Panelists: Caitlin Long, Founder and CEO of Custodia Bank Daniel Awrey, Professor of Law, Cornell University
Moderator: Lukas Wagner, Nyala
Hosted by University of Oxford’s FinTech and LegalTech Society, this panel discussion explored the dynamic and often contentious relationship between the burgeoning world of cryptoassets and the established financial services sector. With leading experts, we delved deep into the opportunities and challenges that cryptocurrencies present to traditional financial systems.
The OFLS had an opportunity to host three esteemed panelists: Caitlin Long, Founder and CEO of Custodia Bank, Professor Daniel Awrey, Professor of Law, Cornell as well as the moderator: Lukas Wagner, Nyala.
Lukas Wagner began the discussion by requesting Caitlin Long to begin with a short introduction into her work, how what she does is different from traditional financial services and how it relates maybe also to what is often referred to as Operation Chokepoint. 2.0.
Caitlin, drawing on her 20 years of experience in the traditional financial world, highlighted the operational challenges inherent in paper-based traditional finance. She noted that these challenges persisted even with digitization, as it primarily involved the digitalization of analogue versions of financial instruments. She pointed out the centralized ledger system that serves as the foundation of traditional finance, which necessitates constant duplication and reconciliation of information across databases maintained by multiple financial institutions. In this context, she emphasized the potential of Bitcoin, which eliminates the need for constant duplication and reconciliation by relying on a shared ledger.
Caitlin then discussed the Bitcoin custody service offered by Custodia, which provides segregated Bitcoin custody utilizing the Bitcoin blockchain as the base ledger (rather than, as most custodians do today, custodying all customer bitcoins in a single omnibus wallet and maintaining customer records in a centralized subledger off-chain). She explained how this service provides a secure bridge for digitally native assets to connect with the traditional financial system. She concluded by mentioning the lawsuit involving Custodia Bank’s access to a Federal Reserve master account. Separately but related, when Custodia applied to become a Fed member bank the Federal Reserve deemed Custodia Bank’s non-lending, 100% reserve model for US dollar banking as unsafe and unsound. (She noted the Bank of England recently recommended that UK stablecoin issuers be required to be non-lending, 100% reserve banks and that the stablecoin bill under discussion in Congress, if it becomes law, would do the same.) The Fed also raised questions about whether interactions with public permissionless blockchains could comply with the Bank Secrecy Act in the US.
Lukas then sought Professor Daniel Awrey’s comments on non-lending banking as a business and as an alternative banking model.
Professor Awrey discussed that the traditional microprudential regulatory framework has gradually evolved to address the risks arising in connection with credit, liquidity and maturity transformation. Referring to Federal Reserve’s ongoing lawsuit with Custodia, he further called into question whether the same regulatory framework was still required when the transformative element of services is omitted in alternative approaches to banking. Awrey further emphasized how a layer of regulations was built to manage the risks associated with the highly interconnected and fragile nodes within the payment and monetary networks to ensure overall economic stability. Lastly, he noted the evolutionary nature of the regulatory structure and that with technological progress, there have been new opportunities to change the structure of the financial system, particularly its reliance on fragile intermediaries and information silos.
Lukas, referring to the events of March 2023 (the failure of several banks in the US), sought Prof. Awrey’s comments on whether these were examples of the existing financial system and traditional regulatory framework creating risks for the crypto sector.
Awrey, referred to financial intermediaries such as Circle and SVB, pointing out that Circle natively wouldn’t have had any reasons to hold $3.3 billion in a bank account but for regulation that hasn’t caught up to new business models and technologies, illustrating how this ended up creating a channel of contagion. Prof. Awrey argued that it was primarily because of regulation that this ecosystem wasn’t allowed to separate out and operate without reliance on the strategic chokepoint of banks in order to access the payment systems. That is why the UK is adopting proposals that allow institutions like Circle to connect directly with the Central Bank infrastructure so that this leads to (a) a more diversified financial system, where the failure of one institution doesn’t directly lead to failure of others, and (b) new business models that are experimenting and exploring new and better ways to do things.
Caitlin then noted that Silvergate was only holding 10 cents of cash against its demand deposits, which were nearly all digitally driven, and could be withdrawn in the span of hours. The bank run risk was, therefore, acute. Moreover, unlike in the past, where a bank run would possibly happen over the span of a couple of weeks, the run on Silicon Valley Bank showed that a bank can lose its deposits within the span of hours or days in the modern world. She noted that in relation to digital asset companies, the concept of running a traditional fractional reserve balance sheet is a recipe for a bank run.
Lukas then enquired about how new business models such as Custodia are planning to make money if not by maturity transformation.
