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Report Overcoming Obstacles to Banking Virtual Currency Businesses

, Arnold & Porter LLP

, Arnold & Porter LLP

Version 1.0

Abstract

Virtual currency businesses (“VCBs”) offer an alternative payment rail to traditional banks and financial institutions. In order to operate, though, VCBs themselves rely on banks to conduct fundamental payment, savings, foreign exchange and other financial functions. Banks, as heavily regulated entities, apply certain levels of scrutiny to their potential customers and it is common industry knowledge that certain types of businesses, such as money services businesses, have historically had difficulty establishing relationships with banks. In the last several years VCBs have become more numerous and reports of their difficulties in establishing banking relationships have been the subject of both the popular press and industry lore. In order to examine this difficulty Arnold & Porter LLP and Coin Center collaborated to research and analyze the issue. This paper presents the methodology, findings and recommendations resulting from the research and analysis.

Article Citation

Pratin Vallabhaneni, David Fauvre, "Overcoming Obstacles to Banking Virtual Currency Businesses 1.0," May 2016.

Table of Contents

Introduction

Virtual currency businesses (“VCBs”) offer an alternative payment rail to traditional banks and financial institutions. In order to operate, though, VCBs themselves rely on banks to conduct fundamental payment, savings, foreign exchange and other financial functions. Banks, as heavily regulated entities, apply certain levels of scrutiny to their potential customers and it is common industry knowledge that certain types of businesses, such as money services businesses, have historically had difficulty establishing relationships with banks. In the last several years VCBs have become more numerous and reports of their difficulties in establishing banking relationships have been the subject of both the popular press and industry lore. In order to examine this difficulty Arnold & Porter LLP and Coin Center collaborated to research and analyze the issue. This paper presents the methodology, findings and recommendations resulting from the research and analysis.

Methodology

VCBs have a variety of business models. Given this variation, we hypothesized that banks would apply varying degrees of scrutiny to different VCBs depending on where any particular VCB resides within the virtual currency ecosystem. Thus, the first step in our study was to divide the VCB industry into different sectors. While we recognize that any classification of VCBs may carry with it inherent biases, we attempted to classify the industry as neutrally as possible along generally accepted sectors, as follows:

  • Wallets. These businesses store the private keys needed to access a virtual currency address and spend the coins. There are various models of custody that wallet companies provide.
  • Exchanges. These businesses create a marketplace where a fiat currency (or other asset) can be exchanged for a virtual currency, and vice versa.
  • Payment Processing. These businesses enable various parties to transact in virtual currency by enabling merchant payments through their platform.
  • Specialized Service Providers. These businesses provide various services to assist in the use of virtual currency, and include insurers, device manufacturers, platform designers, and compliance firms, among others.
  • Mining. These businesses use special software to solve math problems that help authenticate virtual currency transactions and are rewarded with virtual currency. They may also manufacture hardware and sell it to others that mine virtual currency.
  • Blockchain. These businesses are those whose business is based on blockchains and not the use of virtual currencies as a means of payment per se. They include blockchain analysis firms and smart contract companies, among others. They may be financial service providers to the extent their services also involve the blockchain.

The second step in our study was to contact various VCBs that occupy one or more positions within the virtual currency ecosystem and conduct open-ended interviews with each one. Generally the representative for each VCB was the founder, chief compliance or legal officer, or treasurer. We spoke with one dozen VCBs that range from small start-ups to some of the most well-established and well-funded VCBs that have raised in excess of $100 million. In each case we asked a set of predetermined questions and then followed up with questions based on the nuances of any particular VCB’s responses or idiosyncratic business model. Each VCB we contacted was either based in the United States or maintained significant operations in the United States. Questions that we asked each VCB included the following:

  • Describe your experience with establishing a banking relationship? Were there any difficulties and, if so, what were they?
  • If you were denied an account or had an account closed, what were the cited reasons for denial or difficulty?
  • What banks provide you bank account services and what kinds of services do they provide? What banks denied you services or terminated your services and what kinds of services were involved?
  • What suggestions do you have for new entrants looking to establish a banking account?

