Episode 32: Decrypting Crypto and Banking

Cryptocurrencies have evolved from sideline oddities into hot commodities. Where does this leave financial institutions? We asked our resident payments expert and a representative from NYDIG, a technology and financial services firm dedicated to bitcoin products across industries, to explain why financial institutions should care and how to move forward.

Transcript

Saxon Prater (SP): So, Laura, have you hopped on the crypto train yet?

Laura Sewell (LS): No, Saxon, I still have a lot more learning to do. What about you?

SP: I have a bit of bitcoin, but I’m mostly just crypto curious.

LS: Well, what got you interested?

SP: Working here at CSI. Since it’s so popular, I figured I should know what all the fuss is about.

LS: Very good point. Well, Bitcoin was the world’s first cryptocurrency proposed in 2009 as a form of currency that doesn’t rely on a central issuer, but rather a complex network of computers.

SP: While it was first met with overwhelming skepticism in just over a decade, the crypto market has become a booming industry.

LS: Now, even those skeptics are paying attention to this growing ecosystem called decentralized finance.

SP: But what do these developments actually mean for traditional financial institutions?

LS: For that, we asked the head of Banking Solutions at NYDIG, a technology and financial services firm that’s dedicated to Bitcoin for institutions, and he said:

Rahm McDaniel (RM): Consistently, the research tells us that over 80% of people who already took their money out of the bank and put it into an exchange somewhere and bought Bitcoin with it would rather keep it with the bank if they could. And two thirds of them would actually switch banks to one that provided the service if they could keep it with them.

LS: I’m Laura Sewell.

SP: I’m Saxon Prater. And you’re listening to Fintech Focus from CSI…

With a market cap around $3 trillion. A recent executive order and even Super Bowl ads, crypto is a white-hot topic. But the market has primarily been dominated by third party digital upstarts.

LS: So, should traditional financial institutions care? And if so, what can they do about it? Here to talk us through it are Rahm McDaniel, head of Banking Solutions at NYDIG, and Matt Herren, director of payment strategy at CSI. Rahm and Matt, welcome and thanks for joining us on Fintech Focus.

RM: Thanks very much. It’s great to be here.

LS: Yep! Rahm let’s start off with you. How would you describe the cryptocurrency market over the last few years?

RM: Well, changing and changing fast. I mean, look, I think over the last few years it has gone from something that had a niche community of true believers into something that has become much more mainstream and much more pressing for traditional chartered financial institutions.

But at the same time, it’s also gotten bigger, more diverse and more confusing and a lot noisier. So, you know, NYDIG, I think, is here to try to simplify some of those issues and work with our clients. But it’s a big, loud, crazy world out there.

Here’s a good example of the change I’m talking about. Every May 22 is Bitcoin Pizza Day, and it celebrates the day in 2010 when a guide bought a couple of pizzas for 10,000 Bitcoin and that 10,000 Bitcoin is worth roughly $420 million today.

So, what that tells you over time is that something has gone from you know 10,000 bitcoins being worth $41 to 10,000 bitcoins being worth $480 million by virtue of growing network adoption and usage, which is to say you look at the address there’s simply more people, more companies, more things involved in the Bitcoin network.

Second is the increase in the holding periods, meaning people who own cryptocurrencies, specifically Bitcoin and some of the high-quality ones are holding them longer than the percentage the ones that are held for at least a year is going up.

And then there’s much higher numbers in the number of addresses, which is to say that the wallets, the owners of the Bitcoin that are holding large balances, so call it a thousand plus. And that really points to institutional adoption. And so, what that really adds up to is that Bitcoin and maybe to a lesser extent Ethereum are very, very mainstream.

And some of the, some of the other more long tail stuff is not at all mainstream yet and really doesn’t rise to the level that, you know, bankers necessarily need to think about it yet, except to the extent that they’re interested in the adoption of new technology.

Matt Herren (MH): There’s a concept called Metcalfe’s law, which pretty much states that a network impact or value is the square of the number of nodes in the network.

And I think that really applies to the space in that. I mean, a decade ago, virtually everyone, aside from a small niche of diehard people, really saw crypto assets, cryptocurrencies in general as a fad. You know, it was a sort of side project, you know, almost just like a curiosity.

But as adoption has grown, you know, and we’ve sort of hit an inflection point in terms of the number of participating users that has really, you know, again, based on that Metcalfe’s law concept, made this something that almost has to be taken seriously and as more users adopt, as more people are participating, holding, utilizing in some way, that value just continues to rise exponentially.

