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The Business Path Is Gradually Clear and the Future of Crypto Banks Can Be Expected

Summary:

In 2020, under the macro environment of the Covid-19 and the continued easing of the US dollar, digital assets are becoming increasingly popular with institutional funds, and their unit prices and market values have both risen; and the regulatory system for banks operating in cryptocurrency business in Europe and the United States is gradually clear. In this context, demand for compliant custody, institutional fiat-to-crypto channels, etc. continues to grow, ultimately boosting the concept of a crypto bank.

According to the research, there are more than 30 banks providing services to digital currency companies around the world, and more than 10 banks have disclosed that they are directly involved in custody and trading. Since December in 2020, both Standard Chartered in the United Kingdom and DBS Bank indicated that they would launch the custody and transaction services of institutional cryptocurrency. On the other hand, crypto exchanges are seeking bank identity. Kraken obtained the Special Purpose Deposit Institution (SPDI) license in Wyoming, the USA in September last year, becoming the first crypto company in the U.S. that obtains a custody bank license; while Paxos, Bitpay, and other companies also submitted applications for Federal Trust Bank licenses to the U.S. Office of the Comptroller of Currency (OCC) in December.

Most of the crypto-friendly banks only support deposit account services, and a few provide custody, loans or other innovative services. The main profit model is to use the interest-free deposits of crypto companies for lending or investment, thereby earning high interest differentials or zero-cost investment income. Among them, the development of Silvergate Bank is particularly eye-catching: it began to focus on providing services to the crypto industry in 2013 and was successfully listed in 2019; there are currently 928 crypto customers; interest-free deposits reached US$2.2 billion, accounting for 95% of the total deposits; formed a complete profit model for issuing interest-free deposits and water testing custody business. In addition, emerging banks such as Sygnum and Revolut are actively innovating their businesses and opening up a new path for the development of crypto banks, which are receiving great attention from investors.

Crypto banks are gradually becoming a new track, traditional and emerging banks are accelerating their deployment, and crypto companies are also seeking new identities. Looking to the future, Europe and the United States are expected to accelerate, and the United Kingdom, Germany, and Singapore may have cases landed. In the short term, traditional and emerging banks will differentiate in businesses. In long run, crypto banks will become an important part to promote the exponential growth of the scale of crypto assets and user penetration. Or interact with the real economy.

Authors:

【Huobi Research Institute】Xu Miaoyan, Chen Han, Yuan Yuming

Contact the Authors:

Huobi Research Institute: HuobiResearch@huobi.com

1. Institutions landed Ahead? The Past and Present of Crypto Banks

The predecessor of the crypto bank is the crypto-friendly bank. It can be seen that Metropolitan Commercial Bank provided Coinbase with fiat currency account services as early as 2015 and has become a representative case of crypto-friendly banks. As the value of crypto assets still relies heavily on traditional fiat currency, operating companies such as exchanges, and wallets have been striving to open up fiat-to-crypto channels or seek strong partners to achieve smoother and low-risk exchanges. As a natural fiat-to-crypto channel, banks have a natural attraction to cryptocurrency operators and holders.

However, it is difficult for crypto asset companies to find reliable financial service partners, because any customer who intends to open a bank account must comply with strict anti-money laundering (AML), know your customer (KYC) and counter-terrorist financing (CTF) policies; at the same time, they need to undergo entire due diligence to ensure not violating any financial sanctions. Traditional banks need to use a lot of property and manpower to deal with the complex and underdeveloped cryptocurrency customer supervision system. The long-term absence of mainstream banks has given this track an opportunity. Prompted by many factors such as potential customer groups and new sources of profit, a number of crypto-asset-friendly banks emerged as the predecessor of crypto banks.

So far, only 32 banks within the scope of the research provide services to crypto companies, 90% of which are concentrated in Europe and the United States. These crypto-friendly banks have some common characteristics: most of them are small and medium-sized banks in scale; 90% of them are concentrated in Europe and America, especially in the United States and Switzerland.

Source: The Block Research, compiled by Huobi Research Institute

According to the research data, the median total assets of these crypto-friendly banks are only 866 million US dollars. Except for JPMorgan Chase, only two large banks (Silicon Valley Bank, Signature Bank) serve cryptocurrency customers. Large mainstream banks have relatively stable customer acquisition channels and a solid existing customer base, and still maintain a cautious operating attitude towards cryptocurrency companies.

