Sea Change in the USA Digital Asset (Cryptocurrency) Infrastructure
Why after almost thirty years in global markets (investment banking) did I accept the role as CEO of a financial services startup? Why is a U.S. chartered bank going to provide such a long-term competitive advantage to our company?
Now that VRBex is ready to launch, what is so compelling for investors to participate in our first funding round?
The first wave of digital infrastructure firms (exchanges, wallets, payment firms, etc.) landed on the beach some time ago, but the wind has changed, and the second wave of entrants are on the way. If history is our guide, the firms destined to be industry leaders have not yet appeared. Want a recent example? Use Google to search Altavista or Yahoo.
For this piece we can define the universe of digital assets to include cryptocurrencies, tokens (which may or may not legally be securities), and digital securities. It is within these groupings that things get interesting.
Cryptocurrency, narrowly defined as those assets deemed by U.S. regulators not to be securities, is a newly emerging financial asset class.
Certainly, there are naysayers who question the viability of cryptocurrencies, and a healthy skepticism is valuable in analysis of new financial instruments, but empirically it is hard to dispute the existence and persistence of the asset class. The arguments regarding use cases, communities, and underlying protocols are important, but for this analysis we can reach our conclusion with three key points: the market capitalization is material, the assets are volatile with continuous trading activity (exchange providers are generating material commission revenues), and the number of market participants is growing across the spectrum (retail to institutional).
Now let us examine what it means to be a newly emerging financial asset class.
Newly Emerging: Things can seem chaotic, and the rules may not yet be in place or fully understood. The early-adopters are passionate enthusiasts. Early participants potentially receive very large returns. The brave first movers who set up the infrastructure rush to make things happen, and perhaps they even believe in “fail fast” (i.e. learn from mistakes in actually doing).
Financial Asset Class: Money (“currency” is even in the name). Money — especially other people’s money — means rules. The exchange or transmission of money is well covered by existing laws and operating a firm within this space requires significant compliance and regulatory oversight. In addition, companies providing services within financial asset classes are fiduciaries, and they have an obligation to safeguard customer assets.
I tip my hat to the first movers within the USA cryptocurrency space (exchanges). It is through their efforts that we have the market today. However, I believe it is fair to say that the founders of most existing cryptocurrency exchanges, regardless of location, were not experienced financial services professionals. As a consequence, the early movers were not always in compliance with longstanding financial industry regulations. Although many, but not all, exchanges are moving to be compliant, there is still considerable regulatory “tail risk” with most firms. There are many reports of activities by cryptocurrency exchanges that, should they have occurred within a regulated U.S. entity like a chartered bank or broker-dealer, would have resulted in quite harsh reactions from the regulatory agencies. I cannot speculate what, if any, consequences the regulatory risk will hold for existing exchanges, but my experience leads me to believe there will be some.
If we were to step back from thinking about the current exchange providers, and consider the market as it stands in the USA today, what regulatory structure would we imagine as corresponding best to cryptocurrencies? It does not take a leap of imagination to see the similarities from a trading and financial standpoint between cryptocurrency and foreign exchange. We should therefore learn from the FX markets.
The States are all proceeding a bit differently, but in general the State regulators require cryptocurrency businesses to register as Money Services Businesses or Money Transmitters. This is consistent with FX.
New York State took an early leadership position, and through the New York Department of Financial Services, created two legal vehicles for firms to offer cryptocurrency services to NY state residents: the “Bitlicense”, and a limited purpose bank (“Trust” bank).
It is our position that the optimal regulatory structure to provide the safety, security, and oversight that all customers demand of financial services providers is an extension of the options of NY State: a full-service U.S. Chartered Bank. It is our position that over time the regulatory environment for cryptocurrency service providers will become less friendly for those firms that do not acknowledge their role as fiduciaries, and full-service banking institutions will become the dominant firms.
In addition to regulatory considerations, we believe that customers will demand their cryptocurrency providers are as safe, well-regulated, and well-managed as traditional financial institutions. We believe this is particularly true for institutional customers who will expect the financial transparency and robust oversight that is a hallmark of U.S. banking institutions.
From a commercial prospective we also believe the U.S. chartered bank offers substantial long-term competitive advantages. Within financial institutions the customer acquisition process comes with a non-trivial cost, and to best offset that cost it is highly desirable to offer multiple products to existing customers. The most successful financial services firms are those that are able to provide multiple products that their customers actually want. It is our business plan to acquire a U.S. chartered bank so that we are able to offer our customers cryptocurrency exchange services, as well as traditional banking products and products tailored to the digital asset markets (for example, secured lending against cryptocurrency balances, margin lending, custody and trust services, and potentially cryptocurrency deposit/lending).
One thing that we have heard many times is “the market for cryptocurrency exchanges is crowded”. That statement probably could be made about every existing market, and we would agree…. Except if you add “in the USA” to the end of the sentence. Outside of the USA there are numerous exchanges — both big and small — and in many cases it is hard to ascertain an individual firm’s competitive advantage or customer target market. We do not believe that is the case in the USA.