SP: So, Rahm, how are these trends affecting the US economy and traditional financial institutions overall?

RM: Well, I mean, obviously they’ve got larger and larger activity taking place in the economy. I mean, we’ve all read the stories about NFTs and the huge, huge auction values that some of these are commanding. And I think there’s more interest broadly. What I think is, is kind of more interesting in this context is how it affects traditional financial institutions.

So, stepping back for a second. You know, there’s good research that says that something like 20% to 30% of American adults own Bitcoin today. And I think we can kind of look at that as a proxy for what we’re talking about here, since it’s you know, nearly half the market and it’s the oldest of the cryptocurrencies, kind of beginning of the blockchain phenomenon.

So, 22%, according to our research. 32% according to Visa’s research of American adults owned Bitcoin today. I can’t think of another example of a financial product that a quarter of the population or so is participating in that banks and credit unions don’t participate in at all. So, when we talk about how it’s impacting the economy, if you say, okay, 20 or 30% of the population or somewhere in between is using this in some way as part of their daily lives or as part of their financial planning or as part of their economic lives or their spending patterns or their savings behaviors or asset communication.

Clearly, that’s affecting the economy. I think the next question is what are financial institutions and what are financial services providers more broadly doing about it? And the fact is that a few are and quite a few aren’t.

MH: So, at CSI, we help facilitate financial activity for millions of Americans, you know, across hundreds of financial institutions. And so, we have a ton of data around what’s taking place across, you know, the consumer base.

And we found, you know, in looking at, you know, crypto activity on various accounts you know, virtually 100% of our financial institutions have some crypto-related volume at this point taking place within their customer base. And so, while there’s no, you know, quote unquote, “Bitcoin flag” on a transaction, you know, we know who the biggest crypto exchange vendors are.

And similarly, we know some percentage of activity going to entities like PayPal, Robinhood, Square Cash, are similarly going to crypto once the money has been moved into their ecosystem. The banks, that we’ve talked to have been shocked once we contextualize their volume and kind of gave them some parameters to start looking for, just go out and search for you know, two or three of the biggest exchanges.

And the volumes in terms of both transactions, as well as dollar amounts, were really surprising to bankers who genuinely if you asked them the day prior would have said, “Yeah, maybe, but probably not that much.”

RM: To add on to that: As we talked to our bank partners in our credit union partners, this is often the beginning of the journey for them. Right? Meaning an analysis of withdrawals to the combination of crypto exchanges and also some percentage of their withdrawals to, you know, PayPal, Cash App, Venmo, etcetera.

You know, and very often, it’s it turns out to be, you know, a quite significant percentage. And what’s more interesting about it is that the demographic breakdown within that percentage is very much like the mainstream of the institution itself. Much to their surprise, there is no particular group that is you know, and this is, you know, based on a limited sample size, but no particular group appears to be uniquely well-defended or uniquely at risk.

There’s broad interest in crypto currency that they discover under the surface when they look at their withdrawals.

SP: You’re listening to Fintech Focus. We’re discussing all things crypto with Rahm McDaniel, head of banking solutions at NYDIG, and Matt Herren, Director of Payment Strategy at CSI.

LS: So right now, Matt, you’ve talked about a lot of our institutions are in the crypto space, but it does seem like a lot of traditional institutions are cautious. And according to CSI’s recent Banking Priorities Survey, only 5% of the institutions who answered the survey named cryptocurrencies. The most impactful issue in 2022.

So, Matt, why should institutions be paying attention? What can you say to those who don’t want to enter this arena? Why should they be concerned or why should they be paying attention?

MH: Sure. So, you know, my point is whether a bank thinks of themselves as being involved in the crypto space today or not, you already are. The question now is, do you want to encourage customers to go and utilize a third party or do you want to have a stronger relationship with your customer and help facilitate that demand and assist them in and participating in a financial transaction that they want to ultimately utilize?

I think many banks initially maybe think of this as a risk, but I think this is an area where it’s important to think about risk from a different angle. If you encourage customers to look elsewhere to meet their demand, you’re essentially telling that customer, you know, “no thanks. I’m going to encourage you to go up the street or up a virtual street to a direct competitor” who will gladly embrace them and encourage them to move more and more of their financial relationship to them.

So, you know, think of these exchanges, think of these entities as direct competitors, because I think in reality, they very much are.

LS: So that is an indirect risk. Well, direct or indirect to institutions. Are there any risks to consumers who delve into Bitcoin without the help of their financial institution?