The third step in our study was to contact various banking organizations that have both accepted VCB clients and those that have not. We formally interviewed representatives of four banking organizations ranging in size from under $1 billion in total consolidated assets to roughly $50 billion in total consolidated assets. We also informally discussed our interview questions with several banking organizations that included some of the largest banking organizations in the United States. These interviews were conducted with business development officers, compliance staff, or account managers. The interviews were open ended, but generally included the following questions:

  • Does your bank accept VCB clients? Why or why not?
  • What mistakes do prospective VCB customers make? What do they do well?
  • What is the onboarding process for a new customer?
  • What would you recommend to a VCB customer looking to establish a bank account at your bank?
  • Is your bank becoming more open to VCB customers?

The fourth step in our study was to analyze the information collected and formulate our recommendations to VCBs, the banking industry and the prudential banking and consumer finance regulators such that VCBs will have access to banking services without presenting unwarranted risks to the banking industry. Our analysis and recommendations follow.

The VCB Perspective

  1. Lack of Access to Banking Services Is a Significant Issue for Many VCBs

From our discussions, it was clear that lack of access to the banking system is a significant issue for many, if not most, VCBs. This lack of access can be devastating to VCBs as banking services play a variety of roles within a VCB’s operations. At the most basic level, VCBs require transactional accounts to conduct their fundamental operations, which can include paying vendors and employees. Such accounts also enable VCBs to receive payments for services rendered and goods sold, whether by electronic ACH or otherwise. VCBs also require savings and cash management accounts to manage their funds on an ongoing basis. Bank accounts are particularly important following a capital raise or receipt of funds pursuant to a credit facility so that funds do not sit idly and can be productively invested before their deployment into a VCB’s business operations.

More complex banking relationships may be needed for some VCBs. For example, some VCBs may require accounts to hold customer funds as a custodian, permit clearing and settlement, convert currencies, facilitate correspondent banking and cross border payments and effect a variety of other purposes. Thus, having a meaningful banking partner that can provide the full scope of traditional banking services may be essential for a VCB to operate.

VCBs reported that they have been denied banking services from dozens of banks across the country of all sizes and with various state and federal regulators, including the Board of Governors of the Federal Reserve System (“Federal Reserve”), the Office of the Comptroller of the Currency (“OCC”) and the Federal Deposit Insurance Corporation (“FDIC”). Some banks provided little to no insight or explanation as to the rationale behind their denial of banking services. Other banks stated that their respective risk committees decided against taking on a particular VCB as a customer after a review of the facts and circumstances. Some VCBs reported receiving rejection letters that noted that the rejecting bank had blanket policies against providing accounts to VCBs, whether regulated or unregulated, including administrators, exchangers, miners, wallet providers, and any providers facilitating such activities. Other VCBs were simply told that the bank in question “do[es] not bank ‘bitcoin’ companies.”

Another issue VCBs reported is that banks, after having provided a bank account, have suddenly terminated such accounts with no more warning than a letter and without providing much if any rationale or justification. Often such account terminations occurred around the six-to-12-month mark following the establishment of the account.1

Despite the difficulties they face, VCBs report success to various degrees in establishing accounts with a handful of banks that have established themselves as providers of banking services to the VCB community. Certain banks have limited the types of accounts they are willing to provide, such as transactional and/or wealth management accounts, but have stopped short of offering deeper partnerships with VCBs. Some banks have been willing to provide banking services to VCB holding companies but not the actual VCB operating subsidiaries. Other banks have provided broader services and full scale partnerships with VCB wallets, exchanges and payment processors. Generally, the banks that have been willing to provide services to the VCB community have been community banks with more nimble decision making processes and histories of working with start-up and technology-focused customers.

In each instance of having established an account, VCBs reported that the process was long and intensive, often times taking six or more months. The banks involved have conducted searching interviews with the VCBs, reviewed the histories of the executives and financial sponsors and requested customer lists, organizational charts, tax structuring and filing information, compliance and reporting structures, general accounting records and other materials. Managers of VCBs with experience in other industries reported that the level of bank scrutiny was higher than they had seen when working with other, non-VCB companies.

