Two Worlds Colliding - Mainstream Finance and Cryptocurrency

As financial technology continues to explode, the world of payment and finance is evolving at a blistering pace. Major institutional players are testing the efficacy of cryptocurrency to replace traditional financial methods in the banking and payments domains. Cryptocurrency is a digital currency in which encryption techniques are used to regulate the generation of units of currency and verify the transfer of funds, operating independently of a central bank. In its early days, these digital assets were often associated with unregulated markets and criminal activity, leading to volatility, liquidity, and security risks. 

While these risks exist, cryptocurrency continues to gain prominence and acceptance by investors, financial institutions, and regulators, as a potential way to improve the financial system by increasing their use for legitimate banking activities within an effective regulatory framework. The $1.7T size of the crypto market as of March 2021 is evidence of its continued growth and push into the mainstream economy.

As the adoption of cryptocurrency accelerates, key risks remain and pose challenges to mainstream adoption. Where should companies focus risk mitigation efforts to maximize impact?

Scanning the Horizon for Risks

There are four key risk areas that Guidehouse believes may curtail broader adoption in the cryptocurrency market:

1. Regulation: The Financial Crimes Enforcement Network is proposing rules changes in compliance for cryptocurrency transactions with unhosted wallets. The SEC has recently published details on the framework in which the agency will examine cryptocurrency investments handled by transfer agents, broker dealers, and investment advisors. The Office of the Comptroller of the Currency (OCC) continues to caution that digital currency payment activities also raise heightened compliance risks related to anti-money laundering (AML) and counterterrorism financing.
2. Volatility: While there has been increasing blue-chip investment into cryptocurrency, companies remain concerned that volatile price swings will negatively impact their balance sheets. Because these assets do not meet specific requirements under current accounting standards, they will have to be treated as separate tangible assets which may incur large write-downs during sustained price weakness.
3. Custody: BNY Mellon has announced that it will be rolling out a digital custody unit later this year to assist clients with digital assets. While this is good news for large institutions, there is still the risk that existing smaller crypto custody firms could become insolvent or incur heavy losses through error or poor performance. 
4. Cyber threat: Cryptocurrency, because it  exists only as a digital token, which makes it easier to erase its online footprint, is particularly susceptible to hacking risks. Estimates show that almost 1 million bitcoin have been stolen from exchanges over the past decade. Using a bitcoin price exceeding $40,000, this implies an equivalent of over $44 billion in losses to date. To protect against illegal activities, more investment will be needed in secure transactions, together with an encryption and privacy strategy to prioritize the safety of company assets.

Use Cases

Large  financial services companies have made recent strides building cryptocurrency-based solutions or partnering with crypto firms to offer consumer-based financial products. Examples of these developments include: 

Payments companies:

At the end of 2020, PayPal began allowing US users to buy, sell, and hold cryptocurrency. Mastercard announced preparations to support select cryptocurrencies later this year. The crypto processing market, those entities that accept and convert cryptocurrency to fiat currency for payment services, now includes over two dozen players.

Crypto exchanges becoming licensed as banks:

Federal law, and some state laws, require cryptocurrency exchanges to register as money transmitters, but some are choosing a different route. Digital asset company Kraken Bank won approval by the State of Wyoming to become the first Special Purpose Depository Institution. This bank charter means that under federal and state law, it will be able to provide comprehensive deposit-taking, custody, and fiduciary services for cryptocurrency. The exchange currently supports seven fiat currencies and stablecoins, such as USDC and Dai. Additionally, in February, the OCC granted its first Federal Crypto Bank Charter to crypto custodian Anchorage.

Lending collateral services:

Fidelity Digital Assets will allow customers to use bitcoin as collateral against cash loans in partnership with BlockFi, a cryptocurrency exchange platform. Non-traditional exchange platforms, those that offer loans backed by cryptocurrency, such as SALT, also service the lending industry.  

Credit card rewards in bitcoin:

BlockFi also has plans to unveil a bitcoin-earning credit card in the first half of this year as part of the Visa network. It will offer holders a flat 1.5% cash back that converts to bitcoin across spending domains. Other cards in development, by platforms such as Gemini, will offer similar benefits.

Bitcoin in self-directed IRAs:

More custodians adopted strategies that allow investors to diversify their IRAs with bitcoin investments. Offerings such as Bitcoin IRA, with over 50,000 account holders, help investors to diversify their retirement strategies by employing bitcoin in accounts to achieve the same tax advantages found in traditional asset accounts. They have processed more than $500 million in total customer transactions since 2016.

Key Trends

As businesses continue to embrace cryptocurrency, there are some notable trends in the short to medium term:

Banks will broaden their reach into the stablecoin market:

The OCC recently issued new guidance detailing how banks may use new stablecoins and independent blockchain node verification networks to perform bank-permissible functions. By removing legal uncertainties about connecting to and using these decentralized technologies, banks will expand their reach into this space as they see opportunity to drive faster and more efficient payments for their customers.

Publicly traded firms will hold more cryptocurrency reserves:

Several public companies are leveraging bitcoin rather than traditional assets for reserves and making amendments to their investment policies to pave the way for further diversification into this area. Firms such as MicroStrategy (the first public company to add bitcoin to its balance sheet), Tesla, and Square are representative of the increasing pattern of organizations joining the purchasing trend. Crypto asset managers such as Grayscale hold over 3 million Ethereum assets, currently worth approximately $5 billion.

Mergers & Acquisitions:

The skyrocketing price of digital currencies, along with upcoming events such as the IPO for the cryptocurrency exchange Coinbase, point to more institutional buy-in and potentially increased merger activity in 2021. These activities mean exchanges may start to resemble banking institutions as they acquire fragmented services that have developed around cryptocurrencies in the past few years. 

How Guidehouse Can Help

Our Cryptocurrency and Digital Asset Services team can assist companies with the strategic planning and risk management program design needed to enter this arena. As regulations and policies are created and amended, our BSA/AML team has the expertise to guide your organization through the regulatory and compliance environment and address the mounting complexities as cryptocurrencies are integrated into the finance mainstream.

Additional author: Lwanga Phillip.