Banks And Crypto: Can They Invest?

The rise of cryptocurrencies like bitcoin has sparked a debate among banks about whether to embrace them as a legitimate asset class. While some banks are still reluctant due to regulatory concerns and the volatile nature of cryptocurrencies, others are exploring ways to cater to the growing demand for crypto services. This includes developing specialised payment systems, offering crypto custody solutions, and even launching their own digital coins. As the crypto market continues to grow and gain traction among investors, banks are under pressure to decide whether to join the crypto revolution or risk being left behind.

Crypto banks and their services

Crypto banks are financial institutions that offer similar services to traditional banks, such as loans, but using cryptocurrencies instead of traditional currencies. Crypto banks aim to make transactions faster, safer, and more convenient by combining the functionality of digital banks and cryptocurrencies.

Types of Crypto Banks

There are several types of crypto banks:

• Traditional banks with crypto licenses
• Digital banks with crypto licenses
• Crypto banks with digital bank functionality
• Digital asset platforms with crypto bank functionality

Services Offered by Crypto Banks

Crypto banks offer a range of services, including:

• Buying and selling of digital assets
• Access to cryptocurrency exchange platforms
• Functionality of digital banking, such as holding balances and making payments with crypto debit cards
• Earning interest on crypto holdings
• Crypto interest accounts offered by crypto-based companies, such as Crypto.com and Gemini
• Crypto-backed loans

Examples of Crypto Banks and Their Services

• Silvergate Capital: Offers the Silvergate Exchange Network (SEN), a digital payments network that enables instant transactions in U.S. dollars between users. It also provides lending products, such as SEN Leverage, which allows customers to obtain lines of credit in U.S. dollars collateralized by bitcoin.
• Signature Bank: Offers Signet, a digital payments system based on blockchain technology, allowing commercial clients to send and clear payments instantly.
• JPMorgan Chase: Launched its own digital coin, the JPM Coin, for global payments. It also has a dedicated digital currency division called Onyx and a Blockchain Center of Excellence for research and development.
• U.S. Bank: Offers an internal cryptocurrency custody service, allowing customers to hold crypto alongside traditional securities, cash, and other assets.
• BankProv: A full-service commercial blockchain bank offering dedicated crypto business banking products, including crypto-friendly lending and cash management tools.
• Revolut: Allows international-based crypto companies to receive, hold, and exchange money in multiple currencies. It also offers the ability to purchase and sell various cryptocurrencies.

Crypto as a legitimate asset class

One of the key indicators of crypto's legitimacy as an asset class is its significant market cap, which stood at over USD 1.7 trillion at the end of March 2021. While this is small compared to other asset classes such as real estate or stocks, Bitcoin's market cap alone accounts for USD 1 trillion, or 60% of all cryptocurrencies. This makes the crypto market too big for banks to ignore.

Another factor contributing to the legitimacy of crypto as an asset class is its unique characteristics. Cryptocurrencies differ from traditional asset classes due to their underlying blockchain technology, incentive design, and decentralized governance. They also exhibit a weak correlation with the price development of other assets, making them a potential diversification tool for investors.

The improved liquidity of cryptocurrencies in recent years has also enhanced their legitimacy as an asset class. Despite historically low liquidity, cryptocurrencies have become more liquid, making them more accessible and attractive to investors.

The recognition of crypto as a legitimate asset class is evident in the actions of major financial institutions. For example, Goldman Sachs, which previously denied that cryptocurrencies were a viable asset class, has since changed its stance and now considers crypto to be "a new asset class". JPMorgan Chase, another major financial player, has also shown an increased interest in crypto, with its co-president Daniel Pinto acknowledging the potential of embracing Bitcoin.

In conclusion, crypto is establishing itself as a legitimate asset class, with its significant market cap, unique characteristics, improved liquidity, and growing institutional adoption. As the crypto market continues to evolve and mature, it is likely that more banks and financial institutions will recognize its legitimacy and embrace it as a viable investment option.

Crypto custody solutions

The main utility of cryptocurrency custody solutions lies in safeguarding cryptocurrency assets. Private keys, which are alphanumeric strings used to conduct transactions or access crypto holdings, are the target of crypto-asset thieves because they provide access to the assets.

According to the Investment Advisers Act of 1940 (amended), institutional investors with customer assets are required to store their holdings with a "qualified custodian". The definition of qualified custodians includes "...a federal or state-chartered bank or savings association, certain trust companies, a registered broker-dealer, a registered futures commission merchant, or certain foreign financial institutions."

Within the cryptocurrency ecosystem, very few mainstream banks offer custodian services. The task of holding cryptocurrencies and crypto-assets has fallen to businesses already involved. Coinbase Custody is the custodial services provider for the popular exchange Coinbase, while Gemini Custody is the custodial solution provider for the Gemini Exchange. Both are licensed by the New York State Department of Financial Services (NYDFS) as qualified custodians. The BitGo Trust Company is another popular and large qualified custodian, receiving its license from the NYDFS in 2021.

