Article: Should Your Bank Crypto?

The last ten years have seen dramatic changes in the payments landscape, including evolving data standards such as ISO20222, new payments rails featuring instant payment capabilities, the ever-growing promise of data analytics to drive new customer growth and profitability, and the introduction of perhaps the most mysterious of new payments technologies, cryptocurrencies.

While there are a wide variety of cryptocurrencies or “crypto”^[1], they are all based on Blockchain or Distributed Ledger Technology (DLT), invented by a person or group using the pseudonym “Satoshi Nakamoto” in 2008. In early 2009 the first version of the Bitcoin (₿) software platform was released and it became possible to “mine” the digital coins, a process that generates new coins and is designed to become more difficult over time to create scarcity. The number of Bitcoins in circulation passed 10 million in 2012, but the ever-increasing computing power required has slowed mining. Today there are just over 18 million Bitcoins, and there will never be more than 21 million.

From its origins with Bitcoin, DLT has expanded into additional currencies, and today there are more than 8,000 of them (up from about 1,000 three years ago), with 20 or more having greater prominence and wider circulation, including Maker, Ethereum, Aave, Litecoin, and others. Various exchanges exist (more than 500, though the top 10 dominate the market), and it is now easy to buy and sell these currencies using US Dollars or other fiat currencies. A number of people have gotten very wealthy buying and holding cryptocurrencies, especially Bitcoins, which are valued at more than $50,000 each, up from just $1 ten years ago. A $100,000 investment then would be worth $5 billion today.

Given the excitement around cryptocurrencies and the profit opportunities they could represent, should a community bank be making moves to be more involved? There are hurdles to going in that direction, including regulatory uncertainty. Crypto has, at times, gotten bad press, much of it deserved. As your BSA Officer will tell you, an all-digital, irrevocable, largely anonymous payment method is custom-designed for illicit purposes such as money laundering, narco-trafficking, gunrunning and even tax evasion. Some cryptocurrencies have introduced ways of identifying participants to each other to mitigate this risk somewhat, though Bitcoin itself still largely exists in a monitoring-free zone.

While the regulatory environment remains murky, it has gotten somewhat less so over time. FinCEN has provided some guidance on virtual currencies and a proposed rule from the end of last year further clarifying how to handle crypto from a BSA perspective. Even the IRS weighed in, telling taxpayers to treat crypto as a capital asset and not as a currency at all. The National Defense Authorization Act of 2020 passed in January included the Anti-Money Laundering Control Act of 2020 in whole as an amendment. It explicitly gives FinCEN the authority to regulate virtual currencies.

Another challenge with cryptocurrencies is price instability. Even if the people using it are engaging in legal, honest exchange, there is still the problem of valuation. For example, today you could buy a luxury car for 1.5 Bitcoins (that would be an $83,000 car), but as recently as the end of February those Bitcoins would have been worth “only” $68,000. In mid-March it would have been a $91,925 car. It’s not clear how crypto can operate effectively as a medium of exchange when its value changes up and down so dramatically. There are newer versions of cryptocurrencies called Stablecoins that seek to mitigate these wild fluctuations by pegging their value to fiat currencies, usually US Dollars, or to a commodity, such as gold. If successful, these currencies (such as TrueUSD, USD Tether and Digix Gold Tokens) could provide all of the benefits of other crypto and add price stability.

Cryptocurrency is a big topic and one article can provide only the briefest introduction. Banks looking to permit crypto-trading customers should consider them higher-risk Money Service Businesses (MSBs) and implement appropriate monitoring and controls. If a bank were to develop a crypto trading  service they’ll find themselves at the edge of what many regulators will be comfortable with, and a long and thorough product development phase to identify and mitigate risks on the cutting edge of finance will be the best way forward.

There are many aspects of the technology that weren’t covered in this brief article. Perhaps the most exciting uses of DLT don’t involve using the currencies as a medium of exchange at all. The Blockchain can be used to facilitate smart contracts, where the legal terms are built into the transaction itself, various types of insurance policies, supply chain tracking and much more. Ripple Labs is an example of a company looking to solve real-world financial services problems using Blockchain. Within the financial industry it’s these out-of-the box, non-currency uses of DLT that could present some of the best opportunities for a bank’s own business, when they are better developed and ready for prime time.

[1] Cryptocurrencies are a sub-set of virtual currencies, a more general term for all digital currencies.