What’s next for banking-as-a-service, crypto, and fintechs

By Gene A. Grant II, LevelField Financial CEO

For the over thirty years since I started my very first job on Wall Street, I have watched the banking and financial markets evolve. For many of those years I held roles managing change within global banking institutions, and the lesson most impressed upon me is that change happens slowly – until the regulatory agencies decide something must stop. In those rare events, circumstances change very quickly, and we may be seeing a few of those events in 2023.

Banking-As-A-Service Steps Back

Banking-as-a-Service (“BaaS”), somewhat similar to the concept of “Open Banking”, is likely a target for regulatory pushback. BaaS is by no means dead, but the activity will need to be re-shaped.

Simply put, BaaS is the technologically enabled provision of banking products to non-bank third parties. These third parties, commonly called fintechs, directly acquire customers who may not even be aware that they are consuming products from the underlying bank.

Diverging from the U.K. and E.U., in 2023 the U.S. is likely to experience opposition to the continued movement of banking products and services outside the perimeter of the highly regulated banking industry.

In a continuing trend across the multiple U.S. banking regulators there is an increase in the scrutiny of the overall risk profile of banks, and that has led to considerably more attention to third-party relationships. Banks are now under pressure to ensure that they fully understand the risk characteristics of firms that provide services to the bank as well as those that receive services from the bank.

The largest area of emphasis is regulatory compliance. In a BaaS relationship, the fintech is essentially interacting with the customer on behalf of the bank, and that means all the activities of the bank and the Fintech must be compliant with the relevant regulations. Expect heightened attention to Know-Your-Customer rules, Bank Secrecy Act provisions (anti-money laundering), marketing and advertising standards, and all aspects of credit.

There are a number of banks in the U.S. participating in the BaaS space. Expect them to demand more from their fintech partnerships. The cost model for the fintech companies will need to be reevaluated in light of the increasing compliance costs, and they will need to be far more transparent to their banking providers.

Regulatory enforcement has already started. In 2022, Blue Ridge Bank NA entered into a formal agreement with the Office of the Comptroller of the Currency (OCC). Blue Ridge Bank agreed to increase the regulator’s oversight of the BaaS activities. Within the OCC order the bank agreed to obtain the OCC’s non-objection before entering into any new contracts with fintech partners or adding new products in cooperation with existing partners.

Perhaps this year will be the beginning of banks taking their place leading innovation in the banking space. It is probably too much to expect banks to immediately embrace the strengths of the fintech players. It is possible, however, that some innovative banks will capitalize upon the regulatory pressures that will no doubt subtract from the profitability of the fintech model and we can see banks seeking to compete in the same space.

Commodity Cryptocurrency Gets a Regulator

Settling the question as to whether cryptocurrency is commodity, security, or something altogether new is not likely to happen in the near term. We can expect that regardless of the classification there will be some movement on the regulatory status of digital assets.

Bitcoin and Ethereum are currently designated commodities, and the Chicago Mercantile Exchange has products based upon those commodities. Any residual questions should be resolved as it is clarified that the Commodities Futures Trading Commission (CFTC) is the regulator for derivative products for these two assets, and that is the case today.

Prior to January 3rd it looked like the banking regulators were going to take the lead for cryptocurrency commodities, currently only Bitcoin and Ether, and perhaps a few stablecoins. In November 2021 the President’s Working Group on Financial Markets, the FDIC, and the OCC issued a report on stablecoins wherein they recommended that stablecoins be issued by insured depository institutions, also known as banks. The states of New York, Wyoming, Louisiana, the federal regulator the OCC, and possibly others enacted rules and regulations specifying the parameters for banks to permissibly offer cryptocurrency products and services.

On January 3rd , the primary banking regulators of the United States issued a news release changing the landscape. The big three banking regulators are Board of Governors of the Federal Reserve System (Federal Reserve), the Federal Deposit Insurance Corporation (FDIC), and the Office of the Comptroller of the Currency (OCC). According to their statement, “It is important that risks related to the crypto-asset sector that cannot be mitigated or controlled do not migrate to the banking system.” Within the statement there was text that essentially indicated banks should not own or issue any form of digital asset.

