by “Dr. Russ” (Russ Hittinger, Ph.D.)
In his famous 1776 celebration of capitalism, The Wealth of Nations, Adam Smith discussed a problem inherent to joint stock companies and limited-liability commercial enterprises, in which the directors of such operations would often engage in risky behavior or carefree attitudes with other people’s money, being exempt from the risk of losing their own capital:
“The directors of such companies, however, being the managers rather of other people's money than of their own, it cannot well be expected that they should watch over it with the same anxious vigilance with which the partners in a private [partnership] frequently watch over their own. Like the stewards of a rich man, they are apt to consider attention to small matters as not for their master's honour, and very easily give themselves a dispensation from having it. Negligence and profusion, therefore, must always prevail, more or less, in the management of the affairs of such a company.”
Careful, TRUSTED, and deliberate custodianship of other people’s money has long been the hallmark value of membership with a credit union or local financial institution, but as we further progress into the age of the ascendancy of cryptocurrency and financial technology, the problem of the good and bad custodianship of “other people’s money” that Smith raised not only remains relevant, but is perhaps the key consideration for CUs and local FIs in the approaching era of banking.
Before we explain the role that CUs and local FIs need to fill in this future (if they wish to remain relevant to members/consumers), it’s worth pointing out a slew of new developments in the cryptocurrency world. In a recent article on this blog we wrote about some of these, but the flood of news this month has not abated:
Intercontinental Exchange (ICE), owner of the New York Stock exchange, has acquired a crypto custodian service called Digital Asset Custody Company, Bakkt, to become a qualified trust custodian for Bitcoin assets
Rumors have been confirmed that Facebook will be rolling out its own “Global Coin” by 2020 and has been meeting with trading firms, cryptocurrency exchanges, and bank officials to get its cryptocurrency infrastructure ready
Groups of major retailers and service providers, including Whole Foods, Gamestop, Nordstrom, AT&T, are set to begin accepting cryptocurrency payments using the Bitpay and Flexa networks
Ripple CEO Brad Garlinghouse, whose company is engaged in an innovation battle to replace the decades-old SWIFT network with Ripple’s transaction settlement software (xRapid and xCurrent), underpinned by XRP currency being adopted by many banks, trumpeted the prospect of breaking up oligopolistic control of financial technology, saying that “99 percent of banks love what we’re doing, because we’re democratizing something that’s controlled by a small number of banks, their competitors.”
The takeaway: Giant banks like JP Morgan and Citibank are pursuing partnerships with Silicon Valley titans to dominate the financial technology and banking industry of the future; CUs and Local FIs are becoming prime targets due to their woeful lack of preparation for the cryptocurrency-influenced financial ecosystem of the future, in which cryptocurrencies will likely become common compliments to national fiat currencies. While we will continue highlighting the impacts of these rapid developments in the adoption of cryptocurrency across the corporate and financial world, it is clear that the question is no longer whether or not cryptocurrency is useful or will be adopted, but rather whether or not we will have a democratic concept of capitalism or an oligopolistic-crony concept of capitalism in the banking and financial industry. In other words, will the local community and consumer have a place in the future of money; or will a small handful of large, centralized, crony-capitalistic powers finally triumph over local banks and credit unions using the energy inherent in the crypto-banking evolutionary moment?
Treating cryptocurrency as a legitimate form of currency (or, at a minimum, an ascendant digital asset appealing to consumers/members) is critical for CUs and traditional FIs in fulfilling their historical roles of holding deposits, processing transactions, and settling payments. The financial institution of the immediate future will be one capable of processing both cryptocurrencies and facilitating exchanges between the traditional fiat currencies such as USD, GBP, and EUR (and many other national fiat currencies). As cryptocurrency continues to be adopted as a medium of exchange and valuable currency asset, all financial institutions that fail to adapt their technological and business strategy will be rendered obsolete (by the most basic force of capitalism, consumer demand!).
Interestingly enough, despite this fact, the rapid adoption of cryptocurrency has been mostly ignored by rather aloof traditional bankers — being slow to accept the reality that cryptocurrency is a new and legitimate form of real (digitally democratized!) money— who have let the crypto custodianship space be almost entirely dominated (at least for now) either by unregulated shady exchanges or giant dotcom Silicon Valley operations. Neither of these polarities, as I will explain below, advances or protects the interests of the stakeholders in the local economy, entrepreneurs, small business owners, and individual depositors, who are the core customer base and future of CUs and community FIs.
Executives in traditional CUs or local financial institutions should pay attention to the MASSIVE opportunity inherent in the crypto space for traditional community bankers in the area of TRUSTED crypto custodianship (and the massive potential losses associated with staying on the sidelines). But let’s look at a cautionary tale from the perspective of unregulated exchanges which shows the opportunity CUs and local FIs have to be TRUSTED custodians of cryptocurrencies and compare it with a scenario in which CUs stay on the sidelines and let Facebook, along with too-big-to-fail banks and crypto exchanges, become the top players in crypto custodianship and financial services.