Caitlin responded by saying that Custodia is fee-based. She categorized FinTechs into Payment FinTechs and Lending FinTechs and observed that Payment FinTechs are largely fee-based services and don’t lend for the most part.
Further, referring to custody services for digital assets, she observed that there exists a lot of counterparty credit risk intraday, involving the timing differences between settlement in digital assets and settlement in fiat currency. In the US context, she observed that given the lack of an e-money structure like the UK, FinTechs must obtain US dollar banking services from traditional banks that are engaging in credit risk and maturity transformation, providing a touch point where the risks from the traditional systems transfer to the crypto world.
Building upon this, Lukas sought comments upon the recently approved Bitcoin spot ETFs.
Caitlin responded that contrary to her fears, the SEC in the context of Bitcoin ETF did not allow crypto custodians to lend out the Bitcoin. She noted that while SEC did not permit leverage on the ETF level, there may be leverage on layers above the ETF where the units of the ETF itself can be lent out but the underlying Bitcoin cannot.
Prof. Awrey agreed and appreciated the SEC’s stance and observed that allowing BTC lending was going to create additional and potentially opaque interconnections, credit exposures within the system that potentially could sow the seeds of future instability. He concluded by calling into question, however, whether the SEC has sufficient vision, clarity and information, to be able to see what leverage is being introduced on top of the ETFs given that it’s really difficult to surveil.
Caitlin in response to this highlighted the alarm bells that are raised because a number of the ETF issuers are charging essentially zero fees and the custody cost is at least 20 basis points above that. She suggests that it may be either an introductory teaser rate, or they may be acting like no-fee mutual funds wherein possibly a lot of securities lending risk happening behind the scenes remains undisclosed.
Lukas then channeled the discussion towards the implications of the concentration risk of just one custodian holding all these bitcoins for all the ETFs and invited comments.
Caitlin discussed the intricacies of custodianship in the context of the financial industry, particularly focusing on the differences between banks and trust companies in the United States. Banks are exempt by statute from US bankruptcy courts, which prioritize customers in the event of bankruptcy, whereas trust companies may end up in a Chapter 11 bankruptcy, prioritizing shareholders. She suggested that there is risk for non-bank custodians that use a trust company structure, like Coinbase and many others. The SEC tried to block banks from becoming large custodians of bitcoin when it adopted an accounting rule for SEC filers called SAB-121. That rule applies to Coinbase, which is an SEC filer but not a bank. She noted that the SEC’s rule had the effect of blocking banks, which meant non-bank custodians became significant players in custodianship for Bitcoin ETFs.
Prof. Awrey followed these observations by emphasizing the significant issue in the United States regarding the lack of bankruptcy protection for innovative financial institutions operating within regulatory frameworks that aren’t considered traditional banks. He stated the importance of recognizing this issue in congressional debates and suggested that legislation should prioritize customer protection in non-bank resolution contexts while noting that Wyoming, with its recent legislations, seems to have taken steps in the right direction. He highlighted the advantage incumbent institutions have due to existing legal frameworks which are either undermining new business models or giving banks a comparative advantage in insolvency. He reiterated the need for a level playing field and the imminent need to address these foundational issues in financial regulation. Prof. Awrey also addressed the importance of access to Federal Reserve’s master accounts by noting that once financial institutions are removed from bankruptcy and traditional credit liquidity and maturity transformation concerns are addressed, there are few reasons to prohibit them from connecting to conventional payment systems facilitated by the Federal Reserve.
Prof. Awrey also discussed the broader regulatory challenges beyond bankruptcy, including anti-money laundering (AML), counter-terrorism financing (CTF), and monetary policy transmission. He highlighted that the need for innovative thinking to address these issues persists across the financial sector, not just within crypto.
Lukas redirected the discussion to recent hearings in the US regarding regulation, particularly for companies outside the country and in this context prompted further discussion on the broader issue of anti-money laundering (AML).
Caitlin highlighted the differing regulatory standards between banks and non-bank entities in the United States regarding anti-money laundering (AML) and counter-terrorism financing (CFT) because banks are subjected to higher standards. Additionally, with regard to the Custodia lawsuit, she referred to the public records of the lawsuit regarding their AML program. She also referred to recent testimony by the head of FinCEN regarding the pervasiveness of illicit finance on traditional financial rails as compared to cryptocurrency networks and emphasised the traceability of crypto transactions given their open public permissionless ledger and immutability.
Prof. Awrey argued that outdated toolkits are still prevalent in financial systems, which hindered efficient surveillance and compliance efforts due to information silos. He highlighted the potential of technological advancements, including web-based APIs, to enable better surveillance and reporting of suspicious activities. He also emphasized the need to move past narratives linking crypto to terrorism and instead shift focus on addressing illicit finance more broadly.