Although the information available for crypto-friendly banks can be traced back to 2015 in the cooperation between Metropolitan Commercial Bank and Coinbase, the concept of crypto-banking has not come to the fore until 2019. On the one hand, the regulatory attitudes and regulatory paths of the major European and American countries, which are the global regulatory vane, are not clear; on the other hand, no large banks will directly participate in the cryptocurrency business.

The concept of the crypto bank is gradually taking shape with the Swiss Financial Market Supervisory Authority (FINMA)’s strategy in supervision in 2019. At the beginning of 2019, FINMA opened financial technology licenses to crypto companies, and the 100 million Swiss franc deposit limit became the demarcation line for whether a bank license is required. In August, FINMA issued the “Blockchain Payment Guidelines” to tighten rules such as cryptocurrency and corporate payments, transfers, etc. In the same year, the Swiss approved banks to operate cryptocurrency approved Vontobel, Swissquote, and other large traditional Swiss banks to carry out custody business, and approved SEBA and Sygnum’s banking licenses based on cryptocurrency business. The concept of crypto banking has opened up further this year with OCC allowing banks to custody cryptocurrency, driving the FOMO sentiment among traditional banks and compliant cryptocurrency providers. DBS Bank, Standard Chartered launched the crypto business, while Paxos and BitPay also announced their application for bank licenses.

2. Different Types of Crypto Banks

At present, crypto banks can be roughly divided into three categories based on their nature and scope of business. They are traditional banks that add basic businesses such as cryptocurrency custody/transaction, fully licensed innovative banks based on cryptocurrency businesses, and special-purpose banks whose businesses are restricted to a certain extent. This section will briefly describe the characteristics of each category for each example.

2.1 Silvergate Bank — — Traditional Bank Adds Crypto Business, the First Listed Crypto Bank

Background:

Silvergate Bank, a commercial bank established in 1987 in the United States, began to launch cryptocurrency industry services in 2013. The 2018Q3 prospectus disclosed its crypto custody business structure in detail and it was listed on the New York Stock Exchange in 2019Q4. Silvergate was initially only a state regional bank with 3 branches. Since the launch of its cryptocurrency service, its interest-free deposit scale has risen rapidly, and its interest rate margin has also increased simultaneously. It was finally listed.

So far, Silvergate has served a large number of cryptocurrency industry leaders including Coinbase, Bitstamp, Genesis Trading, Polychain Capital, Paxos, Circle, etc. By September 30, 2020, the bank has 928 cryptocurrency customers (69 cryptocurrency exchanges, 599 institutional investors, and 260 other customers including blockchain projects, mining companies, stable currency issuers, and other cryptocurrency service providers).

Business Model:

Deposit Business

Silvergate Bank’s deposits are mainly composed of interest-free deposits from cryptocurrency customers. Since 2017, the bank’s interest-free deposits have risen sharply, surpassing the number of interest-bearing deposits at a rapid rate, and now it has occupied an absolute dominant position. By September 30, 2020, Silvergate Bank’s total deposits reached $2.3 billion, a month-on-month increase of 36.5% and a year-on-year increase of 23.4%; among them, nearly $2.2 billion were interest-free deposits, accounting for 94.9% of total deposits, a year-on-year increase of 53.8%.

And these interest-free deposits include customers’ cryptocurrency, as well as institutional customers’ dollar positions. Part of the interest-free deposits creates fee-based non-interest income for Silvergate, while the US dollar position can also be used for inter-bank business in traditional banks to earn interest-bearing income. By Q3 of 2020, the company achieved $3.293 million in cryptocurrency fee income, a year-on-year increase of 201.3%, accounting for 83% of non-interest income.

Silvergate launched SEN (based on Silvergate Bank’s proprietary API and supports customers to integrate APIs into their systems) and cash management solutions launched in 2017 to meet the needs of innovative cryptocurrency customers, boosting the number of customers and deposits ( interest-free deposits) continues to grow.

Loan service

In addition to the traditional bank lending model, Silvergate Bank launched a new USD loan product for Bitcoin collateral in the first quarter of 2020, called the “SEN Leverage” loan. “SEN Leverage” has the function of lending with Bitcoin as a margin and allows customers to borrow U.S. dollars with Bitcoin held in cooperative crypto-asset exchanges as collateral.

As of September 30, 2020, “SEN Leverage” has completed the initial pilot phase, with approved credit lines totaling $35.5 million, significantly higher than the $25 million in the second quarter. The company plans to continue to expand the issuance scale, which is believed to be its main growth driver in the future.

