capable of accommodating the crypto trend — just as they adapted to credit card processing, automated clearinghouse transactions and peer-to-peer payment systems.

While the broader industry sorts out its eventual role in the crypto world, individual banks face more immediate decisions about whether and how they should start accommodating crypto and digital assets. Opportunities abound — beginning with the provision of commercial banking services to companies that hold crypto assets or use them as a medium of exchange.

Beyond standard account services, some banks might choose to apply their expertise in payment processing and settlements to enable digital transactions. Banks with strong custody and wealth management operations might expand those services to accommodate crypto investments. Other banks could decide to accept digital assets as loan collateral.

More specialized, technologically demanding applications could prove feasible for some banks. Possible scenarios include providing merchant processing services using crypto assets, operating crypto ATMs and managing crypto reward or cash-back programs and other decentralized finance applications.

Developing Crypto Capabilities

The first step is deciding which of the various opportunities to pursue. Establishing a separate department or division is usually a poor strategy. A better course is to integrate crypto and digital asset capabilities into existing business lines.

Bank leadership teams clearly have an important role to play in guiding such decisions and should make sure that any venture into crypto and digital assets begins with a thorough strategic assessment. The goal is to identify the bank’s existing strengths and build in crypto components rather than forcing crypto capabilities into business lines where the bank might already be struggling.

Once executives identify promising opportunities, another critical early step is determining the best methodology for developing crypto capabilities. Large banks with extensive in-house technology resources might build their own applications, but most community and regional banks might find it more feasible to work with strong technology partners, including targeted fintech companies supporting the banks’ strategic goals

Risk and Compliance Issues

Risk and compliance uncertainty are common concerns underpinning hesitation among banks when it comes to developing crypto capabilities, given that the relevant regulatory, financial reporting, auditing and tax standards are still evolving. Yet banks can successfully mitigate the uncertainty through effective strategic planning and due diligence.

In addition, regulatory and advisory bodies are actively working to clarify the picture. Agencies such as the Office of the Comptroller of the Currency, the Federal Reserve Board and the Securities and Exchange Commission are crafting guidance or comment letters; financial reporting and accounting organizations are developing standards that will aid board members responsible for overseeing compliance.

With fintech businesses and other competitors eager to engage with crypto-oriented customers, banks cannot ignore the potential customer retention, brand enhancement and revenue generating capabilities of crypto and digital assets. By monitoring the evolving guidance and carefully evaluating the risks and opportunities, banks can pursue a balanced approach that capitalizes on the potential benefits while remaining consistent with their established levels of risk tolerance.

Why Regulation Should be Part of Cryptocurrencies’ Future

Despite a recent embrace by the capital markets and financial corporations, digital assets and cryptocurrencies are still not at the point of widespread, global adoption. To get there, lawmakers and financial agencies should implement rules and regulations to protect consumers and enable the space to develop further as an alternative financial system.

The evolution of digital assets like cryptocurrencies has a phenomenal potential to change the financial industry. However, it also creates challenges. Digital assets are decentralized and do not rely on either governmental authorities or financial institutions to create, transmit or determine the value of a cryptocurrency. Supply is determined by a computer code; prices can be extremely volatile. Over the past decade we have witnessed digital asset exchanges being closed down due to fraud, failure or security breaches.

Within the United States, there is no uniformity in the regulatory framework with respect to how businesses that deal in digital assets should conduct themselves. New York is one of the few states that has a functional regulatory regime through the New York State Department of Financial Services. Meeting compliance in New York has become a badge of legitimacy. However, there are also a significant number of companies that have chosen not to operate in New York due to these regulations. On the other hand, Wyoming has adopted a lighter regulatory framework and is widely considered the most crypto-friendly jurisdiction in the United States.

Congressional Developments
In April, the U.S. House of Representatives passed “The Eliminate Barriers to Innovation Act,” a bill that directs the Commodity Futures Trading Commission and the U.S. Securities and Exchange Commission to establish a digital asset working group and open new regulatory frameworks for both digital assets and cryptocurrencies.

The bipartisan bill would initiate the commission of a specialized working group that would evaluate regulation of digital assets in the U.S. The joint working group would include the SEC and CFTC, in collaboration with financial technology firms, financial firms, academic institutions, small and medium businesses that leverage financial technology and investor protection groups, as well as business or non-profit entities that are working to support historically underserved businesses. The working group would draft recommendations to improve the current regulatory landscape in the U.S., which will then be extended internationally where possible. The working group will be given a year to evaluate and provide technical documentation on how these recommendations should be implemented through compliance frameworks.