To begin this discussion, recall that we expect to see a transition from the existing exchanges — with their regulatory tail risk — to newer entrants that are clearly financial institutions. Now if we look at the existing exchanges, there are only really a handful of U.S. based exchanges, and they each differ in their offerings.
It is our belief that over time the liquidity across the market will become more consistent (through arbitrage, order routing, and open platforms) and hence the differentiation between the customer facing firmss will be based upon customer services levels, offerings, and safety & security. We are confident that we can establish a firm position within our target market of institutional, HNWI, and the mass affluent through our higher touch offerings.
Notwithstanding our faith in our own business model, we are confident that the entire market for cryptocurrency services in the USA will grow in the short/medium term. We base some of this confidence on the continued growth of the markets, but also on FATCA.
FATCA — the Foreign Account Tax Compliance Act. This is a law enforced by the IRS that they summarize as “The Foreign Account Tax Compliance Act (FATCA), which was passed as part of the HIRE Act, generally requires that foreign financial Institutions and certain other non-financial foreign entities report on the foreign assets held by their U.S. account holders or be subject to withholding on withholdable payments. The HIRE Act also contained legislation requiring U.S. persons to report, depending on the value, their foreign financial accounts and foreign assets.”
The topic of FATCA requires considerable explanation far beyond the scope of this note. In general, however, most foreign financial institutions do not permit U.S. residents and citizens to hold accounts because for the foreign institution the reporting requirements are burdensome. On the other side, U.S. residents and citizens are required to report information about their holdings in foreign financial institutions to the USA.
Since the penalties for non-compliance with FATCA can be substantial we expect that in the short to medium term, once the IRS begins to move on the cryptocurrency world, the offshore exchanges will offboard U.S. persons and entities, and that substantial trading activity will flow to U.S. exchanges.
Digital Securitiesare another growing and evolving portion of the digital asset world. At this point we do not see digital securities as a new standalone asset class, but rather an evolution of existing securities. There are numerous potential advantages to digital securities, and for that reason we are interested in participating in the growth of this space.
Similar to the cryptocurrency markets there are a number of participants within the space who do not necessarily have the knowledge and experience to operate within the highly regulated U.S. securities markets.
We believe that the best vehicle to operate within the securities world is a U.S. registered broker-dealer. Members of our team have the required FINRA registrations and experience to operate a broker-dealer, and we will seek to incorporate the broker-dealer business as a subsidiary of the U.S. chartered bank.
Tokens.There is incredible uncertain around tokens. Within the digital asset markets there are numerous teams promoting “utility tokens” and others promoting ICOs. We are looking forward to the time when there is some clarity around these instruments, but in the meantime, it is not in our shareholders’ best interest to become actively involved in these markets. We will work with our legal advisors and our regulators to obtain clarity. When a particular token can be clearly identified as a compliant security, we will seek to offer customers services through the broker dealer, and if a token is deemed appropriate as “not a security” we will seek to offer through the cryptocurrency exchange.
Summary. The existing market within the digital asset class is ready for substantial changes. There are new entrants seeking to enter the markets, and the experience of the new teams in growing businesses within the highly regulated financial services markets will place considerable pressure on existing firms. We expect to see a transition within the USA to management teams accustomed to working within highly regulated industries, and for the customers to demand the safety, security, and protections from the traditional financial services industry.
VRBex is one of the first movers of this second wave of industry participants.
Our elevator pitch:
“VRBex was founded by seven people each averaging 30 years of experience. We are a conservative — but innovative — financial services team and have a well-developed multi-year strategic plan to build a financial services group specializing in digital assets centered around a full-service U.S. chartered bank. Our target customers are institutional participants, high net worth individuals, and the mass affluent.
We will quickly start generating revenue through a US based fiat to cryptocurrency exchange and OTC desk while we finalize the acquisitions of the chartered bank (e.g. traditional banking services and digital asset financing) and a broker-dealer for investment banking services (e.g. underwriting, brokerage, and advising).
We see digital assets as a new asset class, and since we were part of the early movement in interest rate derivatives and credit derivatives, we understand the above normal returns that are available within emerging markets. Our goal is to ensure we establish a financial group that delivers an above-average return to shareholders through the emergence of the digital asset class — and beyond.”
Whatever our individual opinions about the “crypto” (blockchain) universe and the hyperbolic statements and almost unbelievable happenings within the space, we should not ignore the vast revenue streams available today and in the future. The amount of wealth in digital assets has created a viable financial asset class, but the financial infrastructure is far from satisfactory. There is a tremendous opportunity to establish a professionally managed U.S. financial group that has a specialty in the asset class and is also profitable and sustainable regardless of the longer-term developments.
For more information about investing in VRBex first-round funding, contact gene.grant@VRBex.com