A small handful of VCBs reported that they faced relatively few if any issues in establishing bank accounts or more fulsome banking relationships. Those VCBs reported the following reasons as to their perceived success in obtaining and maintaining banking relationships:

  • They made regulatory compliance a high priority area and have, from day one of their operations, put forth the resources necessary to obtain internal talent and external advisers familiar with regulation and compliance. One VCB reported that one-third of its staff are compliance personnel.
  • They are associated with prominent founders, investors and/or executives and advisers with experience in finance, start-up operations, technology and regulation.
  • They employed compliance-related software to allow their banks to monitor their activities in a highly transparent manner.
  • Some of the VCBs observed that their services do not involve taking custody of virtual currency and that explaining the distinction helped their banking partners become comfortable banking them.

A consistent theme reported by VCBs is their perception that banks have been unable or unwilling to differentiate among the various types of VCBs along the ecosystem, or at least to do so insufficiently. For example, VCBs report that banks do not appreciate the distinctions between a standard wallet service and a multi-signature custodial structure. Other VCBs that provide non-custodial services stated that they have been viewed by banks as having similar risk profiles as VCBs that take custody of customer virtual currency. Some VCBs, however, report that banks are beginning to be more open to banking companies that operate in the blockchain services businesses, where fund and value transfer is less central to the service offering.

Based on our discussions with both banks and VCBs, the nature of banks’ confusion or unwillingness to differentiate between VCBs within the VCB ecosystem stem from at least two reasons. First, most banks’ have not had a significantly high volume of prospective VCB clients approach them that occupy positions across the virtual currency ecosystem and, thus, have not needed to spend the time and resources necessary to develop a nuanced view of the virtual currency ecosystem. Second, banks view the differences between VCB business models as being less significant than VCBs themselves do and simply regard VCBs as generally high-risk customers.

Banking Relationships for Exchanges and Clearinghouses

Although banks seem to insufficiently distinguish VCBs within the virtual currency ecosystem, exchanges and clearinghouses present unique challenges. VCBs that offer exchange and clearing services, and thus are subject to oversight by governmental authorities, reported particular difficulty in obtaining banking services. Given that VCBs provide services dealing with commodities and derivatives within the virtual currency ecosystem, they are subject to the Commodity Exchange Act and regulations issued by the Commodity Futures Trading Commission (“CFTC”). These regulations require such entities, including derivatives clearing organizations and derivatives intermediaries, to deposit customer funds in banks, and to obtain written acknowledgements from those banks that the funds belong to customers.2 Relatively few banks are familiar with the derivatives industry and the implications of holding such accounts. Thus, many banks presented with such a letter and who are less familiar with the CFTC may be reluctant to sign. This prevents firms and organizations that seek to offer virtual currency derivatives from doing so. The combination of derivatives regulation with the novelty of new technology can lead to a lack of banking services to an important sector of the virtual currency ecosystem.

Geographic Differences and Global Perspective

Various VCBs that participated in the study have both U.S. and non-U.S. operations. Overseas operations of VCBs have proved to be a complication and garnered great scrutiny from U.S. banks.3 Some VCBs reported difficulty with obtaining banking relationships in the United Kingdom, but others reported some success. There have also been mixed results in the European Union with several different European banks. Certain VCBs reported that U.S. banks have pressured foreign banks with which they have correspondent or other relationships to not accept VCB clients or else the U.S. banks would severe business ties with the foreign banks.

There was a common conception among VCBs that West Coast banks seemed to be more willing to provide services to VCBs than East Coast banks. Our research suggests, however, that banks on each coast have offered banking services to VCBs, including banks in California and New York, and other states. We have not come across many banks between the coasts that bank VCB clients, but this may be due to the concentration of VCBs that are located in California or New York.

The Bank Perspective

Banks, like other for profit businesses, often decide to take on a new customer based on the risk-adjusted return of the relationship. Many VCBs reported that although certain relationship managers at any particular bank desired to accept them as a bank customer, the management staff of that bank decided that the risks associated with the VCB were simply too high to make the relationship viable. In many cases, merely mentioning that an account applicant was a VCB was enough to terminate the discussion.

Banks report that when taking on a VCB customer, costs above and beyond normal operational costs may include third-party surveillance and monitoring of VCB customers, such as to trace the source of funds in VCB transactions. From a compliance perspective, on bank representative noted that no VCB that he had reviewed “had its compliance completely right.” Further, due to the daily monitoring and ongoing enhanced due diligence that is required for some VCB customers, banks have found that their standard charges are uneconomical. They therefore feel compelled to charge extremely high monthly fees, up to $25,000 per month in some instances such as for the largest VCBs engaging in cross-border transfers or merchant acquisition services. These fees compare with the sometimes little or nothing that non-VCB and non-money transmitter businesses pay for comparable banking services.