Regulation Ensures Market Stability
While some people believe that cryptocurrencies should operate completely independently from any form of regulation, publicly accountable businesses are vigorously regulated in order to protect consumers and economic stability. Independent audits are similarly required to protect the interests of all stakeholders, ensure that the applicable laws and regulations are adhered to and that the financial statements are free from material misstatement, as well as fraud (to a certain extent).

Regulators around the world regularly warn crypto asset investors to be extremely cautious and vigilant, partially due to a lack of regulation, which creates an opportunity for fraudsters to prey on uninformed investors. Fraud and error can usually be mitigated by prevention, detection, and recourse. Introducing regulations to govern the cryptocurrency industry will mean preventative measures are in place to ensure fraud doesn’t occur and that there is appropriate legal recourse for victims. There is also a significant role for auditors in detecting possible instances of fraud or error, as well as assisting with the recourse process.

Digital Asset Outlook
Mazars will be keeping a close watch on the progress of the innovation bill. We believe positive regulatory changes are ahead. Gary Gensler, the recently confirmed head of the SEC, has a keen knowledge of, and appreciation for, the applicability of digital assets in the global financial services ecosystem. Gensler is the former head of the CFTC, as well as a professor at the MIT Sloan School of Management where he researched and taught blockchain technology, digital currencies and financial technology.

In a recent interview with CNBC, Chair Gensler said there needed to be authority for a regulator to oversee the crypto exchanges, similar to the equity and futures markets. He said many crypto coins were trading like assets and should fall under the purview of the SEC.

We welcome this level of engagement and improved regulation, which will be good for the industry, investors, consumers and society at large. Without regulation, cryptocurrencies are unlikely to become a standard part of investment portfolios due to the current high level of risk.

The information provided here is for general guidance only, and does not constitute the provision of legal advice, tax advice, accounting services, investment advice or professional consulting of any kind. The information provided herein should not be used as a substitute for consultation with professional tax, accounting, legal or other competent advisers. Before making any decision or taking any action, you should consult a professional adviser who has been provided with all pertinent facts relevant to your particular situation.

Four Things to Do if Your Bank Is Eyeing Digital Assets

Digital banking is evolving in the wake of guidance from the Office of the Comptroller of the Currency as it concerns digital assets and their underpinning technology.

The regulator issued an interpretative letter last July authorizing OCC-regulated national banks to hold digital assets and another one in early 2021 allowing such banks to use blockchain and stablecoin infrastructures. Consumers and commercial entities continue to demand offerings and services for digital assets, and the pandemic has accelerated this push.

This rise of digital assets will have far-reaching implications for the entire banking sector for years to come. It’s crucial for executive teams at traditional banks to understand how best to capitalize on these changes, where the risks lie and how to prepare for the future of banking. For banks weighing how and when to start offering digital asset services, here are four key things leadership teams should do:

  1. Prepare to stake a claim. The evolution of money toward digital assets is affecting bank and fintech organizations globally. Companies should proactively think through adjustments now that will enable them to keep up with this rapid pace of change. At the start of this century, when mobile banking apps first began appearing and banks started offering remote deposit captures for checks, organizations that were slow to adopt these technologies wound up being left behind. The OCC guidance explicitly authorizing the use of digital assets should alleviate any doubts around whether such currencies will be a major disruption.
  2. Assess technology investments. A crucial determinant in how successful a bank will be in deploying digital asset-related services is how well-equipped and properly aligned its technology platforms, vendors, policies and procedures are. One of the primary concerns for traditional banks will be assessing their existing core banking platform; many leading vendors do not have blockchain and digital asset capabilities available at this time. This type of readiness is key if bank management hopes to avoid significant technology debt into the next decade. Additionally, banks will need to assess whether it makes sense to partner, buy or build the necessary technology components to transact, custody, settle and potentially issue digital assets.
  3. Prepare for growing demand. As digital assets become more mainstream, there will be significant growth in institutional adoption and growth in consumer demand, especially from millennials and Generation Z customers. The OCC’s recent interpretative letters and the rapid growth of digital assets even just in the last year only emphasize that the adoption of such assets will be the next phase of evolution for banks. That also involves added responsibilities and regulatory compliance that executives need to start understanding now.
  4. Mind the regulator. The era of digital assets is new, and as such, there is heightened scrutiny around related services and offerings. Executives will need to assess existing “know your customer” compliance obligations and update accordingly. Banks also need to understand necessary capital expenditures related to deploying digital asset services. Regulators will be especially interested in not just what’s under the hood, but how banks are managing these new parts and pieces.

