Introduction
Blockchain technologies and cryptocurrencies offer U.S. banks two big opportunities: operational efficiencies that blockchain technology brings, and the potential to maintain or increase market share by opening up access to cryptocurrency.
But this will not be straightforward. For one thing, progress could be hampered if regulators proceed with intentions already hinted at regarding the hefty risk weightings to be required on crypto that banks hold on their balance sheets.
A minority of banks are tentatively entering the custody arena, but otherwise they cannot match the prime broking services provided, for example, by crypto native companies.
As we show below, banks certainly want part of the expanding crypto market, but they won’t get it without considerable help from those already established in institutional-grade digital asset financial services.
The banks using blockchain technology
In early 2021, Bank of America research reported that 21% of the banks they covered were using blockchain technology in some capacity. Later in the year, in August 2021, Wells Fargo and JPMorgan registered their crypto asset custody divisions (crypto trusts) with the U.S. Securities and Exchange Commission. And in November 2021, it was reported that Citi was hiring 100 personnel in its institutional division to focus on digital assets with a remit to explore product development and management. These developments are further indications of the heightened interest in blockchain technology by major U.S. banks.
And in the only example to date of a digital asset developed by a U.S. bank that has moved beyond testing to live production status, JPMorgan Chase launched its own permissioned blockchain and JPM Coin stablecoin for interbank transactions, cross-border payments, and repurchase agreement (repo) trading for U.S. Treasuries.
Many banks that have no live blockchain deployment are nevertheless exploring use-cases. They are implementing blockchain through a combination of in-house development and/or working with infrastructure-as-a-service partners, such as Coinbase Cloud and R3 and their respective blockchain enterprise products, QT and Corda.
Establishing consortia to explore blockchain uses are key to banks cooperating to hammer out solutions on interoperability and standardization. Deloitte estimated that in 2017 there were 26 consortia in financial services, with U.S. banks featuring prominently.
However, as the Bank of America research points out, none of the banks covered are involved in crypto transactions beyond those relating to custody arrangements.
Background
There has been a modest shift in federal banking authorities’ views toward digital assets. In their statement published in November 2021 regarding policy sprints, the U.S. federal bank regulatory agencies note:
“The Board of Governors of the Federal Reserve System, Federal Deposit Insurance Corporation and Office of the Comptroller of the Currency recognize that the emerging crypto-asset sector presents potential opportunities and risks for banking organizations, their customers and the overall financial system.”
This joint agency statement is slightly less conclusive than earlier interpretive letters from the Office of the Comptroller of the Currency (OCC). For example, there was the January 2, 2021 interpretative letter from the OCC which concluded “that a bank may validate, store and record payments transactions by serving as a node on an INVN [independent node verification network],” along with the announcement in July 2020 that banks and thrifts could take custody of crypto assets. An INVN is a shared electronic database such as a blockchain, where the same information is copied and shared across a distributed network of computers.
The 2020 and 2021 OCC interpretive letters were construed by banking industry observers as permissive, allowing, for example, institutions to take on digital asset custody if they wished. The OCC later modified its letters in November 2021 by indicating that banks should seek supervisory non-objection before engaging in the crypto-related activities permitted.
While banks would still benefit from even greater regulatory clarity, they nonetheless have made strides forward in preparation for the possible implementation of blockchain technology.
There have been plenty of consortia formed, accelerator and incubator investments undertaken, and pilots and papers published on how banking could be made cheaper and more efficient by using it. Just as electronic trading made open outcry redundant, blockchain technology can do the same for share trading and many other financial trading activities dependent on centralized, trusted third parties.
Also, the use of blockchain technology in the banking sector may need to take into account the possible risks this sort of re-engineering of the financial infrastructure may entail.
Add the need to address the problems of interoperability, harmonizing standards and regulatory uncertainty, and the barriers seem steep.
Still, today these issues are more manageable than they were just a few years ago. The challenges of achieving blockchain interoperability are now closer to resolution. Also, the stated endpoint of the policy sprint by U.S. agencies is the creation of a regulatory framework in which standardized systems will be a core outcome.
What crypto-asset services might banks be interested in offering?
In many respects banks are responding to client existing demand, and anticipating demand, for crypto services — whether from institutions or retail customers. The services they will look to offer in the near future break down into five main area.
- Crypto-asset custody
- Facilitation of customer purchases and sales of crypto assets
- Loans collateralized by crypto assets
- Payment activities, including stablecoins
- Activities that may result in holding crypto assets on a banking organization’s balance sheet
Our list of areas of interest tallies with those identified by the OCC, Federal Deposit Insurance Corporation (FDIC), and the Fed. The order might loosely be considered as running from those areas more likely to gain regulatory clarity to those that may require more time.