MH: A lot of the fintech providers, I mean, they’ve in good faith want to do their jobs well. But we have absolutely seen over the last decade a number of exchanges that have had problems, that have had lax security. Sometimes they’re internationally based. They’re not necessarily conforming to industry best practices. And so suddenly, you know, a significant chunk of their value essentially disappears because somebody made off with it.

Or the exchange itself was shut down and that customers kind of left out of the lurch. And so, controlling that consumer behavior isn’t just good for the financial institution from a relationship and from a business perspective, but it is absolutely, you know, a better consumer experience because they know that they’re with an entity that’s going to have best practices in place.

RM: I couldn’t agree more strongly with that, Matt. In fact, it’s very consistent with what we see. I mean, you know, I mentioned at 20% of the population or somewhere, but, you know, somewhere in the neighborhood between 20% a quarter owns Bitcoin today. Consistently the research tells us that over 80% of those people, meaning the people who already took their money out of the bank and put it into an exchange somewhere and bought Bitcoin with it…

Over 80% of those people would rather keep it with the bank if they could. And two thirds of them would actually switch banks to one that provided the service if they could keep it with them, which is kind of astounding if you think about it, because you take that group, then you take the part of the population that doesn’t do anything with crypto at all…

More than half of those people say that they would work with their bank and get crypto if they could. So really those two groups have a lot in common, right? They want familiarity, they want less jargon, they want to work with a trusted entity. They don’t want to give their PII to a company they’re not familiar with or wasn’t one that isn’t regulated.

And fundamentally, they would like to keep their currency, their dollars at the same institution where they keep their cryptocurrency. And their starting point for that journey really is wanting the bank to do it because they want the bank to play the role as an intermediary to the open source, financial, you know, monetary system (for lack of a better description) that that the bank plays as an intermediary to the from the mainstream financial system.

According to the cornerstone research something like 20% of banks and 25% banks have concrete plans to add trading which is to say the ability to buy, sell and hold at least some cryptocurrency inside of their bank by the end of 2023. And that’s pretty mainstream.

LS: I agree that is mainstream and to me the point here is that this is such a great way for institutions to strengthen those relationships with their customers and continue to build that loyalty and trust more so than anything else we’ve seen in a while.

SP: Yeah. And as you say, this isn’t just Gen Z, or millennials, right? This is kind of a cross-section of your customer base. So, to stay at the center of these customers financial lives, it makes sense.

But let’s take a step back and look at what institutions should know if they want to become those intermediaries. Rahm, what are some of the key concepts that every banker should know?

RM: Well, I think it starts with being able to separate the concept of blockchain from the concept of cryptocurrency, from the other noisy stuff that’s happening in the market right now.

So, stepping back, a little bit very high level, when people talk about a blockchain, what they’re talking about is a computer file for storing data or be more technical about it.

It’s an open distribute to a database that is a ledger, right? So, the data contained on the blockchain is distributed and duplicated across lots and lots of computers all over the place. And it’s therefore decentralized. And that’s one of the things that makes blockchain so interesting. Right. I mean, unlike a database or a ledger that lives in one place where the records are processed by one company or one computer or one government, like the entire blockchain is transparent and the data can be is verified by consensus of all the nodes on that network.

Right? So blockchains are incredibly secure and simultaneously very, very transparent. And that’s because there’s no central point. So that’s a really exciting innovation. And that was invented about, I want to say, 13 years ago 2009, I guess it caused a revolution and a lot of other things, smart contracts and NFTS and all this stuff that people talk about that comes with blockchain.

So, blockchain is the technology that underpins Bitcoin and blockchain was actually developed specifically to support Bitcoin. So that was the first time we saw a blockchain doing something and without blockchain, Bitcoin couldn’t exist. So that’s kind of why people conflate those things.

So, Bitcoin what people talk about it is the first digital currency, right? The first open-source monetary system, and it’s very, very transparent in the blockchain level and you can see what happens, but it’s transacted via pseudonyms.

Now, over time, people have found lots and lots of other use cases for blockchain technology and other blockchains have been created. Right? People talk about Ethereum, people talk about stablecoins, people talk about NFTs, and sometimes they can conflate those subjects. So, as bankers think about it, it’s important that they not be confused by all the different topics that are kind of in this universe.

You know, what it comes down to for a banking audience to think about is what are the assets that people need help from the bank with? What do we what do they need to custody? The second thing is, what can the bank do that is compliant because we understand that, you know, banking is a highly regulated industry, and to be innovative, we have to be compliant first.