Internal Position Network-SEN

Silvergate launched SEN for commercial customers in early 2018, allowing commercial customers to transfer U.S. dollars in real time between different crypto-asset exchanges 7*24 hours, thereby improving capital efficiency. During the SEN transfer process between two customers, the deposit will be saved in the Silvergate Bank system. If it is satisfied that the sender and receiver are both SEN participants and there is enough transfer amount in the fund account, the transaction can be settled immediately. As of 2020 Q3, SEN has processed 68,361 transactions, a year-on-year increase of 455%; the corresponding total transfer transaction volume reached 36.663 billion dollars, a year-on-year increase of 252%. Although SEN currently does not charge any fees, it has proven its usage and demand, helping Silvergate directly intervene in the trading business and develop new sources of profit.

Motivation for entry:

The motives for Silvergate’s entry mainly include three aspects:

Enhance profitability. At present, the source of profit is expanded through high interest margin or zero-cost investment income, and the profit from transaction fees can be further covered in the future;

Expand the source of customers by getting involved in crypto assets;

Pursue business innovation and expand business boundaries.

As the first listed crypto bank, Silvergate’s business model and motivations are quite representative. Although it has not yet directly provided transaction services, the design of SEN may be a prototype.

2.2 Sygnum-an innovative crypto bank, established based on crypto asset business

Background:

Sygnum is an emerging crypto bank. In August 2019, it was approved by the Swiss Financial Market Supervisory Authority (FINMA) Banking and Securities Dealer License at the same time as SEBA; in March 2020, it launched the Swiss franc 1:1 anchor currency DCHF; September of the same year Obtained FINMA’s crypto asset trading license.

Business type:

Custody;

Crypto assets-legal currency brokers: legal currency includes Swiss francs, euros, Singapore dollars and US dollars;

Asset tokenization: Primary issuance (Desygnate) and secondary transaction (SygnEx, launched in 2021);

Asset management: α strategy crypto asset fund, ETP products;

Legal currency mortgage: The current collateral includes BTC, ETH, XRP, BCH, XTZ, etc.;

B2B banking services: Provide banking service development interface and accept customized design.

Motivation for entry:

As a newly created bank based on crypto assets, Sygnum’s entry is more derived from the diversified profit sources that have been paid attention to from the crypto asset business. As a result, its current types of crypto businesses are also richer. It broke the business structure of a single interest-free deposit of a crypto-asset-friendly bank to earn high interest differentials/zero-cost investment income, and tried to through asset tokenization (its shares have been tokenized, and plans to be listed simultaneously in Switzerland and Singapore), asset management and other means to expand business boundaries and realize the innovation of crypto asset financial products.

2.3 Kraken Financial-special purpose bank, custodian bank for crypto enterprise transformation

Background:

A subsidiary of Kraken, a US cryptocurrency exchange, Kraken was approved by the Wyoming Banking Commission in September this year to conduct banking business as a special purpose deposit institution (SPDI). SPDI can operate the bank’s conventional business except for USD loans, but it requires 100% reserves for custody of crypto assets.

Business type (expected):

Deposit (custodial) business;

Crypto assets-legal currency exchange business;

Retail business for individual customers: Debit card, legal currency payment, cash business;

Corporate customer business: Fiat money wages payment based on crypto assets, etc.

Motivation for entry:

As a subsidiary of the exchange Kraken, Kraken Financial’s motivation for entering the market is more based on the pursuit of higher-standard compliance identities by crypto asset companies. There are a lot of SPDI restrictions. Kraken Financial currently only exists as a custodian bank and is prohibited from touching the core business of banks such as credit. Nevertheless, it is still actively transforming. On the one hand, it can reduce the external costs of the parent company, on the other hand, it can also increase user stickiness, and deal with the impact of financial institutions’ entry on exchanges.

2.4 Revolut-special purpose crypto retail bank

Background:

Revolut was established in the United Kingdom in 2015, initially as a virtual bank aiming to solve the high friction of cross-border remittance. In 2017, it launched its built-in crypto asset trading and custody business; in 2018, it successively obtained the British AEMI payment license and the bank license approved by the European Central Bank; it is currently applying for an SPDI license in the United States.

Business type (expected):

Retail accounts: Personal account online opening and crypto-assets trading.

Crypto asset custody (deposit).