The third step in our study was to contact various banking organizations, including banks that actively accept VCB customers, or that provide limited services to VCBs. We also communicated with banks that had terminated customer relationships with VCBs and banks that simply would not offer services to VCBs. Below is a discussion of the perspectives of these banks, preceded by a high-level discussion of the regulatory framework that applies to banks, and that informs their approach to providing services to VCBs.

Regulatory Background

The business of dealing with other peoples’ money is highly regulated. Banks are subject to one of the most rigorous, complete and complex regulatory regimes that have been imposed on any industry.

In the United States the charter necessary to conduct a banking business can be obtained either from a state banking regulator (e.g., the New York State Department of Financial Services) or the federal issuer of bank and savings association charters, the OCC. All state-chartered banks are subject to federal regulation by either the Federal Reserve or the FDIC depending on whether the bank is accepted as a member in the federal reserve system. An alternative form of banking can also be provided through credit unions which are chartered by states or, at the federal level, by the National Credit Union Administration. Companies that control a bank or savings association are regulated, in most instances, as holding companies by the Federal Reserve, and in some instances by the FDIC. Banks are also subject to regulations issued by the Treasury Department’s Financial Crimes Enforcement Network (“FinCEN”) and the Office of Foreign Assets Control. Layered on top of these various agencies’ supervisory regimes also exist regulation and supervision by various other agencies and prosecutorial bodies, depending on the nature of a bank’s product offerings, including the Department of Housing and Urban Development, Department of Education, Department of Justice, the Securities and Exchange Commission, the CFTC, and each of the states’ attorneys general, and foreign regulators, among others.

A bank’s regulatory burden is compounded not merely by numerous regulators, but also by the volume of regulations and the nature of prudential regulation, which gives regulators the authority to shape the conduct of a bank. This regulatory framework understandably leaves many banks with a significant risk-averse orientation.

Among the many laws and regulations that banks must manage are those concerning money laundering, terrorist finance, and other financial crimes. These include the Bank Secrecy Act (“BSA”), the USA PATRIOT Act and others. In very general terms, these laws and the regulations issued thereunder require banks to:

  • Exercise due diligence to determine the identities of their customers and persons that control their customers;
  • Vet their potential customers against government listings of persons and entities involved in criminal and terrorist activities;
  • Monitor customer transactions for signs of potential illegal activity; and
  • Report suspicious activity to law enforcement authorities.

The consequences of a failure to comply with these requirements are significant. A bank can face major fines and civil monetary penalties. Regulators may also impose restrictions on a bank’s lines of business. Responsible personnel (including to an increasing extent, compliance officers), may face individual penalties, including termination of employment or an industry bar. A bank may also suffer reputational damage for a violation. Finally, no banker wants to learn that his or her business was used to fund criminal or terrorist activities.

Pursuant to guidance issued by FinCEN, many VCBs are considered to be money services businesses (“MSBs”) because they are involved in the transmission of money.4 The Federal Financial Institutions Examination Council (“FFIEC”)5 has stated that banks are expected to maintain policies, procedures and processes that provide for sound due diligence and verification practices, adequate risk assessment and ongoing monitoring and reporting of unusual or suspicious activities with respect to accounts of MSBs. FFIEC also anticipates that banks will establish and maintain accounts for MSBs that apply appropriate, specific, risk-based, and where necessary, enhanced due diligence policies, procedures and controls. Importantly, FFIEC guidance provides that banks ought to consider the nuanced risk-spectrum that MSBs may fall within and cater due diligence and customer review according to that appropriate risk, per the below statement:

Not all MSBs pose the same level of risk, and not all MSBs will require the same level of due diligence. Accordingly, if a bank’s assessment of the risks of a particular MSB relationship indicates a lower risk of money laundering or other illicit activity, a bank is not routinely expected to perform further due diligence (such as reviewing information about an MSB’s BSA/anti-money laundering (“AML”) program) beyond the minimum due diligence expectations. Unless indicated by the risk assessment of the MSB, banks are not expected to routinely review an MSB’s BSA/AML program.6

Minimum due diligence expectations for a bank to open and maintain accounts for any MSB include:

  • Applying the bank’s customer identification program;
  • Confirming FinCEN registration, if required;
  • Confirming compliance with state or local licensing requirements, if applicable;
  • Confirming agent status, if applicable; and
  • Conducting a BSA/AML risk assessment to determine the level of risk associated with the account and whether further due diligence is necessary.7Enhanced due diligence is also required in appropriate cases. Enhanced due diligence entails:
    • Review of the MSB’s own BSA/AML program;
    • Review of the results of the MSB’s independent testing of its AML program;
    • Review of the written procedures for the operation of the MSB;
    • Conducting on-site visits;
    • Review of a list of all agents, including locations, within or outside the United States that will receive services, directly or indirectly, through the MSB account;
    • Determining whether the MSB has performed due diligence on any third-party servicers or paying agents;
    • Reviewing written agent management and termination practices for the MSB; and
    • Reviewing written employee screening practices for the MSB.8Over the years, and within just the past few years in particular, banks have faced significant regulatory scrutiny in applying due diligence expectations and enforcing AML programs. This has caused a chilling effect on banks’ risk appetite to accept customers that regulators may view with any suspicion. For instance, through the so-called Operation Choke Point the Department of Justice has investigated consumer fraud and money laundering. In order to avoid sanction, banks have reacted by closing the accounts of legal but politically unpopular businesses such as payday lenders, check-cashing services, arms dealers, tobacco sellers and even religious organizations9In this context, VCBs face significant hurdles to obtaining banking services. First, there is a widespread perception that virtual currencies are primarily used to evade the law and commit crimes. Indeed, Bitcoin was used as the means of payment on the notorious “Silk Road” online marketplace, and is used as means to pay off hackers in ransomware crimes.In addition, MSBs have been used to facilitate transfers of funds in furtherance of illicit enterprises. This has caused a retraction of banking services to many MSBs.To address the concerns with banking MSBs and potential unwarranted de-risking untaken by banks to the detriment of the MSB industry, on November 10, 2014 FinCEN released guidance on the provision of banking services to MSBs pursuant to a bank’s obligations under the BSA. At the time, FinCEN acknowledged that MSBs were losing access to banking services, partly as a result of concerns about regulatory scrutiny and the perceived risks presented by MSB accounts and the costs and burdens associated with maintaining such accounts. FinCEN in particular stated that:

      [T]here is concern that banks are indiscriminately terminating the accounts of all MSBs, or refusing to open accounts for any MSBs, thereby eliminating them as a category of customers. Such a wholesale approach runs counter to the expectation that financial institutions can and should assess the risks of customers on a case-by-case basis.10

      FinCEN also noted that a blanket direction by U.S. banks to their foreign correspondents not to process fund transfers of any MSBs, simply because they are MSBs, runs counter to the risk-based approach. FinCEN stated that refusing financial services to an entire segment of the industry can lead to an overall reduction in financial sector transparency that is critical to making the sector resistant to the efforts of illicit actors and emphasized this point with particularity with respect to MSB remittance operations.

      The FFIEC has noted that “while banks are expected to manage risks associated with all accounts . . . banks will not be held responsible for their customers’ compliance with the BSA and other applicable federal and state laws and regulations.”11 Finally, the FDIC most recently stated the following with respect to unwarranted de-risking:

      The FDIC is aware that some institutions may be hesitant to provide certain types of banking services due to concerns that they will be unable to comply with the associated requirements of the [BSA]. The FDIC and the other federal banking agencies recognize that as a practical matter, it is not possible for a financial institution to detect and report all potentially illicit transactions that flow through an institution. Isolated or technical violations, which are limited instances of noncompliance with the BSA that occur within an otherwise adequate system of policies, procedures, and processes, generally do not prompt serious regulatory concern or reflect negatively on management’s supervision or commitment to BSA compliance. When an institution follows existing guidance and establishes and maintains an appropriate risk-based program, the institution will be well-positioned to appropriately manage customer accounts, while generally detecting and deterring illicit financial transactions.12

      Despite the cautious regulatory statements that risk should be calibrated on a case-by-case basis with respect to each customer relationship, the significantly rigorous pressure regulators have exerted on banks to both know their customer and, in some instances in the payments processing space, to know their customer’s customer, has created a climate not conducive to expanding banking services to customers in the business of value transfer.

