US Banks Receive Green Light to Work With Crypto Custody

The US regulator in charge of regulating custody arrangements nationwide has announced that US chartered banks can custody crypto assets.

The US Office of the Comptroller of the Currency (OCC) made the announcement in a public letter dated July 22. Senior Deputy Comptroller and OCC Senior Counsel Jonathan Gould wrote that any chartered national bank can hold the cryptographic keys for a digital wallet or account.

In a move that completes the evolution “[f]rom safe-deposit boxes to virtual vaults”, in the words of Acting Comptroller of the Currency Brian P. Brooks, the opinion “clarifies that banks can continue satisfying their customers’ needs for safeguarding their most valuable assets, which today for tens of millions of Americans includes cryptocurrency”.

The announcement opens the way for traditional banks to enter the digital asset space, custodian digital assets like Bitcoin in the same way they custody other fungible assets like jewelry and fiat currencies.

There are caveats — the letter lays out additional requirements for banks intending to custody crypto assets, though these are defined loosely.

More importantly, though, the announcement shows a way forward for interbank clearing using digital currencies, and points clearly to a future of transparently-priced, secure and effectively instant interbank value transfers.

What does the OCC letter say?

Read the full text of the OCC public letter here.

The OCC letter sets out the rationale for allowing chartered banks to custody crypto assets in terms of an obvious emerging market, and states that there is no legal basis for not permitting crypto custody. Then it goes on to identify how chartered banks in the US must adapt their operations to custody digital assets.

The growing market for crypto custody

“We understand that there is a growing demand for safe places, such as banks, to hold unique cryptographic keys associated with cryptocurrencies on behalf of customers and to provide related custody services”, the letter states, observing that “[these services are in demand for several reasons” including “because the underlying keys to a unit of cryptocurrency are essentially irreplaceable if lost, [meaning] owners may lose access to their cryptocurrencies as a result of misplacing their keys, resulting in significant losses of value”.

Institutional investors’ appetite for crypto custody

In addition, “banks may offer more secure storage services compared to existing options”, and “some investment advisers may wish to manage cryptocurrencies on behalf of customers and may wish to utilize national banks as custodians for the managed assets”.

As well as recognizing this trend and the commensurate requirements — especially on the part of institutional investors — for a form of digital asset custody that is more effective and secure than self-custody, Gould goes on to address the types of services banks can offer, and the changes they need to make in their operations to effectively offer custody for digital assets.

Banks can offer both fiduciary and non-fiduciary custody

“U.S.C. 92a expressly authorizes the OCC to grant fiduciary powers to national banks. National banks may also provide non fiduciary [sic] custody services to their customers. The OCC has determined national banks may act as non-fiduciary custodians pursuant to the business of banking and their incidental powers”, explains Gould.

“Providing custody for cryptocurrencies would differ in several respects from other custody activities”, the letter reads, and “[i]n most, if not all, circumstances, providing custody for cryptocurrency will not entail any physical possession of the cryptocurrency” but instead the cryptographic keys.

Banks must adapt their internal policies, procedures and technologies

In addition, banks must “policies, procedures, internal controls, and management information systems governing custody services. Effective internal controls include safeguarding assets under custody, producing reliable financial reports, and complying with laws and regulations”, says Gould’s letter, pointing to a potential source of friction: how well-prepared are US banks to handle the technological and other challenges of crypto custody?

What effects will the announcement have on banking and crypto in the USA?

There will be several effects on banking, both inside and outside the USA. In the longer term, one effect will be to legitimize the use of crypto assets in major institutions and as a medium of exchange and conveniently fungible proxy value store. More approximately, institutional uptake of crypto custody will accelerate, banks will enter the crypto space in force, and in the process will probably adopt an interbank crypto protocol for major transactions.

(More) banks enter the crypto space

The first effect will be higher uptake of bank-based custody, and the creation inside major charter banks of departments dedicated to managing crypto custody. There are already banks with some exposure to the crypto custody space — JP Morgan Chase, for instance — but the mass of major US chartered banks will likely now seek to offer some digital asset-oriented services.