Crypto-asset debit card: Support consumption and cash back (in BTC, ETH or Ripple) using cryptos.

Motivation for entry:

As an alternative existence, Revolut has a special motive for entering the market. Similar to Kraken Financial, Revolut is also unable to carry out credit business. A main business scope focusing on retail business makes it difficult to balance its cost and income. From 2018 to 2019, Revolut lost 33 million pounds and 107 million pounds respectively. To a certain extent, Revolut represents the “online traffic” economic model that we are familiar with. Through continuous financing, expansion of user volume and transaction volume, a financing cycle is formed, and finally a closed profit loop is completed through listing, issuing platform tokens, and attracting funds. Its current business model is not running smoothly and relies heavily on financing, remaining attention is necessary.

3. Crypto assets enter the mainstream, and crypto banking becomes the key

From 2019 to 2020, with the promotion of the supervision and policy of crypto assets and crypto banks in Europe and the United States, the concept of crypto banking has basically taken shape, and its business development is also constantly being implemented; The Asian region is still planning, Singapore, South Korea and other regions have not yet implemented supervision, and banks have taken the lead in testing or announcing business development plans.

With the maturity of the market and regulatory environment, the demand for bank custody of crypto assets has gradually increased, and the rapid development of crypto business has also opened new growth opportunities for traditional banks. These factors are becoming opportunities for the crypto banking track. At present, the profitability of the banking industry into the crypto asset service market on a large scale is still unclear; and the market is in its early stage, factors such as the high cost of bank innovation are the current challenges facing the track.

Looking ahead, we make the following judgments:

From a geographical perspective, Europe and the United States will continue to attract traditional banks and crypto companies that wish to apply for bank licenses to join; The United States, Switzerland and other regions will maintain the lead; the United Kingdom, Germany and other regions may have landing cases; Asian regions can pay attention to Singapore and South Korea.

From a business and market perspective, in the short term, traditional banks and emerging banks may compete differentiated among institutions and individuals, custody and the source of crypto assets; and large-scale crypto companies will actively deploy bank licenses. In the long run, crypto banks may become the most important part of the crypto industry and dominate the mainstream asset spot trading market. Competition on the track may intensify in the future, the interest-free deposit model will be broken, and banks will launch differentiated services such as crypto asset financing and bulk clearing.

From an ecological point of view, with the entry of the bank, crypto assets will rely on the banking business to move toward the mainstream, and the scale of assets and user penetration may increase exponentially, and eventually interact with the real economy. At the same time, crypto companies that are mainly engaged in trading business will face competition from mainstream asset trading. However, as the user penetration rate increases, leverage and derivatives, non-bank businesses such as STO, NFT, DeFi wealth management and customized businesses will create new opportunities.

We believe that crypto banks are gradually becoming a new track, traditional and emerging banks are accelerating their deployment, and crypto companies are also seeking new identities. As the business path of the track becomes clearer, the future of crypto banks can be expected.

References

[1]The Block Research:https://www.theblockcrypto.com/genesis/73780/a-comprehensive-list-of-crypto-friendly-banks-and-emis

https://www.theblockcrypto.com/genesis/79376/mapping-out-crypto-friendly-banks-e-money-institutions

[2]Silvergate Capital Corporation

https://www.sec.gov/Archives/edgar/data/1312109/000119312519275425/d568616ds1a.htm

https://ir.silvergatebank.com/financials/sec-filings/default.aspx

https://ir.silvergatebank.com/financials/financial-results/default.aspx

[3]OCC:

https://www.occ.gov/topics/charters-and-licensing/interpretations-and-actions/2020/int1170.pdf

[4]Skalex:https://www.skalex.io/crypto-europe/

[5]ICBC:

http://v.icbc.com.cn/userfiles/Resources/ICBC/fengmao/download/2018/gjjrjg20180410.pdf

[6]Tsinghua Financial Review: http://www.thfr.com.cn/post.php?id=1057

[7]PKU Financial Law Research:

https://www.finlaw.pku.edu.cn/flyxjr/gk_hljryfl_20181025180041616718/2018_jrfy_20181029112449438403/d36q5y/492995.htm

[8]SWI:

https://www.swissinfo.ch/eng/business/swiss-law-reforms-make-crypto-respectable/46024124

[9]MAS SG:

https://sso.agc.gov.sg/Acts-Supp/2-2019/Published/20190220?DocDate=20190220#pr23-

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