This past week threw crypto’s banking problems into sharp relief. Silvergate Bank was arguably the biggest provider of banking services to the crypto industry and its unraveling will significantly reduce options available to crypto businesses for access to the world of mainstream financial services. 

As I wrote last year, three banks – Silvergate, Signature, and Customers – were responsible for banking most crypto firms. After news of Silvergate’s problems became public, Coinbase said it was shifting business to Signature Bank.

But that relationship will not last long.  During its last earnings call, Signature Bank’s CEO said it was actively reducing the size of its relationships with digital asset companies. It had already slashed its exposure to crypto by $7.4 billion by the end of last year and plans to shrink it by a further $3 billion to $5 billion by the end of 2023. Given crypto’s fast fading reputation and mounting warnings from federal regulators, it is likely that Customers will follow suit.

Meanwhile, regulatory clarity is still years away. Federal agencies are busy punting the crypto ball amongst themselves and there is no timeline on final rulemaking. This means that crypto firms could soon find themselves marooned, without outreach to mainstream financial services, in the United States.  

What might be the possible banking alternatives to crypto firms?

The Crypto Custody Bank Alternative  

One could be custodian banks. As their name indicates, custodians store client assets. In addition, they are allowed to provide fiduciary services such as business cash management and operational accounts to service their customers.

Brokerage custodians are primarily regulated by the Securities and Exchange Commission (SEC) but may have to fulfil other federal obligations depending on the scope of their operations. Currently cryptocurrency exchanges like Coinbase offer custody service in addition to their regular trading operations.

A Legal Disaggregation  

But their future has come under a cloud after SEC chief Gary Gensler’s comments last week about crypto firms not meeting requirements for custody. In an interview with New York magazine last weekend, SEC chief Gary Gensler sketched a picture of the future in which these functions are “legally disaggregated” as they are in traditional finance markets.

If Gensler has his way, then the winners could be traditional banking custody providers like Bank of New York and Mellon (BNYM). BNYM already provides primary custodial services and reserves for USD Coin (USDC) and permits certain clients to hold and transfer bitcoin and ether.

The SPDI Alternative           

FDIC insurance place constraints on the operations of banks and financial institutions regulated by federal authorities. A possible workaround to this problem is the Special Purpose Depository Institution (SPDI).

SPDIs can receive deposits and conduct other activity “incidental to the business of banking”. Those incidentals include custody, asset servicing, asset management, and related activities, according to Wyoming’s SPDI charter. Since they are not eligible for federal insurance, SPDIs are required to maintain high-quality liquid assets valued at 100% or more of their depository liabilities.

Of course, there is always the argument about high-quality liquid assets.

What constitutes such assets? And what percentage or amount is considered appropriate to make bank customers whole during a bank run? Bank runs in crypto history have mostly been for worthless tokens, where investors have bolted after booking profits. SPDIs are too new as a concept to answer those questions.  

Right now, there are two prominent SPDI entities in Wyoming – Custodia bank and Kraken bank. Custodia bank attempted to push the envelope by applying for a Master account at the Federal Reserve, but the agency rejected its application not once but twice.

An approval for Custodia would have meant it would be subject to the same regulation as other Fed banks, such as AMC/KYL rules and periodic audits. In a crypto ecosystem that is riven with daily arguments about privacy and capital requirements (as in the case of stablecoins), that might be a difficult ask. 

The bank further made its case murky by proposing to list a publicly traded token on Ethereum. Crypto markets already have an unsavory reputation; Custodia’s plan to list tokens only instigates further suspicions from regulatory agencies already wary of crypto.

This means that, while they offer an alternative, SPDIs offer very few benefits.

The Bank Holding Company (BHC) Subsidiary Alternative

The final and, most likely, alternative for crypto banking are subsidiaries of bank holding companies. BHC subsidiaries that deal in crypto are an ideal solution to the industry’s banking problems. The Fed has limited authority over nonbank subsidiaries of a BHC, meaning the stringent capital and risk management requirements applicable to banks will not apply to such subsidiaries. This will allow them to service the crypto industry without running afoul of existing financial regulation.

In 1978, the United States Supreme Court interpreted the Bank Holding Act of 1956 to mean that the Federal Reserve Board could deny an application for BHC if it determined that the company “would not be a sufficient source of financial and managerial strength to its subsidiary bank.” In other words, the parent company should serve as a source of financial strength for its subsidiary.

Silvergate’s collapse last week demonstrated that the business of servicing crypto is inherently unstable and requires significant capital and managerial cushion to withstand deposit runs. This means that only large bank holding companies – the likes of JP Morgan Chase, Citigroup, and Goldman Sachs – should be able to service those requirements.

The BHC subsidiary alternative also dovetails nicely with the legal disaggregation suggested by SEC chief Gary Gensler in his interview. Bank holding companies will need the services of custodians and trading exchanges to administer their business. All of this means that the future of crypto is disaggregated and likely dominated by existing financial services firms rather than a new roster of players.