The Office of the Comptroller of the Currency issued an interpretive letter, in July 2020 on U.S. banks’ authority to provide cryptocurrency custody services for its customers. This is a pivotal development as a record number of the world’s population begins investing in cryptocurrency. Even institutional investors are jumping into digital assets. Thus begins a new era of banks as crypto custodians.
In this post, we discuss the sorts of custody services that banks are likely to provide going forward as they make use of this authority to provide custody solutions across emerging asset classes. We will also explore the competition (or rivalry) that may develop among banks offering these services.
Crypto Products and Earnings Calls
The OCC’s interpretive letter says, “a national bank [i.e. a federally chartered bank or thrift] may provide secure web-based document storage, retrieval and collaboration of documents and files containing personal information or valuable confidential trade or business information because these services are the electronic expression of traditional safekeeping services provided by banks,” and that the provision of crypto custody as a service fall within a national bank’s long-standing authority to do so as a qualified custodian.
Even without the benefit of this interpretation, banks and other large financial institutions have been increasingly active in the blockchain world, especially on the sell-side of its products. In 2020 there were only about 17 publicly owned sell-side corporations that even mentioned crypto during their earnings calls.
But by the third quarter of 2021 that number had increased to 147, a remarkable sign of how these traditional institutions are stepping into digital currency and related business lines and making themselves vulnerable to its difficulties.
In a related development, in recent days the Federal Reserve has finalized its guidance for applications for “master accounts.” This finalization leaves the door not just ajar but wide open for fintech and crypto firms to apply for such accounts. So, the crypto world is moving in on banking just as the banking world is moving in on crypto.
Banks as Custodians
How can financial institutions themselves become effective custodians, both of their own keys and of those whom they serve? At first glance one might think that they will simply have to choose one of the other of two venerable solutions: the cold or the hot. They can keep the keys offline, or they can have them online by involving multiple parties in every transaction, with each party holding only part of the key.
The benefit gained from hot custody is its flexibility/liquidity. The problem with any hot custody, though, is that a bank is, in Willie Sutton’s famous phrase, “where the [crypto] money is.” The bounty is big enough to justify considerable investment in the desired theft. That means that hackers can expend the necessary resources to compromise each of the multiple parties involved.
The best approach may well be a combination of elements from the “hot” and the “cold” approach. Both off-line storage and on-line multiple parties’ custody may be combined. A custodian might, for example, keep the bulk of assets in a cold vault but keep a small percentage online and so ‘on hand’ for immediate demands within an MPC system.
The war between hackers/thieves and the crypto-security industry will surely continue. We have sought to outline one of the current battlefields.
The Differences Among Banks
Another key question in this new era of banks as crypto custodians is how will they differentiate themselves? What economists call a market of “perfect competition” is one in which there is no product differentiation. A given widget maker’s widgets are just like its competitor’s widgets, so the pertinent decisions are about price and quantity. Are any two national banks that offer crypto custody services going to be offering the same widgets?
Some grounds for distinction among competitors (for actual rivalry rather than mere competition) suggest themselves. One bank, for example, may integrate its custody service with the broader support of digital assets such as the Central Bank Digital Currencies.
Any move linking bank-offered custody services to CBDC is likely to affront some potential customers. After all, many people believe that the rise of CBDCs is an ominous development, even one that threatens to guide digital buyers and sellers into “digital cattle chutes where [they] can be slaughtered with account freezes, seizures, etc.” Those are the words of James Rickards, a lawyer who has held key positions at Citi, Long-Term Capital Management, and Caxton Associates, and who writes for the influential blog, Daily Reckoning.
In one plausible scenario two distinct niches develop for banks in the crypto-custody business. Some link their custody and other services with support of CBDCs. Others market their services as free of contamination from the CBDC menace.
The most likely scenario is that banks, as they enter this field in force, will become rivals — they will learn to differentiate their services and to market their differences. In this way a wide range of niches may open by the forces of spontaneous order, in ways that likely will elude our preliminary speculations.
No matter which way the crypto market moves, it’s a $2 Trillion industry to date and it’s here to stay.
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