What’s next?
Banks that are contemplating or already in the process of deploying digital asset services will need to understand the regulatory requirements in this space and make upgrades to their core banking platforms to make sure those systems can interface with blockchain and other distributed web (sometimes called Web 3.0) technologies. To learn more about how your executive team can prepare, register now for BankDirector’s May 11 webcast — sponsored by RSM — on the future of bitcoin and digital assets.

How Innovative Banks Capitalize on Cryptocurrency

This summer, three new developments in the relationship between banks and cryptocurrency players signaled a shift in attitudes toward digital assets.

In May, JPMorgan Chase & Co. began providing banking services to leading crypto exchanges Coinbase and Gemini Trust Co., — a notable change given that Chairman and CEO Jamie Dimon called the seminal cryptocurrency Bitcoin “a fraud” just three years ago. In July, the acting comptroller for the Office of the Comptroller of the Currency, Brian Brooks — who served as the chief legal officer for Coinbase prior to his appointment — released an interpretation letter confirming that financial institutions can bank cryptocurrency clients and could even serve as digital asset custodians. And this month, the popular crypto exchange Kraken secured a special purpose banking charter in Wyoming, marking the first time a crypto company gained banking powers, including direct access to payment rails.

Cryptocurrency is gaining wider acceptance as a legitimate commercial enterprise. But, like other money services businesses, these companies still find it difficult to obtain basic banking services. This is despite the fact that crypto is becoming more mainstream among consumers and in the financial markets. The industry is booming with a market capitalization equivalent to over $330 billion, according to CoinMarketCap, but it’s currently served by just a handful of banks.

The best-known institutions playing in the cryptocurrency space are New York-based Signature Bank and Silvergate Capital Corp., the parent company of La Jolla, California-based Silvergate Bank.

Signature’s CEO Joseph DePaolo confirmed in the company’s second-quarter earnings call that $1 billion of the bank’s deposits in quarter came from digital asset customers. And at just $1.9 billion in total assets, Silvergate Bank earned over $2.3 million in fees in the second quarter from its crypto-related clients. These gains weren’t from the activity taking place on the banks’ respective payment platforms. They came from typical commercial banking services — providing solutions for deposits, cash management and foreign exchange.

One community bank hoping to realize similar benefits from banking crypto businesses is Provident Bancorp. The $1.4 billion asset institution based in Amesbury, Massachusetts, which recently rebranded as BankProv, aims to treat crypto companies as it would any other legal commercial customer. Crypto customers may have heightened technology expectations compared to other clients, and present heightened compliance burdens for their banks. But the way CEO David Mansfield sees it, these are all things BankProv needs to address anyway.

It really pushes traditional, mainstream corporate banking to the next level,” he explains, “so it fits with some of our other strategic goals being a commercially focused bank.”

Before BankProv launched its digital asset offering, it did a lot of groundwork.

The bank revamped its entire Bank Secrecy Act program, bringing in experts to help rewrite procedures and new technology partners like CipherTrace to provide blockchain analytics and transaction monitoring. It retooled its ACH offerings, establishing a direct connection with the Federal Reserve and expanding its timeframe for processing transactions to better serve clients on the West coast. And BankProv’s team met with crypto-related businesses for insights about what they wanted in a bank partner, which led the bank to upgrade its API capabilities. BankProv is working with San-Francisco-based fintech Treasury Prime to make it possible for crypto clients to initiate transactions directly, instead of going through an online banking portal.

At the same time, BankProv made plans for handling the new deposits generated by the business line; crypto-related companies often experience more volatility in market fluctuations than typical commercial clients.

“It’s definitely top of the regulator’s mind that they don’t want to see you using these funds to do long-term lending,” Mansfield says.

For BankProv, part of managing these deposits is deploying them toward the bank’s mortgage warehouse lending business; those loans are short-term, maturing within seven to 15 days. “[Y]ou need to find a good match on the asset side,” Mansfield explains, “because just having [deposits] sit in Fed funds at 10 basis points doesn’t do you much [good] right now.”

While BankProv officially announced that it would begin servicing digital asset customers in July 2019, the onset of Covid-19 made it difficult to get the program into full swing until recently. With travel being severely limited, BankProv made it a priority to hire new business development talent earlier this month that came with a pre-existing Rolodex of crypto contacts. The digital asset business hasn’t appeared in the company’s 2020 earnings releases so far.

Banking crypto-related clients will only make sense for some of the most forward-thinking banks; but for those that are successful in the space, the upside is significant. Mansfield believes BankProv has the attributes needed to thrive as a part of the crypto community.

“You have to be open minded and a little innovative. [I]t’s certainly not going to be right for the vast majority of banks,” he says, “and I think that’s why there’s really only two that are dominating the space right now. But I feel there’s at least room for a third.”