Operational Implications of Crypto Currency Accounts as a New Service
Crypto currencies and initial coin offerings (ICO) provide attractive service and revenue opportunities but come with compliance and operational risks. Gazprombank Switzerland, Synpulse and Prospire reveal how crypto currency accounts and ICO support can be offered in corporate banking in a compliant, efficient and secure way.
Among crypto-friendly nations, Switzerland has positioned itself in a top rank. Proof of this is the «Crypto Valley» in Zug. It has become a globally recognized center of crypto innovation and domicile of some of the most recognized initial coin offerings (ICO). Especially the vehicle for ICO has become very popular in the start-up scene. ICO enable young companies to raise funding by issuing tokens as digital assets. Buyers of such tokens gain tradeable assets. These assets, in turn, grant access to a future service of the start-up (like a voucher) promise a certain return based on predefined rules (like a smart contract). Often, the funding is paid in established crypto currencies (e.g. Bitcoin, Ethereum). After collecting the funds, the start-ups have huge amounts of crypto currencies in their wallets. But they face three key issues during the process:
- Many banks do not offer ICO start-ups bank accounts. This is due to uncertainty about the ICO’s unregulated business. Banks are concerned that they may support illicit activities.
- Start-ups need to exchange crypto currencies into fiat currencies. This will enable them to pay their ongoing expenses or invest in business development. However, as described in The Magazine 1-2018 int’l, banks refrain from co-operating with ICO start-ups. They do not accept deposits of crypto currencies due to compliance risks. It is therefore difficult for start-ups to make use of their existing funds.
- The start-ups’ wallets are mostly held by a broker or wallet provider, but not by a bank. Safekeeping of the crypto holdings is an expensive task, as it requires a sophisticated security concept. Most brokers and wallet providers are start-ups with limited funding themselves. Along with the sakekeeping issue, there is counterparty risk.
These examples highlight the demand for banking services for ICO start-ups in the blockchain and crypto currency environment.
Regulatory Framework for crypto banking
In February 2018 the Swiss Financial Market Supervisory Authority (FINMA) published «guidelines for enquiries regarding the regulatory framework for initial coin offerings (ICOs)». It provides the first regulatory framework for crypto currencies and, hence, reduces the risk of banks not being compliant when doing business with the ICO sector. Some banks see great opportunities in the crypto area and believe the guidelines are a starting point for developing service offerings. For banks, the opportunities in this space are attractive as they can leverage their banking license as well as their core capabilities, that is extend them to the specifics of crypto currencies.
Crypto banking services
To address the demand of institutional and corporate clients in the blockchain space, three crypto banking services must be established:
- safekeeping of wallets and crypto currencies;
- investments in crypto currencies;
- and inbound and outbound transfers of crypto currencies.
Safekeeping of crypto currencies and providing crypto wallets is similar to providing and securing bank accounts. Investing in crypto currencies is already well established in the Swiss financial market (e.g. Falcon Bank, Swissquote). Here, bank clients can buy and sell crypto currencies by debiting their fiat currency accounts and exchanging them for crypto currencies. We see the transfer of crypto currencies as the next step for crypto banking. This can be done by transfer to a beneficiary’s crypto currency wallet (outbound) from an originator’s crypto currency wallet (inbound) outside the bank. Essentially, this service is like a cross-border payment with traditional fiat currencies.
Based on these three crypto banking services, banks can provide a variety of services to their client base. Or they can serve blockchain and crypto start-ups. Such service could include ICO execution, ICO financing and ICO investment banking.
Approach for a Succesful Crypto Initiative
- Level the playing field and enable the management team to understand and assess the potential of blockchain technology.
- Start with the client experience and then determine the gaps and risks in the system along the client journey.
- Go beyond fiat standards and use the technological advantages of crypto currencies to mitigate risk.
Five challenges for crypto banking services
Banks who want to offer crypto-related services need to be aware of the specific challenges and risks. This is especially true when it comes to offering inbound and outbound transfer of crypto currencies. We identified several issues that banks need to solve to be legally compliant.
1. Safekeeping and segregation of wallets
- segregated crypto wallets for the bank’s clients; and
- a safekeeping solution for crypto currencies, wallets and private keys.
2. Unknown counterparty and legal framework
Unlike with current fiat payments, the beneficiary or originator is not an account holder at a regulated bank respecting the same standards like «Know Your Customer» (KYC), «Anti Money Laundering» (AML) and «Financial Action Task Force» (FATF). The beneficiary or originator is an unknown identity hidden behind a public wallet key. To bring crypto transfers into a regulated environment, due diligence on the beneficiary or originator needs to be done. Unmasking the originator would also make the crypto transfer similar to today’s payments.
3. Use of crypto coins from illicit sources
To comply with AML regulation, the history of transactions needs to be explored in the fiat world. The client needs to declare this history to the bank. The blockchain, however, offers an advantage that can be used to increase the level of confidence among regulators and compliance specialists regarding the transfer. The blockchain stores every transaction in a history that can be analyzed. It can be identified from which wallets a specific coin has been transferred. If this wallet was connected to illicit activities in the past, the blockchain can reveal this by analyzing the transaction history and then calucating an AML risk score. This score indicates whether it is recommended to execute the transfer with the beneficiary’s or originator’s wallet.
4. Core banking integration of cryptos
Crypto currencies need to be integrated into existing core payment processes and systems. Our view is that existing payment processes may be used for crypto payments after being slightly adjusted. Fig. 1 provides an overview of the outbound transfer process and the difference between current payment processes is highlighted.
5. Investor protection of crypto currency specifics
Crypto currencies are more volatile than fiat currencies. Additionally, liquidity might be an issue if the crypto currency is not well known and therefore not traded frequently. In order to protect its clients, a bank should carefully select among the crypto currencies provided. Additionally, clients must be made aware of the risks before they invest in crypto currencies. Other measures to mitigate risk to the client are limit orders, loss reporting and investments without leverage.
Success factors for new services-setup
Based on our experience, it is crucial for banks to find viable solutions for the challenges presented. These must be checked with their clients, the regulator and those responsible at the bank. We have identified some general factors behind the success of a crypto initiative.
Educating the bank’s leadership and all project managers at the beginning of the initiative is crucial so that they all understand the basic concepts of blockchain and crypto currencies. This will enable an assessment of the opportunities and risks related to blockchain, distributed ledger technology and crypto currencies. The bank’s solution should also focus on leveraging existing processes and frameworks for payments. While the technology and many of its features are new, the payment services essentially remain the same. It is, however, necessary to adapt the processes to comply with regulatory requirements and to take into account crypto currency specifics.
Our assessment shows that by dealing thoroughly with the challenges described and applying the success factors, banks can access the field of crypto product and service offerings.
In addition to the authors mentioned below, Edouard Hurstel, Advisor to the CEO of Gazprombank Switzerland Ltd. and Dennis Flad, Partner of Prospire AG have contributed to this article.
This analysis is based on an initiative of Gazprombank Switzerland Ltd.