So, what are the quality assets that people actually see value in and they want a custody of the bank? What are the things that we’re able to do in a compliant way? And then also strategic fit, right? What are the digital assets that fit into the business model of banking as it stands today, which is to buy and sell money to manage deposits to process payments and to issue loans?

And so, once you kind of step back from it, the universe and the and the set of issues here becomes a lot more clear, right? Because some of the things that people talk about in the world of crypto or the world blockchain aren’t necessarily relevant. But if you look at, you know, you look at the market cap, you know, Bitcoin certainly seems to be relevant.

Right? And there there’s clear compliance perspectives on the custody of Bitcoin in a banking environment and there’s clear perspectives on how to secure it. There are clear perspectives on KYC, there’s clear perspectives on potentially how you might use someone’s Bitcoin assets as collateral to secure and service a U.S. dollar denominated loan. So, I think once you look at cryptocurrency, the same way that a bank would look at any other product choice or any other choice of technology, then the world gets a lot simpler to understand.

LS: You’re listening to Fintech Focus, where we’re digging into crypto and banking with Ronna McDaniel, head of Banking Solutions at NYDIG, a Bitcoin and banking provider, and Matt Herren CCS director of Payment Strategy.

SP: So, let’s talk about how institutions can use those concepts. Matt, what advice would you give to banks that want to dip their toes in the water?

MH: For me, I would start with, you know, creating kind of a war room. You know, put together a team of individuals who tend to be somewhat customer facing and innovation minded and think of it like a new product offering. Determine whether or not, you have customer demand, which frankly, from my internal research, I can say there almost certainly is. But start looking for activity that would fit this bill to kind of quantify the opportunity and validate that your customers have interest in the space. And then B: move forward with a desire to meet that demand.

This is something that I think once you do that research and understand that there is demand, then it’s about assessing your comfort level in terms of what you want to do and also how to do it as a financial institution with your various policies and strategies in mind. A lot of banks do compliance very well, which is one of the reasons why, you know, customers want to do business with them.

But at the same time, you know, we want to make sure that that we’re growing with new customer demands. And so, you know, in my mind, compliance is something, you know, through partnerships like with NYDIG where there there’s assistance in helping figure it out. I think that’s something that can be solved for, you know, in terms of just getting comfortable with this new space and applying your existing strategies and policies to this existing…to this new space.

But ultimately, I think, you know, where we need to go is understanding the marketplace. Educating yourselves if you aren’t already familiar, maybe going out and even trying some of the crypto exchanges that are in the marketplace. I think that is a great place to start for anyone who is not familiar whatsoever with these processes.

LS: Rahm, did you want to add anything?

RM: Yeah. I mean, I think, I think that’s- I think that’s great advice. Again, understanding demand, though, is very often the starting point. I mean, it’s worth mentioning, you know, we’re doing this – NYDIG is doing this today. We have institutions that are partnering with us that are live today in offering cryptocurrency as part of their banking environment.

Where that conversation usually starts is with an understanding of the demand that exists with their customers by looking at, you know, the outflow, the withdrawal of deposits to exchanges and fintechs that provide cryptocurrency options.

LS: So, when I am reading about cryptocurrency with Bitcoin, a topic that comes up a lot is security. I think that’s something… I don’t know about financial institutions, but I think definitely consumers still are just not sure of because just because it’s so such still a new concept. So, from let’s start with you. Are there any actual security concerns that consumers or institutions should be aware of?

RM: Very often this is the jumping off point for the conversation because it’s directly connected to why the people who own cryptocurrency today would like to hold it with the bank. Imagine how much how you might feel about the security of your money if you didn’t have a bank to work with. If you were responsible for the safekeeping of it yourself.

The people that you know own cryptocurrency today are hyper aware of the fact that they are responsible for the safety of that money. Right? And if it’s you know, as I mentioned earlier, a blockchain is transparent, but it is also not exactly anonymous, but you’re using it under a pseudonym, right? Your public key, as it’s called.

So, if somebody takes over your account on an exchange, that’s what’s called a hot wallet. It can be transferred it out to a wallet somewhere. And, you know, wall security is getting better and it’s increasingly likely that you would get it back. It is not certain by any means.

Likewise, if you got what’s called a cold wallet, you got your Bitcoin on a thumb drive somewhere, you could throw it away and you could be like the guy in England who is soliciting investors to dig up a landfill because he’s got half a billion dollars’ worth of Bitcoin on a thumb drive he thought he threw away.