Custody
The boldest step so far by a U.S. retail bank came when U.S. Bank, the country’s fifth-largest consumer-facing institution, announced a crypto custody service in October 2021. But, as with other banking entrants to crypto custody, to date this service is for institutional clients only.
More banks, including Bank of New York Mellon, State Street, and Northern Trust, have indicated that they have started or are ready to start crypto custody services. However, some may now await further regulatory clarity following the OCC letter in November 2021.
In an interview with Reuters, FDIC chair Jelena McWilliams said one main objective of the policy sprint was to get ahead of the curve on crypto custody. Referring to crypto custody, Chair McWilliams said: “I think that we need to allow banks in this space, while appropriately managing and mitigating risk.”
Many observers are interested to see whether banks will take custody of digital assets at the institutional level and on behalf of retail customers. In a related context, we have already witnessed the launch of the first bitcoin ETF in the U.S. The ProShares Bitcoin Strategy ETF (BITO) debuted on October 19, 2021 as the second-most heavily traded ETF ever, with a turnover of nearly $1 billion. Such strong demand may cause banks to become more interested in retail crypto business, including custody.
Loans and stablecoins
Digital asset companies and entities have already done much of the groundwork on how crypto-collateralized loans and stablecoins work and are managed, but continue to seek additional regulatory clarity.
U.S. agencies are currently wrestling with the systemic risks that such instruments could bring. These relate to how loans and stablecoins can be operated with sufficient capital adequacy. What difficulties might arise from counterparty risk or loss of confidence in a widely used stablecoin? And how might such a loss of confidence affect the value and/or trust in the underlying asset that a stablecoin is pegged to, usually the dollar?
Banks may find the regulations overseeing loans and stablecoins more stringent than other asset classes, but in return they may receive preferential roles in issuance, with other non-bank entities obligated to acquire bank charters.
On November 1, 2021 the President’s Working Group on Financial Markets published its report on stablecoins, highlighting concerns around financial stability and investor protection. In commenting on the report, Secretary of the Treasury Janet L. Yellen said: “Stablecoins that are well-designed and subject to appropriate oversight have the potential to support beneficial payments options. But the absence of appropriate oversight presents risks to users and the broader system.”
Once regulatory boundaries have been agreed upon, offering stablecoins as a payments rail would present little difficulty, although accepting “pure crypto” as payment for services would be entirely different. U.S. banks are unlikely to offer a service enabling crypto transactions for goods and services in the near future.
Crypto on bank balance sheets
All the above activities naturally lead to the question of whether banks will eventually be permitted to hold crypto on their balance sheets.
In reality, that depends partly on how fast the crypto asset class matures. One indicator would be to quantify how many non-bank corporates hold crypto on their balance sheets. While Tesla, and MicroStrategy both have significant bitcoin positions on their balance sheets, so far there is no sign of mass adoption by mainstream corporate America.
If central banks began to adopt CBDC deposits and make it legal tender, it would represent a transformational development at a societal level. Such a lead from on high would likely see banks take crypto assets onto their books.
However, banks could yet introduce crypto onto their balance sheets without the developments outlined above, although with very strict safeguards. The OCC has indicated that it is minded to agree with the Basel Committee on Bank Supervision.
For what the Basel Committee calls Group 2 assets — cryptocurrencies such as bitcoin, ethereum, dogecoin, etc. — a bank must assign a risk weighting of 1,250%. Such onerous risk weighting requirement is normally reserved for unrated securitization exposure. Under its rules this would require banks to hold capital equal to or greater in value than the Group 2 asset. The Basel Committee determines stablecoins to be Group 1 assets, where capital adequacy must at least equal those of traditional assets. See table below.
Banks could widely embrace crypto only once rules and risk controls are in place
Crypto banking services are still on the horizon, but with strong supervisory and regulatory headwinds. Banks may need to deepen existing relationships with crypto-native companies or develop them. Institutional services are continuing to drive adoption, especially with custody, where some banks already have products up and running.
Crypto product offerings such as loans and stablecoins may take longer to emerge, with high barriers to entry, assuming regulators decide crypto-backed loans are permissible for banks and other financial institutions.
As crypto matures and bank crypto activities grow, banks may eventually accept crypto onto their balance sheets, but with stiff capital requirements. We think it likely that banks will seek out crypto-native firms to help set up and manage such endeavors. In turn, banks’ adopting digital assets can help bolster the crypto ecosystem by offering a custodial framework that complements current options for traditional investors
