The Intersection of Financial Institutions and Technology Leaders

Is There a Decentralized Future for Custodial Banking?

By Esther Sandlin and David Lopez-Kurtz

The meteoric rise and fall of FTX, the disgraced cryptocurrency exchange and crypto hedge fund, has put a spotlight on the impact of decentralized technology, such as blockchains and the cryptocurrencies it supports, on traditional banking. One emerging question is whether trusted custodians can serve as a buffer between retail and institutional market participants and the bleeding-edge products, services and ventures they want to engage with.

Centralized Solutions for Decentralized Problems – Crypto-players in Custodianship
Custodial banking is structured to provide consumers with regulated and trusted protection of a wide variety of assets. It came as no surprise in 2021 that banks jumped at the chance to provide traditional banking custody services for cryptocurrency. In order to provide sufficient control to meet custodial requirements, banks turned to crypto custodians such as Fireblocks and Custodia Bank to provide a quick and proven path to market to meet clients’ needs.

Fireblocks offers custody for digital assets by managing the owner’s digital wallet, which holds the private and public keys. Fireblocks, the custodian, manages the wallet on behalf of the wallet’s owner. In 2022, Fireblocks partnered with Bank of NY Mellon Corp., the largest custodian bank in the world, to launch a crypto custody software — illustrating the market interest in custody for cryptocurrencies.

Custodia is a Wyoming-based special purpose depository institution (SPDI) that connects digital assets to traditional banking. Custodia is not insured by the Federal Deposit Insurance Corp. but offers custody services. As an SPDI, Custodia must maintain certain high-quality liquid assets valued at 100% or more of its deposits in reserve and cannot make loans on customer deposits.

Custodia gained the spotlight by taking on the Federal Reserve in litigation regarding its pending application for a Federal Reserve master account, which would allow it to reduce costs through direct access to the central bank’s payment rails. Custodia first claimed that the Federal Reserve Bank of Kansas City unlawfully withheld or unreasonably delayed the decision-making process for the application. Custodia also claimed that direct access to the Federal Reserve would allow it to offer a secure, compliant bridge between digital assets and the United States dollar payment system.

Policymakers’ Thoughts on Cryptocurrency Custodianship
Banking industry regulations have a particular orientation toward risk aversion when a matter concerns user funds or other assets. It comes as little surprise that when dealing with digital assets, including cryptocurrencies, policymakers are attempting to extend this risk aversion to the breadth of financial technology firms and the crypto ecosystem.

In 2021, the Basel Committee on Banking Supervision presented a consultative document that proposed applying a 1,250% risk weight to a bank’s exposure to bitcoin and certain other cryptocurrencies. This is the highest risk category and, for example, would require $1 in capital for every $1 of bitcoin held. The high risk category is designed to hold banks back from accepting cryptocurrencies; however, the final rule exempted assets held in custody from the high-risk weighting. The Basel Committee rules are set to be implemented by Jan. 1, 2025.

Most recently, the Fed and the Office of the Comptroller of the Currency joined the FDIC on a statement addressing the risks of crypto-assets to banking regulations. The January 2023 letter applies to all FDIC-supervised financial institutions and reads like a lessons learned from the FTX saga. For example, the letter warns banking organizations of “legal uncertainties related to custody practices … some of which are currently the subject of legal processes and proceedings.”

The agencies cautioned banks not to let uncontrolled risks from the crypto-asset sector “migrate to the banking system.” The agencies also stated that they are working on building expertise related to the risks that crypto-assets may pose to traditional banking institutions, consumers and the American financial system. While the statement did not prohibit traditional banks from engaging with the crypto-asset sector, the agencies instructed banking organizations to make sure there are proper risk management and compliance policies in place.

Fintech and traditional banks have an opportunity to provide services to this emerging and growing market segment. However, the industry can expect regulators to continue paying ever more attention to the ways crypto-custody interacts, or even threatens, the traditional bank model. No matter what the future of custodial banking holds, it will be critical for all digital asset custodians to anticipate new regulations and proactively develop an effective compliance framework, paying special attention to internal and external policies and controls.