Crypto's rapid move into banking system elicits alarm in Washington

Washington

BLOCKFI, a fast-growing financial startup whose headquarters in Jersey City, is across the Hudson River from Wall Street, aspires to be the JPMorgan Chase of cryptocurrency. It offers credit cards, loans and interest-generating accounts. But instead of dealing primarily in dollars, BlockFi operates in the rapidly expanding world of digital currencies, one of a new generation of institutions effectively creating an alternative banking system on the frontiers of technology.

"We are just at the beginning of this story," said Flori Marquez, 30, a founder of BlockFi, which was created in 2017 and claims to have more than US$10 billion in assets, 850 employees and more than 450,000 retail clients who can obtain loans in minutes, without credit checks.

But to state and federal regulators and some members of Congress, the entry of crypto into banking is alarming. The technology is disrupting the world of financial services so quickly and unpredictably that regulators are far behind, potentially leaving consumers and financial markets vulnerable. Top officials from the Federal Reserve and other banking regulators have urgently begun what they are calling a "crypto sprint" to try to catch up with the rapid changes and figure out how to curb the potential dangers from an emerging industry whose short history has been marked as much by high-stakes speculation as by technological advances.

In interviews and public statements, federal officials and state authorities are warning that the crypto financial services industry is in some cases vulnerable to hackers and fraud and reliant on risky innovations. In August, crypto platform PolyNetwork briefly lost US$600 million of clients' assets to hackers, much of which was returned only after the founders begged the thieves to relent.

"We need additional authorities to prevent transactions, products and platforms from falling between regulatory cracks," Gary Gensler, chair of the Securities and Exchange Commission (SEC), wrote in August in a letter to Senator Elizabeth Warren about the dangers of cryptocurrency products.

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The SEC has created a stand-alone office to coordinate investigations into cryptocurrency and other digital assets, and it has recruited academics with related expertise to help it track the fast-moving changes. Acknowledging that it could take at least a year to write rules or get laws passed in Congress, regulators may issue interim guidance to exert some control. BlockFi has already been targeted by regulators in five states that have accused it of violating local securities laws. Regulators' worries reach to even more experimental offerings by outfits such as PancakeSwap, whose "syrup pools" boast that users can earn up to 91 per cent annual return on crypto deposits.

Treasury Secretary Janet Yellen and Fed chair Jerome Powell have also voiced concerns, even as the Fed and other central banks study whether to issue their own digital currencies. Mr Powell has pointed to the proliferation of so-called stablecoins, digital currencies whose value is typically pegged to the US dollar and are often used in digital money transfers and other transactions like lending.

The cryptocurrency banking frontier features a wide range of companies. At one end are those that operate on models similar to those of traditional consumer-oriented banks, such as BlockFi or Kraken Bank, which has secured a special charter in Wyoming and hopes by this yearend to take consumers' cryptocurrency deposits - but without Federal Deposit Insurance Corp (FDIC) insurance.

On the more radical end is decentralised finance, which is more akin to a Wall Street for cryptocurrency. Players include Compound, a firm in San Francisco that operates completely outside the regulatory system. Decentralised finance eliminates human intermediaries like brokers, bank clerks and traders, and instead uses algorithms to execute financial transactions, like lending and borrowing.

BlockFi's extraordinary growth - and the recent crackdown by state regulators - illustrates the fraught path of cryptocurrency financial services companies amid confusion about what they do.

BlockFi's business is not dissimilar to that of a regular bank. It takes deposits of cryptocurrencies and pays interest on them. It makes loans in US dollars to people who put up cryptocurrency as collateral. And it lends crypto to institutions that need it.

For consumers, the main allure of BlockFi is the chance to take loans in US dollars up to half of the value of their crypto collateral, allowing them to get cash without the tax hit of selling their digital assets, or to leverage the value of holdings to buy more cryptocurrency. The firm also offers interest of up to 8 per cent per year on crypto deposits, compared with an average of 0.06 per cent for savings deposits at banks in August.

How can BlockFi offer such a high rate? In addition to charging interest on the loans it makes to consumers, it lends cryptocurrency to institutions like Fidelity Investments or Susquehanna International Group that use those assets for quick and sometimes lucrative cryptocurrency arbitrage transactions, passing on high returns to customers. And as BlockFi is not officially a bank, it does not have the large costs associated with keeping required capital reserves and following other banking regulations. Also BlockFi does not check credit scores, relying instead on the value of customers' underlying crypto collateral.

The model has worked for BlockFi. It is hiring employees from London to Singapore, while prominent investors - including Bain Capital, Winklevoss Capital and Coinbase Ventures - have jumped in to fund its expansion. The company has raised at least US$450 million in capital. But to regulators, BlockFi's offerings are worrying and perplexing.

BlockFi chief executive Zac Prince said that the company was complying with the law but that regulators did not fully understand its offerings.

Decentralised-finance protocols largely rely upon stablecoins, cryptocurrencies that are ostensibly pegged to the US dollar for a steady value but without guarantees that their value is adequately backed. The overall market of stablecoins has ballooned to US$117 billion as of early September from US$3.3 billion in January 2019. That has regulators worried.

"These things are effectively treated by users as bank deposits," said Lee Reiners, a former supervisor at the Federal Reserve Bank of New York. "But unlike actual deposits, they are not insured by FDIC, and if account holders begin to have concerns that they cannot get money out, they might try and trigger a bank run." NYTIMES