Notes 8/16: Crypto Banks

Establishing an interface with banks has been one of the biggest problems for cryptocurrency businesses in the last ten years. Bitcoin’s dubious utility, an absence of regulatory guidance and volatility in crypto markets has made mainstream banks wary of processing transactions that involve cryptocurrencies. Crypto companies have, instead, turned towards smaller institutions.

Three banks – Silvergate Bank, Signature Bank, and Customers’ Bank – have garnered most of their business. These banks serve a vital function: they connect crypto transactions to fiat currency and enable transactions.  

How are these outfits, which do not have the resources and capital available to their larger counterparts, managing their affairs in the recent crypto implosion and its subsequent aftermath? Very well, it would seem.

Silvergate bank reported deposits of $14.7 billion in the first quarter of this year, up from $13.3 billion in the previous quarter. The number of digital currency customers at the banks rose to 1,503, an increase of 400 customers, in the same time period.

While its deposits fell by $5 billion on a yearly basis in the last quarter, Signature Bank reported record earnings and income in the second quarter of 2022. In the last two years, its cash deposits have grown by $66 billion – another record.

But crypto customers took $2.4 billion off its books this past quarter. The exodus was led by digital asset exchanges, who took $1.5 billion off the bank’s books “in search of higher yield”. Digital miners and institutional traders in crypto withdrew $40 million and $100 million from their accounts. Those exits were balanced by an increase in the client count for its digital asset business, which rose to 1323 – an increase of 121 – from the previous quarter.

Customers’ Bank reported 32.3% increase in its core earnings this past quarter. Total deposits, loans and leases available to retail and industrial customers jumped by double digits as compared to the previous year. It welcomed 90 new customers, a ninety percent increase from the previous quarter, for its CBIT token that enables instant transfers and liquidity for crypto clients and investors.

The Wall Street Journal reports that the banks have a “bigger cushion” for “unexpected outflows” of deposits from cryptocurrency clients due to the current turmoil in crypto markets. Deposits from crypto businesses surge, as they did during the pandemic bull run, during times of plenty and decline in the ensuing crypto winters.

The vertiginous cycles might be a cause for concern investors but the banks say they are well capitalized. Christopher Smalley, head of digital operations at Customers’ Bank, told the Journal that they are “prepared for an extinction level event where bitcoin would go down to zero.”    

All three banks have the standard business model for such businesses – a mix of lending and investing activities. Their interface with crypto is different because it includes payment networks. Silvergate has the Silvergate Exchange Network (SEN), Signature Bank has Signet and Customers’ has CBIT. These networks ensure instant liquidity and transfers and are available 24X7X365.

That is a pretty big deal for institutional investors and hedge funds because it enables instant payment rails. Their business model is a pointer to the future of finance, one in which banks will have their private payment rails to facilitate instant transfers between their customers.

Federal Reserve Plans to Unveil Guidance for Crypto Banks

But their business model as intermediaries might not last long. The Federal Reserve announced this morning that it was planning to publish guidance for financial institutions that offer novel products and services. Two Special Purpose Depository Institutions (SPDIs) from Wyoming – Custodia Bank and Kraken Bank – have applied for master accounts at the Federal Reserve. These accounts enable instant settlement for transfers and banking transactions. They also eliminate big banking institutions that act as gatekeepers and process transactions.

The Fed’s guidance will be similar to the one it proposed in 2021. It envisages a three-tiered structure based on levels of federal oversight. Thus, Level 1 consists of financial institutions directly under the Fed’s oversight will have the least regulatory burden while institutions that are not overseen by the agency, i.e., those under Level 3 supervision, will be subject to strict supervision. Kraken Bank and Custodia Bank fall in the Level 3 category.

In a previous interview, David Kinitsky, CEO of Kraken Bank, said the bank aims to provide crypto banking in addition to traditional banking services. This translates to instant transfers for crypto transactions and holding of cryptocurrencies in bank accounts. An account with Kraken will also enable transfers of bitcoin-denominated wages. He also said that Kraken will not have fractional reserve banking, meaning it not will use customer cash for interest-generating activities on the backend.

“We plan to maintain 100% of customer cash”, said Kinitsky. [The alternative to fractional reserve is a Full Reserve approach in which commercial banks back up 100% of their customer assets]. Custodia is advertising itself as a financial institution designed to provide real-time settlement finality for U.S. dollar payments in digital asset transactions.

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