Preparing for Institutional Risks as Cryptocurrencies Expand

Two words that highlight why digital assets – in particular, cryptocurrencies – are a valuable addition to the financial services ecosystem are “speed” and “access.” However, banks and other organizations that transact in cryptocurrency need to be aware of, and prepare for, unique risks inherent to the digital asset ecosystem.

The technology that supports cryptocurrencies has accelerated the speed of clearing financial transactions. Over the last 25 years, financial institution technology has progressed significantly, but transfers can take several days to clear; international wire transfers take even longer. Cryptocurrency transaction clearing is immediate.

Cryptocurrencies are also increasingly adopted by individuals who have been previously unbanked or “underbanked” and have had difficulty accessing traditional banking systems. Transaction speed, customer experience and an expanding market of digital asset users make cryptocurrencies attractive for more institutions and organizations to adopt, but they need to think about and prepare for a number of risks.

Current State of Regulation
One of the reasons the traditional banking industry is trusted by the public is because of the regulatory environment. Regulations, including those within the Bank Secrecy Act (BSA), outline the customer identification program and know-your-customer requirements for onboarding new customers. While the cryptocurrency ecosystem is often panned for its perceived lack of regulation, there are layers of regulation that some crypto companies must comply with. For example, the BSA applies to money transmitters, like crypto exchanges. U.S. Securities and Exchange Commission Chair Gary Gensler recently noted, when prompted about large crypto exchanges, “It’s a question of whether they’re registered or they’re operating outside of the law and I’ll leave it at that.”

Does that mean that crypto is regulated as strictly as financial institutions? No, but regulation is progressing. President Joe Biden’s March 2022 executive order included a provision requesting the Financial Stability Oversight Council (FSOC) convene and report on the risks of digital assets to the financial system and propose any regulatory modifications needed to mitigate the risks posed to the financial system by cryptocurrency. Treasury Secretary Janet Yellen, who has been tasked with convening the FSOC, has been a vocal proponent of crypto regulation.

The Treasury Department also released a fact sheet outlining how the United States would work with foreign governments in regulating digital assets.

What does that mean for crypto companies? Considering digital assets were mentioned over 40 times in the FSOC 2021 Annual Report, and since the total market cap of crypto has fallen from $3 trillion in November 2021 to $900 billion as of June 28, 2022, it’s likely regulators will propose new requirements.

Risk Management
Emerging or evolving regulation over large exchanges may not be the panacea that enables financial institutions the carte blanche access to offer all cryptocurrency products. However, it is a step toward being able to offer new products or access to products within the confines of a regulatory framework, and it creates a standard against which banks can measure their offerings.

However, risks remain. Retail banking customers still interact with virtual asset service providers that operate under innocuous-sounding names and decentralized crypto exchanges run by decentralized autonomous organizations (DAOs) without the corporate governance or regulatory requirements of financial institutions. As regulation evolves, institutions wishing to participate in this market will still be responsible for monitoring and mitigation activities. The good news is that as these risks have evolved, so have the tools used to monitor and mitigate them.

When it comes to risk, adding a new category of services requires changes throughout the organization that include people, process and technology. The digital asset ecosystem requires a different skill set than traditional banking and capital markets. The lexicon is different, the technology is different and the market is more volatile. Trusted information sources have transitioned from global business publications to social media. Institutions looking to participate are going to need to partner with different service providers to help facilitate programs, build infrastructure and provide access to the knowledge, skills and expertise to be successful. These institutions are also going to need to reassess their strategy, how and where digital assets fit, the organization’s new risks resulting from this strategic shift and how they plan to mitigate those risks.

The crypto market has garnered the attention of the current presidential administration, the regulatory environment is continuing to evolve, retail participation continues to increase and the technology supporting the marketplace has the potential to become more efficient than traditional infrastructure. Banks that aren’t assessing their strategy as it relates to digital asset risk will be left behind. Institutions planning on participating should understand the people, process and technology needed to execute their strategy, as well as the potential risks to the organization. Regardless, the cryptocurrency marketplace has given institutions and those charged with governing them a lot to consider.