Banking in the shadow of crypto banks

Last month, the Federal Reserve released guidelines that will allow crypto banks access to master accounts.

This opens up the door for crypto banks and stablecoin issuers and gives them direct access to the global payments system — national and international payments — that Federal Reserve bank master accounts provide access to.

The new guidelines provide a consistent and transparent process to evaluate requests for Federal Reserve accounts and access to payment services. Applicants will have to meet six criteria: 1) be legally allowed to apply for a Reserve Bank account, 2) verify they would not create a risk to the Federal Reserve Bank that grants them an account, 3) verify they will not create a risk to the overall payment system, 4) verify they will not create a risk to the U.S. financial system, 5) prove they won’t allow illicit activity, 6) and show they won’t “adversely affect” the Fed’s ability to draft and apply monetary policy.

This is a very important step in bringing crypto one step closer to being integrated into the mainstream economy.

The big question is, why now?

Crypto companies market themselves as platforms for users to buy and sell crypto but also function like stockbrokers, and, more concerningly, their core business models closely resemble banking.

In companies like Celsius and Voyager, customers’ accounts were not held separately in their wallets but rather held in a pool owned by the platform. The platform would use this pool of money to make loans or to engage in its own speculative investing.

We all know how that turned out.

When depositors cashed out, they were paid from the pool, which under normal conditions was able to cover withdrawals, but did not have enough cash to handle everyone pulling out simultaneously.

These guidelines are long overdue and a step in the right direction.

They recognize that other players can provide value to the economy and should be able to join the club. The legacy financial system is an exclusive club of banks and inclusion means that participants need to follow the rules. This can only be a good thing. It protects customers and creates a regulatory path for entities without deposit insurance or federal supervision to work directly with the Fed.

But the Fed’s announcement adds another interesting twist. It pushes regular banks even more in the direction of crypto, to compete with crypto banks.

The banking industry was already racing to catch up and profit from this new world. Facing stiff competition from their big rivals, crypto provided smaller banks with a winning edge.

The crypto market was an alternative for smaller banks to boost their deposits, by providing corporate accounts to the likes of Coinbase, Binance, and Celcius, making it easy for crypto companies to provide liquidity to their customers and allow for the fast purchase of digital assets.

Silvergate Capital, Signature Bank, Customers Bancorp, and LHV Pank snapped up billions of dollars in deposits from crypto businesses and grew with the market.

Also, community banks got into crypto. Community banks are an important provider of credit to small businesses and an essential element for the development of local economies. In 2019, there were 4,750 community banks, compared to only 427 non-community banks operating in the US.

Vast Bank, a community bank in Tulsa, Oklahoma, became the first nationally chartered, FDIC-insured bank to offer crypto banking, a product that allows customers to buy, sell and hold virtual currencies through the bank’s user interface. Two small California community banks, First Foundation Bank in Irvine and Suncrest Bank in Visalia, quietly built the capability for customers to buy, sell and hold bitcoin. Account holders can manage and monitor their crypto holdings alongside their checking, savings, and other traditional bank products.

But this year’s decline in cryptocurrency prices has put some of these smaller players on a rollercoaster ride and created a lot of skepticism about their course.

In the second quarter, deposits at Silvergate fluctuated by $5 billion before ending at $13.5 billion.
Signature posted a decline in deposits in the second quarter, for the second time in the last ten years, and Celsius Network one of its major clients filed for bankruptcy.
As for LVH, the bank’s consolidated net loan portfolio increased by €172 million in a quarter, but consolidated deposits fell by €44 million and deposits associated with payment intermediaries fell by €94 million.

Most people agree that in the future — it might be 10 or 20 or years or it might be sooner — all assets are going to be digital. It was inevitable that crypto banks would be brought into the fold of the international payments systems.

Now the Fed’s guidelines for crypto banks add another strain to regular banks.

Crypto banks and other fintech companies will no longer need partnerships with traditional banks that serve as their intermediaries and will be able to send and receive money cheaply and seamlessly. The ruling is also important for stablecoin issuers that have sought banking charters or may be required for dollar-pegged cryptocurrencies to be banks.

There have been several crypto institutions like Kraken and Custodia applying for access as early as 2021. While these attempts dragged on for the last 18 months, they may have set in motion the need for new guidelines to grant “novel” banks access to the existing legacy financial system.

These should have been wake-up calls for existing banks. The potential to access the global payments system gives crypto banks the option to perform a dual function.

The decision does undermine the ideals of crypto, beginning with bitcoin as a decentralized peer-to-peer digital cash network, but for cryptocurrency to reach mainstream adoption and be a serious contender to fiat currencies, it is important to create an environment of transparency, security, and consistency.

The banking system is on the verge of radical changes. There are risks, but there are also really huge opportunities and while traditional banks could have played an important role, they were sidelined. They thought crypto was their enemy and instead and experimenting with it and embracing it early on, they fought it for years.

Now the cat is out of the bag and crypto banks and other fintech companies don’t have to go through their gateways.

Giving crypto firms more access to central bank infrastructure, there will be far greater oversight than ever before. This can increase the trust within the crypto space and legitimize digital assets.

More than holders of our assets, our future banks will be the holders of our trust. The ones that manage to enter the system and maintain their core values will survive, while the rest will go the way of the dinosaurs.

by Ilias Louis Hatzis is the founder and CEO of Kryptonio wallet

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