      Banks’ Perspective

      Following the financial crisis, the passage of the Dodd-Frank Wall Street Reform and Consumer Protection Act, and heightened regulatory scrutiny of their regulatory compliance and operations, many banks have engaged in a de-risking campaign. Banks with which we spoke noted that they have focused on stabilizing their existing business models and de-risking and, therefore, did not seek to invest in learning about, or to acquire customers in, new industries. Many banks reported that their central issues have been a lack of quality opportunities with capital deployment and not deposit growth or new deposit account customer generation. Thus, many banks simply have not had the risk appetite or strategic need to focus on providing banking services to emerging VCBs. On the other hand, banks also report that they are becoming increasingly focused on financial technology clients.

      The few banks that did make investments into understanding and working with VCBs report that they did so consciously to reap the rewards as first movers. VCBs are generally reluctant to discuss what banking institutions they maintain relationships with, as in the words of one VCB founder, “bank accounts are a competitive advantage in this industry.” Nevertheless, through word of mouth, industry events and referrals, a small handful of banks have received a disproportionate amount of the VCB market as customers.

      The banks with which we spoke generally follow a similar pattern with respect to new client intake and so it may be instructive to VCBs to understand that process. Generally a relationship or account manager will form a relationship with a potential new VCB customer and bring that customer to the bank for review. The bank’s compliance and risk personnel will then assess the customer and conduct a due diligence review, in order to determine where along a risk spectrum the customer falls—low, medium or high. The due diligence process covers the aforementioned FFIEC guidance and any other items the bank deems necessary. After this review process, the potential customer’s case is presented to a review or risk committee for final determination. While the account manager may be involved in presenting the case for a customer, the risk committee retains full discretion to approve or deny accepting the new account.

      Banks that we spoke with showed (a) a mixed understanding of the VCB ecosystem and (b) a mixed ability to differentiate risk structures among VCB operating models. Bankers with limited exposure to VCBs referred to such “bitcoin companies” generically. Other banks, while seemingly able to different between business models, refuse to bank any VCBs, “regulated or unregulated, including administrators, exchangers, miners, wallet providers, and any providers facilitating such activities.” Nonetheless, even those banks that are sophisticated as to the virtual currency ecosystem seem to generally place VCB clients in the “high risk” category. Accordingly, these banks conduct both enhanced due diligence and establish very high risk committee hurdles to pass before taking on a new VCB customer regardless of specific business models.

      During our conversations with banks it became clear that most banks take the position that they are willing to offer their services, but that clients must meet the bank’s standards. One bank noted that it had not seen a single potential VCB client that “had done everything quite right” in terms of compliance and operations. Common items that banks noted were problematic with potential VCB customers included the following:

      • Staffing the chief compliance officer role with a person who is primarily performing a separate role in operations, technology or finance.
      • Lack of a dedicated compliance professional with a compliance background in financial institutions matters;
      • Lack of a culture of compliance wherein high-level executives do not focus on compliance with the level appropriate for a finance company and instead regard the company as a non-regulated technology company; and
      • VCBs without a stable long-term business plan or that pivot quickly their offerings and platforms.

Recommendations

The observations and reactions gathered from our research with VCBs and banks and our experience with regulators suggest that there are several areas in which each of the parties involved might take actions to improve the number of and extent to which VCBs are banked consistent with regulatory expectations. These observations follow below.

Recommendations for VCBs and their Sponsors

The difficulties that VCBs face in obtaining banking services are significant. However, our examination reveals certain measures common to successful banking relationships that can be employed by a VCB in order to ensure a potential banker that the VCB is a viable customer.