Some will buy in technology and supply their own professionals; others will likely seek to acquire startups or headhunt top talent pools; some banks may even create spin-off legal entities for their crypto work.

Investors will have more high quality options

All this matters if you are inside the banking or crypto spaces. If you are an investor, the most crucial change will be a rapid, radical increase in the range and quality of institutional-grade crypto custody available. Where this is currently largely supplied by crypto-based startups as a build-out from exchanges or token issuance and blockchain management companies, banks will approach the matter from the opposite direction — finance first, then crypto as a special case — and with significant financial backing and the benefit of wide-ranging relationships in the existing financial industry.

Banks will seek to create an instant, secure clearance system

The picture for the wider financial world is more radical yet. Chartered banks can use the leeway granted by the new rules to set up a nationwide system of financial clearance that operates on the blockchain.

That would eliminate the requirement for clearing by trusted entities; the blockchain itself uses publicly auditable transaction logs and modular, effectively-unbreakable encryption to make double-spending and fraudulent transactions near-impossible.

Without becoming too technical, the critical risk of fraud on a blockchain based system like Bitcoin is sometimes referred to as a “51% attack”, because to be successful, a bare majority — 51% — of addresses on the blockchain must participate in creating fraudulent transactions.

While this is technically possible and has happened on some small blockchains, it has never happened on the Bitcoin blockchain and the risk is generally regarded as extremely low. The risk of ordinary “hacking” or “infiltration” is eliminated by the structure of the blockchain itself and thus a clearing system based on self-executing smart contracts operating on a blockchain would be both more secure than the current arrangement, and much faster.

Crypto-based clearance: secure, instant

Currently, retail level bank transfers typically take 24 hours if they take place within the same institution, or up to three days otherwise, but they can take up to a week. Institutional transfers of investment deposits can take weeks. A blockchain-based system in which major chartered banks were address-holders would allow of instantaneous transfers of even large sums; the bank can transfer your deposit as crypto, credit your account from its own reserves and off-ramp the crypto transfer to fiat behind the scenes or leave it in the system as circulating capital.

However, there’s a problem with this approach.

Most crypto assets are attractive as investment opportunities for two reasons: they’re regarded as a safe-haven value store, and they have volatile pricing that offers the opportunity to gain rapidly by trading. Bitcoin, the most valuable crypto asset and the one with the largest dollar-value investments and trades, sometimes gains or loses 20% or more of its value in a single 24-hour period. Meanwhile, BTS accounts for the majority of individual transactions but is ill-equipped to handle institutional quantities of value.

The killer crypto banking app: ERC-20 tokens backed by gold

What’s needed to make this work is a proven blockchain system, and a token operating on that system which has a stable, reliable value.

We foresee the use of a gold-backed digital asset, and expect it to operate on an established blockchain like Ethereum. Why?

Gold is remarkable for its capacity to both retain value and to remain stable; gold prices in US dollars fluctuate more because of the changing market value of the fiat currency than because gold’s perceived value is changing, and its purchasing value changes largely in response to changes in the prices of other articles.

Gold makes a good basis for a bank transfer token, too, because its value is broadly recognized.

The Ethereum blockchain is the best candidate for token creation for the same reasons; it’s tested and has broad acceptance and interoperability. The BitShares blockchain has solutions that make it possible to port off-chain tokens directly into the BTS environment, but lacks the recognition within the industry and the track record of backing high-value tokens that make Ethereum the natural choice. The ERC-20 token protocol is now well-understood and has been used as the basis for multiple high-value tokens.

In all likelihood, a banking-only token backed 1:1 by pure gold metal and offering real ownership — not the proxy ownership of an ETF.

It’s unlikely that banks will want to use a pre-existing system, however; we at Stably foresee banks seeking a partner who can help design a suitable system from the ground up, one that will offer both retail purchasing integration and interbank clearance using crypto assets.

Our team at Stably can help you get started with crypto custody! Want to tokenize your own assets or explore other options? Reach out to us and become a partner!