Should US Banks Custody Your Bitcoin?

The US Office of the Comptroller in charge of regulation and supervision of all US national and foreign banks, declared that US banks could now custody bitcoin.

Initially published on the blog of Knox Custody.

Either way, the OCC says they are now able to.

In a July 2020 letter, the US Office of the Comptroller—an agency within the US Department of the Treasury in charge of regulation and supervision of all US national and foreign banks, declared that US banks could now custody bitcoin. The letter explicitly permits banks to both custody cryptocurrency for customers and provide banking services for cryptocurrency businesses, which has been a hurdle in the past.

A substantial shift is happening in the US when it comes to the financialization of Bitcoin. After a publicly-listed company purchased a quarter billion dollars worth of bitcoin for their treasury, Wall Street seems to be getting cozier with Bitcoin, now more than ever. How does this announcement affect existing Bitcoin custody providers? Is this a bullish stamp of approval for the industry? Does the OCC letter trigger a new regulatory regime for custodians? How does this shift market structure and the competitive landscape? How will it affect consumer and institutional participation now that chartered banks can hold Bitcoin keys? Does it open an avenue for Bitcoin’s Executive Order 6102? In this article, we will attempt to explore all of these important questions.

OCC Interpretations and Actions
OCC Interpretations and Actions

Trust or chartered banks?

As regulators, the OCC released an interpretative letter, which is an announcement that falls under the current regulatory regimes established in the US. It does not legislate new law but presents an opinion on the interpretation of existing legislation. This letter came as a response to an unnamed bank, which presumably prompted the OCC to answer questions on the matter of Bitcoin custody for banks. A few main points are highlighted in the letter, such as the irrevocable nature of Bitcoin key losses, as well as the fragility of centralized exchanges when it comes to safekeeping funds. The OCC assumes that banks may be more secure in holding keys on behalf of customers than exchanges, especially if investment advisors who act as fiduciaries manage bitcoin investments on behalf of principals that they service. While that may be taking a leap of faith, this last point introduces potential partnership opportunities between national banks and native Bitcoin custodians.

Asset management behemoth Fidelity, who recently surpassed $3.3 trillion in assets under management, made an announcement to solidify the growth of sub-custody networks. This could allow legacy national banks to rely on specialized Bitcoin custody providers with adequate risk management when it comes to limiting the risk of theft and loss. A sub-custodian would be allowed to hold Bitcoin keys for the national banks that are providing US customers with custody services.

Until recently, Bitcoin custodians in the US would sooner have been seeking the acquisition of a trust license to act as a qualified custodian to its clients. The OCC announcement takes this a step further, suggesting that Bitcoin custodians may now have to be chartered banks in order to remain competitive. A chartered bank is a financial institution in charge of receiving and safeguarding deposits, as well as providing lending services. The OCC oversees and regulates these entities, whether at the federal or state level, which includes ensuring certain safeguards, such as capital requirements, per Basel III.

As a native Bitcoin custodian, Knox has built a key management system which mitigates critical risk for every phase of the key lifecycle, from key generation, through storage and transaction signing. This level of risk management allowed us to bind an insurance policy, which covers up to 100% of the value that each client holds with us. For a client holding $250 million of Bitcoin, they will be able to receive $250 million of insurance protection, covering the risks of internal and external theft as well as key losses. With that level of risk management, Knox can act as a sub-custodian to regulated custodial banks that want to offer Bitcoin custody services to their clients, but do not have the internal technical ability or strategic appetite to build it from scratch.

Opening the legacy gates

This announcement appears to be positive validation from a major US regulatory agency, which can increase investor confidence in more traditional segments such as fiduciaries and registered investment advisors (RIAs). As Bitcoin custody services entail the management of cryptographic private keys, the possession of such a key is akin to holding a bearer instrument, which means that losing access to it would render the holdings inaccessible. Due to the inherent risk involved in this activity, RIAs would most likely be required to trust a specialized custodial partner.

It seems evident that this pronouncement adds certainty for traditional financial service providers such as banks, which have been reluctant to provide Bitcoin financial services due to the lack of regulatory clarity that is needed for such regulated entities. Banks have customers that may extend their allocations to bitcoin now that they can offer services such as custody and execution. Square’s Cash App exemplifies how lucrative Bitcoin services can be, having booked record-high revenues for Q2 2020 of $875 million, up 600% from last year.

The US commercial bank industry is worth north of $680 billion (measured in revenue), with over 4,000 US chartered banks operating across the 50 states. This network of regulated financial institutions may become quite a material avenue for traditional investors to buy and store Bitcoin over time, strengthening a sustainable demand flow, which is desirable for Bitcoin’s monetization.

Wealth management divisions at chartered banks usually constitute around 40% of the corporate topline, which is a significant figure that testifies to the importance of the OCC’s letter in establishing Bitcoin as a legitimate asset for RIAs and other legacy investors who have been reluctant to dip their toes thus far. After 12 years of uptime, it is now negligent to ignore Bitcoin as an investable asset for portfolio managers.

It will take time for the market to adjust to this regulatory update and for banks to start offering Bitcoin custody services. Undoubtedly, the OCC’s interpretive letter came as a response to a chartered bank that is interested in participating in this market.

With trust comes risk

Unsurprisingly, this regulatory update will trigger market consolidation in the form of partnerships and acquisitions of Bitcoin-native custodians to better service the needs of chartered banks in the US. Custody is not only a matter of regulatory compliance, especially for legacy players. Adequate risk management must be developed with the core technologies that are deployed for key management. Bitcoin custodial services, such as Fidelity Digital Assets or Knox, are inherently trusted third parties, which have been seen to be security holes many times in the past. Educated investors need to be made aware of the options to self-custody, and choose according to their own risk trade-offs what scenarios best meet their needs. US banks now being able to custody Bitcoin offers a new avenue for investors looking to participate in this market.

US Executive Order 6102
US Executive Order 6102

Closer to Bitcoin’s Executive Order 6102?

On April 5, 1933 US President Franklin Roosevelt signed Executive Order 6102 “forbidding the hoarding of gold coin, gold bullion, and gold certificates within the continental United States [...] under penalty of $10,000 and/or up to five to ten years imprisonment.” The rationale behind this confiscation of private wealth was to remove the constraint on monetary easing by the Federal Reserve, which was preventing it from increasing the money supply during the Great Depression. All citizens were required by Law to hand in their private gold reserves to national banks in exchange for bank notes.

As regulated financial institutions such as chartered banks start offering services for Bitcoin custody, it may be tempting for regulators to think that consumers ought to hold their keys with trusted custodians who protect them against theft and loss. In the future, this path could incentivize regulators to demand that consumers deposit their bitcoin with such regulated entities in order to limit the inherent risk of this bearer instrument. This wouldn’t be a bullish case, and such risk should be mitigated with optionality. Allowing consumers to have access to Bitcoin financial services is positive, but investors should retain their ability to move their holdings to sovereign self-custody where they remain in possession and control of their funds.

It remains intriguing what the future holds for the financialization of Bitcoin when it comes to regulatory oversight, but allowing traditional rails to support a sustained fiat conversion into Bitcoin is most definitely a positive step forward.

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