  • Recordkeeping and Reporting. Banks are likely to scrutinize a VCB carefully. They will require extensive reporting and production of sensitive documents. VCBs should be prepared to share such documents with their banking partner and have systems in place to obtain records quickly for delivery to the requesting bank. Such documents and records might include governance documents, organizational charts, customer invoices, accounting records, audit records, records demonstrating compliance with AML requirements, customer transactions and identification and tax information. It will be important for VCBs to realize that a bank’s due diligence will be enhanced and ongoing after the relationship is established.
  • Strong Founder and Executive Team. Banks look to the strength of a VCB’s board and executives to gauge whether to accept a VCB as a client. Executives with strong track records of compliance in regulated industries are viewed favorably. Investors with reputable track records are also viewed favorably as banks may view such investors as having performed appropriate due diligence, including regulatory due diligence, on a VCB. External advisers, such as in the form of an advisory board, may also bolster the executive team for this purpose.
  • Prepare for a Lengthy Diligence Process. VCBs should prepare well in advance of applying for a bank account. The process from approaching a bank, submitting materials, interviewing with the bank and finally obtaining a bank account may take between six to twelve months. Start-up firms looking to establish accounts should thus establish a bank account as an early activity. Mature firms expanding product offerings should seek to obtain broader banking services or secondary and tertiary accounts early in their expansion efforts.
  • Invest in Regulatory Compliance. Start-up firms will have various costs to consider and many have decided to spend as little as possible on compliance. Banks will scrutinize the resources allocated to compliance. Spending sufficiently on compliance resources is an essential aspect of obtaining bank accounts that will be necessary to function and operate. Banks by tradition view external legal and consulting experts favorably, so VCBs should consider bolstering resources with such external advisers. Banks also expect VCB employees to receive appropriate training, especially in key areas such as anti-money laundering.
  • Clarity in Regulatory Structure. Before approaching a bank a VCB should have a clear understanding of, and be prepared to explain, how it is regulated. A bank will want to know what regulatory bodies a VCB is subject to, whether a VCB has obtained all necessary regulatory licenses, registrations or approvals, and in general, that a VCB understands and respects the regulatory limitations that it operates within. Banks will deny services to VCBs that create opaque structures that evade regulation or that banks do not understand. A VCB would do well to prepare a summary description of its regulatory obligations, on a state, federal and potentially international level for discussion with potential banking partners.
  • Demonstrate Solvency as a Going Concern. Banks are reluctant to take on customers that may become insolvent as it causes serious administrative and claims issues. As many VCBs are still in their start-up and growth phases, it is important to demonstrate to a prospective banking partner that the VCB is solvent, has a strong business plan and is not likely to go bankrupt.
  • Proactive Regulatory Engagement. Finally, in order to overcome some of the negative preconceptions that the uninformed may have regarding their businesses, VCBs and industry groups, such as Coin Center, should be proactive in their outreach and engagement with regulators at the federal and state levels. Outreach should focus on the lawful and responsible operations of VCBs and the potential uses of their new technologies. This type of ongoing engagement may reduce apprehensions among supervisory authorities that may unduly discourage banks from doing business with VCBs.

Recommendations for Banks

The following are recommendations banks may wish to consider as VCBs continue to receive capital funding, grow their operations and seek more and deeper banking relationships.

  • Consider Early Adopter Advantage. Capital continues to flow into VCBs. In 2015 there was an estimated $1 billion of venture capital funding of VCBs, and some estimate that the 2016 total investments in blockchain-related startups alone could reach $10 billion.13 Despite these investment flows there are an insufficient number of banking options for VCBs. This supply and demand imbalance creates significant opportunity for the banks that have familiarized themselves and become comfortable with banking VCBs.
  • Appreciate the Nuances of the Virtual Currency Ecosystem. It is clear from FinCEN and FFIEC guidance that not all potential bank customers should be treated the same. Not all VCBs are MSBs, and even then, not all MSBs have the same risk profiles. Banks that understand the nuances of virtual currency and blockchain technology will be able to assess risk and calibrate their risk approach to customers appropriately.14
  • Critically Assess the Nature of De-risking. Banks should scrutinize their de-risking efforts and consider whether such actions are an overcorrection to the heightened risk that only certain banks took on prior to the 2007-2009 financial crisis.
  • Draw Upon Internal Resources. As large and multi-dimensional organizations, banks may not be fully utilizing their own internal resources and learning. For example, banks may have investments in virtual currency and blockchain technologies, such as through their venture or innovation divisions, yet at the same time refuse to bank VCBs via their deposit offering platform. This incongruous position can be resolved by fostering inter-departmental communication.

Recommendations for Regulators

For regulators, a bank’s compliance with AML and other requirements must remain a priority. At the same time, banks and other financial institutions are exploring the use of virtual currency and blockchain technologies in connection with clearance and settlement of transactions, accelerated payment systems, remittances and more. These technologies hold considerable promise, so it is important that U.S. developers and VCBs be able to maintain ongoing access to the banking system.