Shady exchanges: insecure hot and cold wallets
In the current “wild west” moment of cryptocurrency and the evolution of money/banking towards digital tokens and electronic assets, the choice for holders of cryptocurrency who want to hold and keep their digital assets safe (let’s call them “deposits,” if you will) is currently limited to two options:
1) keep your cryptocurrencies liquid in an online exchange “hot wallet” owned by a cryptocurrency exchange
2) move your cryptocurrencies into a “cold wallet” or “cold storage”
Both of these options currently leave much to be desired from the consumer perspective. Hot wallets, basically a giant bucket of deposits with account identifiers showing which pools of money belong to which depositors, are the most common form of monetary custodianship on cryptocurrency exchanges. Essentially it is little more than a giant pool of cash from which the exchange promises to pay you your money when you want it. Hot wallets hosted on exchanges pose grave security risks, and have resulted in notoriously heinous and unprofessional losses of deposits due to hacking and technical malfeasance (read a few more lines below).
While “cold wallets” are superior to online “hot wallets” in terms of security, given that funds are stored on offline computers or external wallet devices with encrypted security keys, cold wallets also suffer from serious issues because of their high security and lack of redundancy or non-local backup. For example, if individual depositors lack proper technical expertise in setting up encrypted keys, make a technical mistake in transferring funds from one wallet to another, or simply lose or “forget” the password or security key to their offline cold wallet, funds are completely unrecoverable. In fact, an estimated 3.79 million Bitcoin are estimated to have been permanently lost from the limited 21 million coin global supply due to user error, device error, etc.
Average holders and users of cryptocurrencies, the common consumer, just as cryptocurrency payment platforms and dozens of currencies become legitimate and mainstream, are puzzlingly stuck between a rather risky “do it yourself” solution of cold wallet storage (which also makes liquidity and transactions problematic, against the utility of digital currency) and large, unaccountable exchanges where storage of funds in “hot wallets” has had disastrous consequences for depositor funds.
What sorts of disasters have happened? Horror stories abound regarding “hot wallets” or exchanges. It is not exclusively the fact that hot wallets are connected to the internet and therefore susceptible to hacking that makes them problematic. In fact, the traditional banking industry has long been familiar with and adapted to the security risks of digital banking that has led the cyber security market to be on track to surpass $251 billion by 2024. The problem with “hot wallets” is that they are both susceptible to internet security threats and housed on exchanges run by small teams of fiduciary-free company officials, the sort Adam Smith derided, with either a) limited cyber security skills b) ethical problems and conflicts of interest c) lazy bookkeeping and record keeping protocols d) a simple lack of competence, professionalism, or care for taking care of other people’s money or e) all of the above. Further, these exchanges are essentially tantamount to the territorial banks of the western frontier, with little regulatory oversight or scrutiny and representing prime targets for outlaws and the contemporary equivalent of the bank robber (the hacker). People have lost astounding quantities of money that could have been protected by CUs and local FIs; that is, if our industry had a functional and sound cryptocurrency strategy.
Cases in point:
in 2014 the Japanese-based Mt. Gox exchange, handling about 70% of Bitcoin trading at the time, went bankrupt, losing about $480 million dollars worth of Bitcoin belonging to thousands and thousands of depositors, which was likely stolen directly out of its “hot wallet,” though no one is really sure if it was “theft, fraud, mismanagement, or a combination of these”
This year Chinese cryptocurrency exchange Binance, which provides a platform for trading over 100 cryptocurrencies and fiat pairs, announced that $40 million dollars worth of cryptocurrency was stolen from the company’s “hot wallet” as hackers were able to steal “API keys, two-factor codes and other information which gave them access to the currency.”
$13 million was recently stolen from Korea’s Bitthumb exchange in suspected insider stealing from the company’s hot wallet
New York Attorney General Letitia James revealed in a court filing that “that the operators of the ‘Bitfinex’ trading platform, who also control the ‘tether’ virtual currency, have engaged in a cover-up to hide the apparent loss of $850 million dollars of co-mingled client and corporate funds”
Finally, in perhaps the most sad (darkly comical?) incident of late, Canadian entrepreneur Gerald Cotten, founder of Canada’s QuadrigaCX cryptocurrency exchange left its thousands of cryptocurrency depositors high and dry to the tune of $250 million CAD ($190 million USD) in losses, when he died in India taking the password to the company’s cold-wallet AND all its funds to the grave. Cotten, allegedly, did not have the most basic custodianship practices and did not bother to share or backup his password to “other people’s money” ANYWHERE, not even in a traditional safety-deposit box.
Want to hear about more? Read Ciphertrace’s 2018 report on losses due to shoddy practices with hot and cold wallets in cryptocurrency exchanges.
