Yes, banks are coming to Bitcoin in the U.S. – to bitcoin custody, specifically. Is this good or bad for Bitcoin markets? The answer is: both.

Bloomberg reported last week that the SEC is now granting “exceptions” to its punitive accounting standard called SAB-121 for “several large banks,” which an SEC spokesman subsequently confirmed to Fox Business. This new fact means some banks are no longer constrained by an accounting rule that previously penalized banks for providing custody services for bitcoin and crypto. After SAB-121 was announced in 2022 many banks downsized or shut down their crypto custody businesses, but this SEC news means the SAB-121 obstacle is no longer in the banks’ way if they can meet the SEC’s workaround requirements. (Bank regulations might still be in the way, though, which is where Custodia Bank may help. Hold that thought.)

The history of banking in the U.S. is one in which large banks that have capital capacity but are growth-constrained will cyclically seek growth through acquisition – usually by acquiring faster-growing asset originators from outside traditional banking. The SEC’s SAB-121 reversal means another such wave is likely.

Buckle up!

WHY IT’S GOOD FOR BITCOIN MARKETS THAT THE BANKS ARE COMING

First, banks structurally provide better protection for custody customers than non-banks can, due to a particular legal feature of banks in the U.S.: by law, banks cannot be dragged into bankruptcy, which – in this context – means custody assets held by a bank cannot be subjected to the uncertainties of the federal bankruptcy process, such as the possibility of subjecting customers’ custodied assets to preferences. Banks are exempt from these uncertainties, and are instead subject to special receivership statutes that are designed to protect customers and ensure they continue to own their assets under custody if the bank ever fails.

The SEC is clearly focused on this issue in granting banks exceptions to SAB-121. An SEC spokesman confirmed it is giving such exemptions if their fact pattern differs from SAB-121, “…such as ensuring that customers maintain ownership of their assets even in the case of a resolution….” Well, by definition banks fit that pattern – because banks cannot be dragged into bankruptcy court, where customers’ assets under custody could become subject to preferences.

Customers of non-banks such as Celsius and BlockFi have learned the hard way about bankruptcy preferences. Celsius’s custody customers agreed to settle with the bankruptcy trustee to recover only $0.725 per dollar of their assets under custody because – even though the bankruptcy court deemed those custody assets to belong to the customers, the trustee could not release them until all preferences cleared. Custody customers settled for $0.725 rather than wait years until the bankruptcy court cleared all the preferences. Two weeks ago, the Celsius bankruptcy trustee sued thousands of former Celsius customers to claw back assets into the estate.

All else equal, custody customers are better-protected legally if their custodian is a bank. Two crypto-native companies are established banks today: Custodia Bank and Kraken Bank.

Second, banks entering the Bitcoin and crypto custody business will of course bring liquidity, because banks bring connectivity to the traditional financial system. Wall Street is coming.

WHY IT’S BAD FOR BITCOIN MARKETS THAT THE BANKS ARE COMING

It’s a double-edged sword. Banks bring liquidity but they also bring leverage-based financialization (aka “paper bitcoin”), which artificially impacts bitcoin’s price. Here are links to explanations why “leverage and bitcoin do not mix, period;” or why “a fool and his leveraged bitcoin are soon parted;” or why if banks go greater than 1:1 leverage, this will someday take down a G-SIB (global systemically important bank). Wall Street’s practices of rehypothecation, commingling and collateral substitution mean it can be easy for leverage to exceed 1:1 without banks’ risk systems detecting it. (Leveraging bitcoin is fine, as long as the leverage stays below or equal to 1:1.) But banks must be especially careful to segregate Bitcoin from their other exposures.

HOW DOES CUSTODIA BANK ENTER THE PICTURE?

Now that the SEC is granting “exceptions” to “several large banks” to enter crypto custody, what’s next for banks?

Banks have a decision: buy vs. build vs. rent, if they want to enter crypto custody. This is where Custodia Bank can help.

Banks entering crypto custody will need to comply with a multitude of bank regulations enacted since SAB-121 – including, for example, the Fed’s novel activities supervision program and third party risk management guidance. The FFIEC exam manual has not yet been updated for crypto activities, but two states – New York and Wyoming – have updated their exam manuals for crypto activities. The Wyoming exam manual is public, and it’s based heavily on the FFIEC exam manual as adapted for crypto by Promontory, which consulted for the State of Wyoming.

Here are some considerations for a bank’s buy vs. build vs. rent decision:

BUY: banks can offer what non-bank crypto custodians cannot at present – the legal benefits of being a bank. I’ve long thought bitcoin custody markets would migrate toward using banks as legal entities, which is exactly what happened in securities custody due to the inherent structural advantages of banks as legal entities. Since crypto-native companies have been blocked from obtaining bank charters (specifically, from obtaining federal depository institution charters or FDIC insurance for state depository institution charters), this means Washington, D.C. gatekeepers have handed a structural advantage to incumbent banks.

But banks buying non-bank crypto companies will face big operational challenges with the integrations. Specifically, non-bank crypto companies have not been operating under the strict guidelines applicable to banks and will likely need upgrades to BSA/AML/OFAC compliance and operational risk management programs once they become owned by a bank. One obvious challenge is that non-bank crypto companies have cloud-native architectures, and mixing on-prem with cloud-native architectures poses increased risk to the bank acquirer.

BUILD: the safest way for a bank to offer crypto custody is to build it in-house. This is what Custodia did, and that’s not a fast process. As a software developers’ saying goes, every third party is a potential security hole. Building native takes time; building by piecing together third parties is available but it amplifies risk issues. A bank could build crypto custody quickly by piecing together infrastructure vendors designed to facilitate speed to market – indeed, many crypto-native companies got to market quickly by doing this. But banks’ third-party risk management requirements (and possibly the Bank Service Company Act) make this harder for banks. Piecing together vendors may not be an attractive option for banks.

RENT: if a bank knew that there’s a bitcoin custodian built to bank standards, that was constructed to meet third-party risk management requirements, that is examined under a crypto-updated version of the FFIEC exam manual, and that could satisfy the SEC’s requirement for an SAB-121 exception (to “…ensur[e] that customers maintain ownership of their assets even in the case of a resolution…”), it would be strategically advantageous for the bank to discuss a potential partnership arrangement with that custodian.

Custodia Bank is that custodian.

We are open to talking to banks mapping out their bitcoin custody strategy about creating new sub-custody and other partnership arrangements.

Get in touch with us: [email protected].

Thanks for reading!

Caitlin Long, CEO