The crypto custody solution industry is likely to continue growing as the crypto industry expands and more institutions become involved in the crypto space. Even governments have recognized the need for crypto storage solutions.

Some of the biggest crypto custody solution providers include Coinbase, Gemini, and Bitgo. Other notable providers include AmbiVault, Fidelity Digital Assets, Anchorage, and Swiss Crypto Vault.

Crypto as a diversification asset

Diversification is a well-known investment strategy that can be applied to cryptocurrency portfolios. By spreading investments across different crypto assets, investors can reduce the overall risk of their portfolio and potentially increase returns. Here are some ways to approach crypto as a diversification asset:

Diversify Across Different Cryptocurrencies

The most straightforward way to diversify a crypto portfolio is to allocate funds to multiple cryptocurrencies. This can include a mix of large-cap cryptocurrencies like Bitcoin and Ethereum, which are more established and stable, as well as mid-cap and small-cap coins, which may offer higher growth potential but come with higher risk. It is recommended that investors hold a variety of coins with different use cases, such as payment coins, decentralised finance (DeFi) tokens, gaming coins, and privacy coins.

Diversify by Market Capitalization

Another approach to diversification is to allocate investments based on market capitalization. Cryptocurrencies can be divided into categories such as large-cap ($10 billion - $200 billion market cap), mid-cap ($1 billion - $10 billion), small-cap ($100 million - $1 billion), and micro-cap ($10 million - $100 million). The smaller the market cap, the greater the risk but also the potential for higher returns.

Diversify with Crypto ETFs and Stocks

Investors can also gain exposure to the crypto market by investing in crypto exchange-traded funds (ETFs) and crypto-related stocks. Crypto ETFs, such as the "Index Coop", offer tokens that track crypto indices or specific sectors like decentralised finance (DeFi). Additionally, investors can purchase stocks of companies that are embracing blockchain technology or blockchain ETFs, providing further diversification.

Diversify with Decentralised Finance (DeFi)

DeFi is a sector within the crypto space that offers a range of financial services and applications. By investing in DeFi, investors can earn yields on their crypto holdings and access a variety of decentralised apps (dApps). US Dollar stablecoins, such as USDC and Tether (USDT), can also be used to stabilise a crypto portfolio as they are pegged to the US Dollar and are designed to maintain a stable value.

Apply Modern Portfolio Theory (MPT)

The Modern Portfolio Theory (MPT) is a mathematical framework that can guide crypto asset allocation. MPT assumes that investors are risk-averse and seeks to maximise returns for a given level of risk. By combining uncorrelated crypto assets, investors can reduce the volatility of their portfolio and improve risk-adjusted performance. MPT suggests dividing assets into traditional (e.g. Bitcoin, Ethereum, stablecoins) and alternative (e.g. DeFi, metaverse, NFTs) categories, with the former being less risky and the latter offering higher potential returns.

Rebalance Your Crypto Portfolio Regularly

Rebalancing a crypto portfolio involves periodically adjusting the weightings of different assets to maintain the desired risk/reward profile. This may involve selling some holdings if they have increased in value to avoid an overly crypto-heavy portfolio. It is recommended to rebalance on set dates, such as January 1 and July 4, to avoid emotional decision-making.

In conclusion, diversification is a powerful tool for managing risk and improving returns in the volatile crypto market. By applying these strategies, investors can build well-balanced crypto portfolios that align with their investment goals and risk tolerance.

Crypto-backed loans

The loan amount is typically a percentage of the value of the cryptocurrency pledged as collateral, known as the loan-to-value (LTV) ratio. The maximum LTV differs among lenders and the type of crypto used. Some lenders accept a wide range of cryptocurrencies as collateral, with Bitcoin and Ethereum being the most popular.

Types of Crypto-Backed Loans

There are two main types of crypto-backed loans: Centralized Finance (CeFi) loans and Decentralized Finance (DeFi) loans.

CeFi loans are custodial crypto loans where the lender has control over the borrower's crypto during the repayment term. In DeFi loans, smart contracts are used to ensure the borrower adheres to the loan requirements, and the borrower retains control of their crypto assets. However, if the borrower defaults or misses a payment, the lender can take automatic actions against their account. DeFi crypto loans may have higher interest rates than CeFi loans.

Benefits and Risks of Crypto-Backed Loans

However, there are also risks associated with crypto-backed loans. The volatility of the crypto market can impact the value of the collateral, and borrowers may need to pledge more crypto if the coin's value decreases. Non-payment or missed payments can lead to penalties and the liquidation of assets. Additionally, the crypto industry has limited regulatory oversight, and there are concerns about the reliability of lenders and the security of crypto assets.

Choosing a Crypto Lending Platform

When considering a crypto-backed loan, it is important to research reputable platforms that offer secure and flexible repayment terms. Some key factors to consider include the platform's security measures, user reputation, interest rates, supported cryptocurrencies, and customer support. It is also essential to understand the loan terms and potential risks before committing to any crypto-backed loan.

Frequently asked questions