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Startup Bank for Interfacing With Cryptocurrencies

by Joel Nagel, Esquire

A Startup Bank for Interfacing With the Cryptocurrencies

Dear Reader,

In last week’s article, I answered a question from Tom in which I examined the process and procedures for starting an international/offshore bank from scratch. If you did not have a chance to read last week’s article, click here, as it may provide context and background for today’s article.

I want to thank my publisher, Dan Wilhelm, for allowing me to answer Tom’s question in two parts over two weeks. Part of the banking question asked about the interface for a startup bank between traditional banking and cryptocurrencies. I really didn’t have the time, energy, or space to tackle that issue as part of last week’s general banking article. This is certainly a new and rapidly evolving area for both business as well as financial institutions, and equally so for the retail consumers who are trying to navigate these new forms of “currency” and “banking” interactions.  

So I wanted to follow up on that aspect of fiat currency to cryptocurrency exchange and its interface with the banking system for any new startup bank (or existing bank, for that matter), in this week’s “ATA.”  

– JN


For any bank or financial institution, it’s important to know your customer (KYC) and to know the source of the funds being transferred (referred to as “anti-money laundering,” or “AML”) to be certain that there is no illegal activity going on within an account inside the bank. The days of “numbered” bank accounts, prevalent in Europe for hundreds of years, where the bank didn’t even know your identity, are long since over. Banks routinely file a large number of activity reports to their Central Bank or financial regulators, including what are called “Suspicious Activity Reports,” or STRs, on all types of inbound and outbound transactions.

Cryptocurrencies, beginning with Bitcoin and now encompassing over 500 tradable currencies with many more in existence and still others coming online every day, were invented in part to make financial transactions completely secure, autonomous, and untraceable to governments. I can remember an early Bitcoin seminar nearly a decade ago (no, I didn’t have the forethought back then to buy some coins for a few dollars per coin) where the speaker made the statement that “Bitcoin was the first currency in the world that you carried around in your mind.”

Think about that for a minute. Nothing to carry, no paperwork to fill out when crossing borders, and no bankers. Just you, the person-to-person transactions where you spent or acquired Bitcoin, and your personal stash of actual Bitcoins which you could access from any country and on any computer in the world using codes that only you knew. The whole thing was utterly brilliant.

The problem, of course, is that these two worlds (that of Central Bankers and regulators, together with commercial banks on one hand and Bitcoins moving anonymously through cyberspace on the other hand) cannot coexist. And since it’s unlikely that governments will ever roll back their KYC and AML protocols, it only makes sense that the use of cryptocurrencies will need to become more and more regulated, especially where the crypto/fiat interface occurs at banks. Alternatively, some cryptocurrencies and some proponents of cryptocurrencies actively promote the notion that eventually anyone will be able to buy and sell anything they wish from whomever they want with cryptocurrencies, without any governmental interference or regulations, making traditional banks and the entire current global banking system obsolete.  

Of course, governments as well as banks, I might add, are opposed to such a development for many reasons, including the AML/KYC issue mentioned above, as well as their ability to ensure that people properly report their taxes, and the government’s ability to regulate the overall economy (interest rates and monetary supply) through the banking industry. The interface and conversion from crypto back to fiat (ie dollars, euro, yen, etc.) within their legal jurisdictions, along with regulatory oversight of cryptocurrency exchanges based within their territory, are really the pinch points where governments can attempt to regulate the cryptocurrency space. 

So, what are the banks to do with cryptocurrency? 

Well for many of them, absolutely nothing. They won’t send or receive money from crypto exchanges and they won’t transfer the proceeds of a crypto transaction or crypto/fiat transaction through their bank. In this scenario, they don’t have to worry about possibly transacting business in any fashion that might violate their AML/KYC rules, because they don’t do any. They simply stonewall any crypto transactions and hope that any demise of traditional banks caused by cryptocurrencies doesn’t happen on their watch. 

Other banks will accommodate crypto/fiat interface as long as they can assure themselves that their AML/KYC policies and procedures can apply to the crypto transaction. They might, for example, only process transactions coming from domestic exchanges with similar regulatory oversight. They might only process a transaction that comes from an exchange or crypto account in the same name as their client. In other words, John Smith could transfer his Bitcoin from his account at an exchange in the U.S. to his account at a U.S. bank, but perhaps not receive the same transfer from Mary Jones in another country.  

In the U.S., Coinbase is largely becoming one of the largest crypto exchanges, and they have negotiated business relationships with a number of banks which will accept transfers from their bank within the United States. But the banks only accept funds from Coinbase if it’s for an account of someone with the same name, and generally not third parties. In Switzerland, some banks will actually allow you to set up a crypto account within your overall banking relationship with them. The coins or tokens are kept in the bank’s name, FBO (for the benefit of…) your name, so that it is possible to show the source of funds used to purchase the cryptocurrency just like any other asset you might hold at the bank, such as stocks, bonds, or gold.