The regulators are going to need to follow up with additional information as this release generated more questions than it answered.

The prohibition against banks owning digital assets is consistent with existing regulations restricting bank ownership of volatile assets, and is consistent with the desire to maintain strong banks. What is novel is the different treatment of the financial commodity digital assets, such as bitcoin, compared to other financial commodity assets. For example, a bank is permitted to own euros, a financial commodity and the currency of sovereign nations, but a bank cannot own bitcoin, a financial commodity and the currency of El Salvador, a sovereign nation.

Similarly, what has changed since the release of the Working Group report on Stablecoins such that the banking regulators no longer want banks to issue digital asset stablecoins at all?

The News Release was still a net positive for the digital asset class. The regulatory agencies have recognized the digital asset class, and have taken note of the numerous areas requiring improvement in the industry that grew up around the asset.

Perhaps it is because of the concerns, and their cautious approach to the asset class, the banking agencies may be the best regulators for the spot trading of digital asset commodities.

Digital assets are not going away, and the sector still has robust activity despite a full year of failures and scandals. Longer term planning is clearly appropriate. The banking regulators are looking at the industry, and participants should be grateful for their attention.

Cryptocurrency Trading Exchange Industry Chaos

The cryptocurrency exchange industry is filled with colorful characters, and generally is not managed by leaders with the same level of experience customers would expect in traditional financial institutions. The rampant fraud within the FTX group by Caroline Ellison and Gary Wang, and alleged conduct by Sam Bankman-Fried, are likely the final push that is going to spur the type of regulatory action that will shock existing industry participants.

The SEC is likely in a fairly difficult position as it pertains to digital assets. SEC Chairman Gensler has stated that most digital assets are securities, and if that is so, then with the exception of the small number of digital assets designated as commodities, the SEC must try to fit digital assets into the existing securities regulations. That challenge is enormous, so to keep the topic manageable comments are limited to trading platforms.

Securities trading platforms in the U.S. must either be designated exchanges, or registered alternative trading systems. In either case there are considerable rules and regulations surrounding the operation of the platforms and the assets which can be made available for trading.

The major cryptocurrency trading platforms in the U.S. today are neither appropriately registered to trade securities, nor do the listed assets meet the requirements for listing.

It is difficult to see how many digital assets will meet the criteria for listing on any regulated platform under the existing securities regulations, and therefore it is probable that a new regulatory regime will be introduced. Somehow standards will be produced that will permit the existing assets to be traded – although the effort to make that happen cannot be overestimated. There is considerable work ahead for the agency.

Assuming that the assets are approved for trading, expect a massive shakeup for the existing industry.

The commodity digital assets will likely be required to be traded on platforms and supported by legal entities completely separate from the digital asset securities. That means Bitcoin and Ether will be distinct from the other digital assets.

All trading platforms and ownership entities will need to meet existing requirements for operating securities trading platforms. There are a long list of probable requirements, but expect to see separate custodians, no market making or trading against customers, segregated funds, minimum capital levels, and full compliance with all industry reporting. The operators of platforms are likely to have to make full disclosures of financial information and seek approval for all beneficial owners and people who control the company.

In short, there should be quite a bit of turmoil as the existing players are replaced by firms better situated to operate in a post-regulatory environment.

CBDC Talk, but no Action

The U.S. will continue to dialog about a Central Bank Digital Currency (CBDC), but they are not likely to move forward as they watch the reaction to privately issued stablecoins.

The market reaction to private stablecoins is not likely to be directly applicable to CBDCs as the commercial viability of privately-issued stablecoins is likely to be challenged through the year.

In a zero-interest rate environment the utility of a fully-backed stablecoin makes it quite an attractive alternative to holding cash. On the other hand, when overnight interest rates are well above zero than the opportunity cost for holding stablecoins compared to holding the underlying fiat currency in an interest paying account can be material.

Should interest rates continue their current trajectory it is likely that the overall value of U.S. dollar stablecoins will fall regardless of the utility.

Summary

Banking-as-a-Service and digital assets are both ideas that have really caught the attention of the financial services industry and the public. In both cases we have seen an evolution over the past ten years or so. This should be the year when big changes occur.