The bottom line: as financial technology around cryptocurrency develops at breakneck speed, as major corporations and retailers are developing crypto strategies for payments and transactions, depositors are tragically dependent on large exchanges with risky hot wallets, possibly used as slush funds by exchange CEOs, or must roll the dice with “do it yourself” cold wallets. In the case of QuadrigaCX, the “trusted” custodian was merely an individual with funds in a cold wallet.
Two possibilities: Credit unions and local banks adapt or get railroaded by the crony capitalist alternative
To wrap up, let’s talk about two possibilities for CUs and local FIs. While I will discuss exciting developments in the cryptocurrency legislation and new regulation in a future article for NetQash, including legal adoption by the state of Wyoming and a new bipartisan law, the Token Taxonomy Act (TTA), working its way through congress, the fact is that in the cryptocurrency revolution, acceptance and adoption are already here and regulation (THANKFULLY) is right around the corner. Legal and regulated checking and savings accounts of cryptocurrency and integration of digital currency into a slew of traditional financial services, including wealth management, are near.
As the leader of a CU or local financial institution you have to ask yourself what is the COST of NOT having a cryptocurrency and financial technology strategy?
Our industry will likely create one of two possible worlds in which we will live in the near future:
1) CUs and local financial institutions will not adopt a Crypto and FinTech infrastructure and strategy and will become obsolete/irrelevant at the expense of democratic capitalism (will contribute to the demise of free, fair, and affordable local financial services relative to digital assets and currencies)
In this world, while cryptocurrency is adopted by large and small businesses; while individuals, particularly millennials and generation Z, adopt cryptocurrencies as a store of value and medium of exchange; while the prevalence of the internet of value and value of digital assets increases; the problems inherent in the storage and custodianship of cryptocurrency become more and more critical to the common consumer and local financial institution. Legislators and regulators step in to shut down and regulate shady exchanges responsible for the losses of millions of dollars of cryptocurrencies and work to develop new legal frameworks. In the absence of any strong entry into crypto technology, smart contracts, transaction processing, deposit holding, and financial advising that treats cryptocurrency as a new reality and mainstream financial asset in the small FI and CU world, the entire marketplace for the banking of the future gets eaten up by a combination of giant national commercial banks like Citigroup, Wells Fargo (a specialist in customer service), and JP Morgan in concert with Silicon Valley mega-corporations like Facebook, Google, and Coinbase. Small, TRUSTED community institutions—which maintain their death grip on a variety of other traditional and tired financial services geared towards the benefit of their aging members—disappear and fade from relevancy. Regulations are written and rubber-stamped by (and for the benefit of) the industry giants. At the end of the day, what will be left are individuals doing DIY financial tech and a small number of large, cookie-cutter financial services and custodianship of other people’s money by those who have little interest in how capital and relationship-banking services can serve local economics, small businesses, families, and community institutions. This world is Adam Smith’s nightmare. A nightmare for widespread, prosperity-oriented capitalism for the average American.
If this sounds far fetched, ZDNet reports that Facebook is already in discussion with US Treasury and Bank of England regulators regarding its GlobalCoin, which Facebook believes will “facilitate the exchange of funds without the need for a bank account.” Or banks. That’s right. The future of Facebook banking is the end of an era for CUs and local FIs – the eradication of our guaranteed and safeguarded relevance.
Or, consider an alternate universe
2) There is another, better possibility: in this world, CUs and local financial institutions adapt to the evolutions in cryptocurrency and financial technology strategy NOW and live happily ever after.
CUs and local FIs, who have strong relationships with local members/consumers, learn how to be TRUSTED custodians of cryptocurrencies and merge the important functions of traditional and legacy banking with the usages and technologies of the future. In 10-15 years, as the adoption of cryptocurrency becomes as much a fact of life in the rear-view mirror as the internet and email is today, local CUs will rejoice that they began to modernize their technology and business strategies and adapted to offer a variety of cryptocurrency and financial technology services to serve their members and communities early, including crypto-FIAT conversions, smart contracts, rapid transaction settlements, and most of all investment and management of cryptocurrency deposits in secure, regulated wallets with proven financial technology. CUs and local FIs flourish and allocate capital at the community level for shared prosperity now and in the future. CU members look just as under 30 as over 60.
Local banking has long been about having a TRUSTED and legally regulated partner in guarding safe deposits and liquid deposits of cash. As cryptocurrency is on the dawn of regulated acceptance as real money, why should CUs stand on the sideline of TRUSTED custodianship of other people’s money?
The choice is yours. Let NetQash help. Let’s talk.
"Dr. Russ" Hittinger is a crypto economies and strategy consultant with NetQash. He holds a Ph.D. from Columbia University, where he studied the history of capitalism and political economy. As an educator, he enjoys working with NetQash and its clients so that they have a strategic edge in enriching local economies and strengthening human flourishing in this era of rapid advancements within capitalism, technology, and corporations.