But you could just lose it, right? Or you could have it on a on a computer that you forgot the password to. So, people do have concerns about security. And I think that’s part of the reason why they look to institutions to solve for those security issues.

Now, the way that NYDIG solves for that is to provide a cold storage solution, which is to say that the cryptocurrency that we custody for our partners is kept in an offline environment in a way that is not hackable. Essentially, we’ve turned a network security problem into a physical security problem. We are storing the crypto offline.

And the way that we do that is beyond the scope of this conversation, but only to say that the banks that work with us haven’t changed their attack surface or their profile because we are keeping the crypto in custody in cold storage.

You know, but yes, I mean, I think it’s important that institutions be cognizant of the of the nature of what they’re working with.

SP: So, we’ve talked about Bitcoin a lot specifically. Rahm, can you speak to why?

RM: Sure. We keep talking about, you know, clarity and security. You know, not only is Bitcoin the largest asset in terms of market cap and the most widely held, but it’s also the asset where we have the greatest amount of regulatory clarity about what a bank or what a financial institution can do.

So, not only is the one where the greatest amount of interest, not only is the one where the greatest amount of value that’s locked up that people want to access via loans and other things, you know. But it’s also the one where, you know, a bank can have some measure of safety as they roll it out as opposed to the very, very long tail of several thousand other assets that they could theoretically offer in combination with some partner or whatever.

LS: Okay, now that we looked at the current state of digital assets, let’s look a little bit ahead. Matt, we’ll let you feel this one, then let Rahm get the final word. Where are we going with cryptocurrencies and Bitcoin in particular?

MH: I think the short way to think of it is this isn’t going away. The imperative here for financial institutions is, you know, you have to start somewhere. And I think Bitcoin is a perfect place to start.

That being said, we’re certainly not done. You know, there could be other assets that could be fractional shares of NFTs, should those continue to be relevant, utilizing blockchain chain technology for you know, with auto sales or mortgages, property registration. All of that seems like it has a lot of potential and so it’s worth keeping an eye on.

But at the same time, you know, we just don’t know in terms of certainty and really process how that’s going to how that’s going to kind of, you know, flesh itself out in the coming decade. There’s so much happening in the space. There’s so much opportunity and innovation. You know, Citibank was just discussing the Metaverse as a $13 trillion opportunity.

And I think that’s really important to keep in mind. We need to be paying attention. And so, this is a perfect place to kind of dip your toe and start the process. But keep in mind that this is not going to be the end. You know, we’re not we’re not launching a product and kind of washing our hands of it and never looking at it for thinking about it again.

This is just the first step of what will probably be many.

RM: Yeah. I mean, I think you nailed it, right? It’s less a question of what’s next and more question of what’s first. Right? And what’s first is for banks to bring digital assets, Bitcoin in particular into the existing business model of banking starting with an account, a store of value.

Right? The ability to buy and hold or import from somewhere else. The Bitcoin that I own, the digital asset that I own into the banking environment. You know, the next step for that is to you know, is to incorporate that capability into other things that the bank does. You know, things like debit rewards, things like credit rewards, things like interest enhancement. These are things that NYDIG is working with banks on today.

You know, likewise, over time, bank customers will accrue more value in digital assets. And they have today, and they will also bring in particularly the 22% we talked about that owns Bitcoin already. They will import digital assets into the banking environment that represent a significant part of their net worth. And these are assets they really don’t want to sell they want to get access to the liquidity in those in those assets. And that’s where there’s an opportunity to make loans, all that.

What I would also say, though, is that not just on the consumer side, there’s a number of commercial applications of cryptocurrency here, too, ranging from business-to-business payments to financing mining operations which is to say the underlying activity that that brings digital assets to life.

So, there’s a there’s a variety of things that we do here. But at the end of the day, the business model that we’re supporting at NYDIG is banking. And what we find is that digital assets, Bitcoin in particular, fit into the business model of banking.

LS: Perfect. I think that’s a great note to end on…

That’s it for this episode of Fintech Focus. Thanks again to Rahm McDaniel and Matt Herren for joining us today. And thank you all for listening.

SP: Check out previous episodes of this show and learn more about who we are and what we do at CSI by visiting csiweb.com. You can also subscribe to Fintech Focus wherever you get your podcasts. We’ll be back soon with another episode. But until then, say hi to CSI on Twitter @csisolutions or on our Facebook page: facebook.com/csisolutions.

See you next time.