He suggested that government incentivization could drive industry-wide adoption of technologies to improve financial monitoring. Additionally, he criticized existing systems that may have produced biased outcomes, such as triggering suspicious activity reports based on ethnic names. Prof. Awrey concluded by noting that the US Congress, currently resistant to change, leaves a lot to be desired in designing and implementing necessary reforms.
Caitlin then highlighted regulators’ limited understanding of the internet due to legacy technology. Prof. Awrey agreed, stating that regulatory leaders had grown up when IT in finance was viewed as purely a back-office function.
Prof. Awrey then contrasted the past reliance on mainframe-based systems for data storage and management with the current landscape of web-facing businesses and cybersecurity threats. He highlighted the shift from a centralized node model to one requiring resilience across multiple nodes and interconnections. He further underscored the importance of understanding technology as both an opportunity and a threat in finance, emphasizing the need for constant vigilance.
Caitlin then expressed concerns about what she perceived as a backward trend in the United States regarding banking access for tech-forward companies. She criticized what she viewed as an anti-tech stance, citing a crackdown on banking access for both the crypto and fintech industries. She highlighted the pressure on banks from bank regulators to close accounts for fintechs of all types, leading to existential worries for fintechs about losing access to payment rails. This pressure had pushed some fintech companies to consider obtaining their own bank charters as an insurance policy against losing access to card networks that require a bank to sponsor their access.
Prof. Awrey concluded by noting a prevailing phobia around technology without a clear vision of its role or how law, regulation, and policy could facilitate its integration. He suggested that there seems to be a tendency towards knee-jerk reactions to anything tech-related, without considering the broader policy objectives. He suggested that viewing financial services and technology as integrated “stacks” could be beneficial, emphasizing the importance of understanding the various technological and financial components to grasp threat vectors, opportunities, and competitive impacts across different dimensions of the industry.
In a similar vein, Caitlin noted that it becomes quite problematic when decision makers at the regulators lack even basic knowledge about technology such as APIs and are far from understanding more advanced concepts like cloud computing, let alone digitally native financial instruments such as Bitcoin or tokenized securities.
Hatim Hussain, OFLS President, began the Q&A by enquiring about regulating industries operating on decentralized platforms with varying degrees of regulatory oversight. He asked whether traditional regulatory approaches, like the Financial Stability Board’s “one risk, one principle,” still apply in these scenarios and sought insights on how to effectively regulate such decentralised environments.
Caitlin’s response to this question emphasized the need for regulators to acknowledge the inevitability of decentralized technologies and focus on integrating them into regulatory frameworks rather than attempting to ban or suppress them. She compared the situation to the adoption of cell phones at regulated carriers while the internet facilitated unregulated calling as well, suggesting that the goal should have been to incentivize the use of regulated platforms (which provide better user interfaces and security, so people voluntarily use the regulated platforms even though they could use unregulated alternatives). Caitlin criticized current regulatory approaches for driving legitimate activities into shadows and unregulated spaces, making it harder for law enforcement to monitor and prosecute illegal activities. By briefly mentioning her involvement in providing evidence of potential crimes at FTX to law enforcement, she highlighted the importance of regulated “on-off ramps” for law enforcement. Ultimately, Caitlin concluded with a prediction current regulatory decisions will probably lead to the emergence of new FTXs.
Prof. Awrey emphasized two perspectives on regulation: as a punitive measure for past or potential wrongdoing, or as a means to ensure credibility and confidence in the system. He noted that policymakers often focus on the former approach, which may push activity into less regulated areas. He highlighted the challenge of allocating responsibility in a code-based, decentralized world, where accountability becomes more complex, especially in cases involving fragmented inputs or open-source software. He suggested that resolving these issues may require new theories of responsibility for disaggregated business models, considering factors like composability and the involvement of multiple autonomous actors in different stages of a tech stack.
Carmen Rodriguez followed up with a question to Prof. Awrey, asking him to compare the regulatory approach to banks in the United States, particularly focusing on how charging practices affect custody, with the approach in the UK.
Prof. Awrey, in response, highlighted several key differences between the regulatory approach to banks in the United States and the UK. He stated that in the US, federalism presented a challenge with the dual banking system and potential disagreements between federal and state regulators. Additionally, the US regulatory perimeter was institution-driven, which contrasted with the UK’s more flexible approach, where regulatory changes could be made efficiently through administrative processes, allowing for nimble adaptation to new developments without the need for new primary legislation. While there might have been technical differences in bank regulation between the two countries, the primary distinction lay in the design of the political system and its interaction with regulatory frameworks.
Hatim concluded the session by expressing gratitude to the speakers for their valuable time and contribution to the session. He also thanked Lukas for efficiently moderating the discussion and extended appreciation to the audience for their participation.