Other countries have similar rules to allow only limited parties with regulated accounts to receive the flow of funds from the exchanges back into their banking system. Some countries haven’t yet developed a regulatory response to cryptocurrencies, and some have even played up their lack of regulation of the crypto industry as a marketing ploy to try and attract the establishment of banks in their jurisdiction for the purpose of non-regulated or lightly-regulated crypto/fiat interface. I believe this aspect was at least part of the background of Tom’s question last week about starting a bank. And while each country can decide for itself how to regulate or not regulate the crypto industry, the fact of the matter remains that those lightly or non-regulated countries do not operate in a vacuum, nor do they really have the ability to offer investors exactly what they are looking for, which is an easy and unregulated crypto/fiat interface on a global scale.

Why, you might ask? Well, it’s simple. Any jurisdiction can offer to sell banking licenses, but what is the license really worth if the bank, once established, has no way to move its funds to and from its customers? You see, the Federal Reserve in the U.S. calls the shots for all of the banks in the U.S. and is very influential in other parts of the world as well. The European Central Bank regulates all of the banks in Europe and is also very influential in other parts of the world. The Bank of Japan regulates Japanese banks and is very influential in other parts of the world, and the Bank of China regulates banks in China and is very influential in other parts of the world. You get the point. None of these Central Banks, nor the commercial banks operating in these countries or in countries influenced by the Central Banks in their region of the world, have any incentive to allow cryptocurrencies to undermine their regulatory policies and procedures, nor to ultimately undermine the commercial viability of their own commercial banks. So, if any bank wants to operate in the crypto space, they really need to bend over backwards to ensure regulatory compliance and, of course, the bank’s business has to make financial sense for their intermediary banks to make the business profitable for them, given the costs of regulatory compliance. 

At present, I understand that a group of the largest European banks is secretly working together with IBM’s artificial intelligence unit to solve a lot of the open questions that surround the crypto/fiat interface, especially the AML/KYC regulatory issues mentioned above. You can be sure that this consortium will not only influence what the governmental and regulatory compliance aspects of crypto/fiat interface become, but they will most certainly try and create a monopoly or oligopoly for themselves to control this business once they have it figured out. Other banks will most likely be able to participate, but only on their terms and conditions similar to how money presently moves around the world through SWIFT. Until that day comes about, these same banks and their governments have no incentive to really let crypto/fiat interface grow on an uncontrolled basis.

For the moment, the thought that an intermediary or correspondent bank would risk heavy fines and penalties and potentially lose its own correspondent relationships with the largest global commercial and Central Banks of the world, just to provide in turn a crypto/fiat interface for a startup bank on a tiny Caribbean island with only a couple million dollars in capital and thin regulations, is…well…not good business for them.

For any startup bank to have a chance to access the global banking system, I would recommend the following:

1) Have sufficient capital to make it worthwhile for an intermediary or correspondent bank to do business with you. Probably $10 million or more. If you don’t have that level of capital, instead approach an existing crypto-friendly bank about making a strategic investment into the bank, so as to facilitate the crypto business which you want to accomplish.

2) Any crypto exchange with which you interface should be properly licensed and regulated in a similar manner as both you and your correspondent banks. Err on the side of working in more developed and regulated countries.

3) Your AML/KYC policies and procedures should go beyond the requirements of your own banking jurisdiction and meet the requirements of any intermediary or correspondent bank’s jurisdiction with which you intend to do business. If you plan to focus on a particular market for your customers, such as the U.S. or Europe, for example, take special care to comport to the regulations in those jurisdictions which themselves might require disclosure of information that might normally be illegal to disclose under the banking laws (privacy and secrecy laws) of your own bank’s jurisdiction. This may require customer waivers to be put into effect as it relates to bank secrecy laws.

 4) Have a strong business plan which outlines your competitive advantage in the marketplace as well as how you can implement your plan within the regulatory legal framework that exists for you as well as your correspondent bank.

By being transparent with your business plan and ensuring that your business will not cause problems to your intermediary or correspondent bank’s business, your chances of getting the necessary global banking relationships put in place improves dramatically. Just remember that you are in the middle of an epic struggle whereby governments want everything über regulated and many elements of the crypto world want nothing to be regulated.  

As a bank trying to serve your clients, you’ll clearly need to come down on the side of über regulation and disclosure if you want to be in that business. You’ll lose some potential clients for sure, but then again, is that business really the business you want to have? There certainly is enough clean business willing to endure government regulatory compliance developing in the crypto space, that a sufficiently-capitalized, well-run bank with solid AML/KYC policies and procedures can do very well for itself. Who knows, the big banks may actually come knocking on your door soon and be willing to pay an absurd premium just to get their hands on your bank and your business model if it’s successful.

I wish you every success as you pursue your goals of building a crypto/fiat startup bank. If I, or my firm, can do anything to assist you in your plans, do not hesitate to call upon us.

Best wishes,

Joel Nagel
Ambassador (Retired)
Senior Partner
Nagel & Associates, LLC
409 Broad Street – Suite 204
Sewickley, Pennsylvania 15143
Phone: + 412-749-0500
Fax:  + 412-749-0505

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