Federal Reserve Outlines What Community Bankers Should Know about Virtual Currencies

Posted on Posted in Bitcoin, Blockchain, Financial Services, Regulation, Virtual Currencies

Wallace Young, director of The Federal Reserve Bank of San Francisco, published an advisory outlining the potential challenges for community banks when working with bitcoin firms and consumers.

Providing banking services to these entities presents some unique risks and challenges

Due to continued growth of bitcoin and other virtual currencies, Director Young emphasizes that “opportunities abound for community banks to provide services to [a wide range of] entities engaged in virtual currency activities…[as well as the possibility] that community banks may find themselves holding virtual currency on their own balance sheets.”

The advisory notes four areas of risk: compliance risk, reputational risk, credit risk and operational risk.

Compliance Risk

Because of the pseudo-anonymous nature of virtual currencies, it “may make it more difficult for a financial institution to truly know and understand the activities of its customer.”  As a result, these types of transactions may “present a higher risk for banks and require additional due diligence and monitoring.”

Additionally, in March 2013, the U.S. Financial Crimes Enforcement Network (FinCEN) issued guidance designating virtual currency exchanges and administrators as money transmitters.  As a result, banks are expected to manage the risks associated with these businesses just as they would for other money transmitters.

Reputational Risk

With high profile failures such as the February 2014 failure of Mt. Gox, another important risk for community banks to consider is reputational risk caused by the activities of its customers.

In the case of Mt. Gox, at least one of the lawsuits claims that the bank should have known about the fraud thereby clearly demonstrating “the potential legal and financial impact if the bank settles or loses any of these lawsuits.”

Credit Risk

Another scenario presented by the continued growth of virtual currencies is the possibility that a borrower would desire to post virtual currency as collateral for a loan.

Director Young advises caution stating “[b]ankers should carefully weigh the pros and cons of extending any loan secured by bitcoins or other virtual currencies (in whole or in part), or where the source of loan repayment is in some way dependent on the virtual currency.”

Of primary concern has been the volatility of pricing for these virtual currencies, especially bitcoin.  As a result, the value of collateral is likely to fluctuate widely on a regular basis.

The other issue to consider in this type of scenario is in the case of default.  In the event of a default, the bank will need to make sure they have appropriate access to wallet holding the virtual currency.

Operational Risk

In the event that a bank acquires virtual currency, there is the possibility of operational challenges for the financial institution.  The advisory notes that “virtual currency acquired in this manner should certainly be liquidated in an orderly fashion, but, before that happens, the institution will need to have internal controls in place to mitigate the risk of loss.”

Holding virtual currency will require management to establish dual control and access processes, valuation of the asset with respect to financial statements, as well as security protocols to protect the asset from theft or loss.

Virtual currencies bring with them both opportunities and challenges, and they are likely here to stay.

In conclusion, the advisory indicates that “[b]anks need not turn away this business as a class, but they should consider the risks of each individual customer.”