    • Foster Innovation and a Positive Tone. In order to permit access to the banking system by VCBs, regulators should give consideration to policies that would foster innovation in a prudent manner. For instance, the United Kingdom’s Financial Conduct Authority has announced the creation of a “regulatory sandbox” that will allow businesses to test new and innovative products and services without immediately incurring all of the normally applicable regulatory consequences. This sandbox approach allows businesses to gauge the viability of a product or service without expending time and resources beforehand. At the same time, it protects consumers by providing for their informed consent, and by providing them with the same rights of redress that they would have if they were dealing with a traditional financial institution.15 VCBs have noted a difference in the tone of regulatory statements in the United States and Europe. The FCA believes that its openness to innovation will yield tangible benefits in the form of better services for consumers and development of the technology industry in the United Kingdom. U.S. regulators should consider similar approaches.
    • Audit and Accounting Guidance. Finally, although not regulators, guidance from the Financial Accounting Standards Board as to the treatment of virtual currencies would help improve the perception and treatment of VCBs. This would also foster an increased willingness of major accounting firms to provide audit services to VCBs, which would further enhance the ability of VCBs to obtain bank services.

Conclusion

Despite the significant and continuing capital inflows into VCBs, and recently blockchain-oriented initiatives in particular, VCBs continue to struggle to gain and maintain access to the banking system. While no one party—the VCB industry, banking sector or banking regulators—is to blame, each have a role to play is resolving this issue. Significant work is left to be done in the areas of public policy advocacy before the financial regulators and compliance enhancements by VCBs. This paper presents various recommendations that we believe will help increase VCBs’ access to banking services in a way that is fully consistent with regulatory expectations that banks operate in a safe and sound manner fully compliance with their legal and compliance obligations.

Notes


  1. We note that non-VCB financial technology companies and other companies that process payments as part of their broader non-financial service offerings recently have also faced similar difficulties in establishing a bank account or have received sudden account termination notices from their banks. 
  2. 17 C.F.R. § 1.20. 
  3. However, some VCBs reported that they have had greater success establishing banking relationships overseas than in the United States, such as in the Cayman Islands. 
  4. FinCen, FIN-2013-G001, “Application of FinCEN’s Regulations to Persons Administering, Exchanging or Using Virtual Currencies,” (Mar. 19, 2013). 
  5. FFIEC is an interagency council of banking regulators that establishes uniform examination and compliance standards among the multiple federal financial regulators. 
  6. FFIEC, Bank Secrecy Act Anti-money Laundering Examination Manual, Nonbank Financial Institutions–Overview, available at http://www.ffiec.gov/bsa_aml_infobase/pages_manual/olm_091.htm. 
  7. Id. 
  8. Id. 
  9. See, e.g., Sheila Tendy, De-Risking Threatens Religious Access to Banking Services, American Banker, Jan. 27, 2015, http://www.americanbanker.com/bankthink/de-risking-threatens-religious-access-to-banking-services-1072363-1.html. 
  10. FinCEN Statement: FinCEN Statement on Providing Banking Services to Money Services Businesses (Nov. 10, 2014), available at https://www.fincen.gov/news_room/nr/html/20141110.html. 
  11. FFIEC, Bank Secrecy Act Anti-money Laundering Examination Manual, Nonbank Financial Institutions–Overview, available at http://www.ffiec.gov/bsa_aml_infobase/pages_manual/olm_091.htm. 
  12. FDIC FIL-5-2015 (Jan. 28, 2015). 
  13. Shiwen Yap, Blockchain Startups To Raise $10b in Funding During FY 2016, Deal Street Asia, Mar. 2, 2016, http://www.dealstreetasia.com/stories/blockchain-raise-10b-funding-2016-31398/. 
  14. Broadly speaking, banks should at a minimum be able to distinguish between VCBs that facilitate in the transfer of virtual currency and those that do not, such as service providers. Within the group of VCBs that do facilitate virtual currency transfer, banks should understand the differences between VCBs that take custody of their clients’ virtual currency and those that do not. 
  15. Financial Conduct Authority, Regulatory Sandbox (November 2015), available at https://www.fca.org.uk/static/documents/regulatory-sandbox.pdf.