The digital currency environment is one space that traditional financial institutions should watch in order to stay competitive. There is much to gain from understanding and getting ahead of emergent trends like digital currency investment and custody services.

From the rise of decentralized finance to the possibility of a Central Bank Digital Currency, consider customer demands and how to best position your institution for success in this new landscape. Doing so will differentiate your institution and save you from being left behind.

Here are some common questions bankers have about this brave new world. Check out the full executive report for an in-depth view of bankers’ industry perspectives, including their crypto concerns, challenges and priorities.

What is Decentralized Finance?

Decentralized finance (DeFi) is an umbrella term for peer-to-peer financial services on public blockchains. This economic structure aims to eliminate intermediaries (like banks) between parties in a financial transaction by utilizing blockchain technology. DeFi encompasses everything from digital payments to smart contracts and cryptocurrencies.

Not surprisingly, non-traditional participants such as digitally oriented technology companies, venture capital and private investment firms and fintechs have contributed heavily to DeFi’s expansion. Some examples include:

• Technology companies: Facebook, Amazon, Alibaba, WeChat
• Venture capital and private investment firms: Andreessen Horowitz
• Fintechs: Paypal, Coinbase, Robinhood

New firms, such as BlockFi, are oriented around digital currency-based credit cards, loans, and now interest-generating accounts.

DeFi can enable most of the practices traditionally dominated by banks — earning interest, borrowing, lending, buying insurance, trading derivatives, trading assets and more. However, it’s faster and doesn’t require paperwork or a third party. As a result, the rapid growth of these businesses and decentralized finance poses a threat to institutions that do not prepare accordingly.

What is a Cryptocurrency?

A commonly discussed aspect of DeFi, cryptocurrencies are digital or virtual currencies protected by encryption, making counterfeiting and double-spending practically impossible. Many cryptocurrencies use blockchain technology—a distributed ledger enforced by a network of computers.

In a traditional economic environment, centralized bank systems like the U.S. Federal Reserve oversee monetary policy and control the economy’s money supply. But cryptocurrencies are decentralized and therefore unconnected to a sovereign currency system like the U.S. dollar.

The blockchain architecture that underpins these currencies is made up of a complex system of computers that confirm and validate the value of each cryptocurrency. As such, cryptocurrencies bypass traditional payment infrastructure, such as credit card services, Fedwire and ACH’s key transaction clearing systems.

Cryptocurrencies and digital assets have also become more popular in recent years. Time reported the world’s cryptocurrency as worth more than $3 trillion globally, and consumers transact trillions of dollars in value each year.

While there has been much debate over the true “value” of cryptocurrencies, these digital assets have undoubtedly made headlines for the value the marketplace has placed upon them. You can learn more about how cryptocurrencies work here.

What is a Stablecoin?

Stablecoins are a class of digital currencies linked to the value of an existing currency and have a 1:1 price goal. For instance, a stablecoin tied to the U.S. dollar may represent one dollar that the exchange has on hand.  So long as stablecoins maintain their value to the U.S. dollar, these are far less volatile than other cryptocurrencies. A consumer that wishes to cash out can do so and receive their portion of the traditional currency the exchange has on hand.

In other words, stablecoins use the encryption of cryptocurrencies and apply it to a more consistent, stable issuer. As a bridge between decentralized finance and traditional fiat currency, they are better suited for everyday commerce and facilitating digital exchanges.

Stablecoins are primarily used to underwrite cryptocurrency transactions or other cross-border transactions where the purpose is to keep the value stable. These digital assets therefore create a vital part of the cryptocurrency ecosystem.

However, it should be noted that due to concerns over money laundering, tax evasion and other risks, they are also one of the FDIC’s primary points of focus when considering future regulations. Some regulators have questioned how consistently these exchanges have reserve-backed assets on hand. To further complicate matters, stablecoins with volatile offshoots, such as TerraUSD and Luna could undermine that baseline stability.

What is a Central Bank Digital Currency (CBDC)?

On Jan. 20, 2022, the Federal Reserve Board released a discussion paper that summarized the state of domestic payments, including digital payments and assets like cryptocurrencies and stablecoins. It also weighed the pros and cons of a U.S. central bank digital currency and invited comment. Then, on March 9, President Biden signed an executive order to explore digital assets, including CBDCs.

To quote the executive order fact sheet, “Over 100 countries are exploring or piloting Central Bank Digital Currencies (CBDCs), a digital form of a country’s sovereign currency.” Official research into them is significant, as a CBDC tied to the U.S. dollar could monumentally affect how Americans transact.

CBDCs differ from stablecoins in that they are regulated, legal tender issued by central banks or government authorities. Many see promising potential in CBDCs to:

• Speed up transfer payments, including cross-border transfers
• Lower the cost of cash management by embracing digital currency
• Broaden financial inclusion by lowering the barrier of entry for the unbanked

However, CBDCs could prove controversial, as they have the capacity to track transactions and restrict transaction types. Some have also suggested that they could lead to banking sector disintermediation, reducing the need for intermediaries like banks by giving the Federal Reserve direct control and reducing the need for cash deposits at financial institutions.

Since the impact of CBDCs depends upon implementation, the banking industry must underscore its critical role in the U.S. economy, and financial institutions should prepare to leverage all forms of legal tender.

In the meantime, becoming comfortable with how digital assets work could give institutions a jumpstart to maintain their role as secure financial advisor and mediator.

Why Should Your Bank Consider Entering the Cryptocurrency Marketplace?

There’s really no reason traditional institutions can’t dip their toes in the water. According to a recent Cornerstone Advisors survey, 60% of crypto owners would use their bank to invest in cryptocurrencies, and another 32% might.

Forbes also explored consumer interest in cryptocurrencies and argued that volatility doesn’t justify sleeping on cryptocurrencies. After all, your customers can already invest in volatile assets on the market or even use funds for outright gambling if they choose.

So, the takeaways are simple – customers are interested in digital assets, and banks can use this interest to extend their position at the center of customers’ financial lives.

As with previous innovations like digital banking, your capacity to control customer experience and truly drive your strategy depends upon how quickly you adopt. Learning along the way will better prepare your institution for future offerings, including a potential CBDC.

First, you must explore the fintech market to find digital currency and DeFi technology platforms that might be in demand by your customers. Then, weigh these possibilities against their requirements to choose solutions and partners that can help meet those unique technology needs.

What About Cryptocurrency Volatility?

Volatility has been a part of the crypto space since its inception, but volatility is present in any emerging space. For example, Amazon lost more than 95% of its market value from late 1999 to 2001.  Today, few would consider Amazon stock at a low price a bad investment.

At the time of writing this blog, many are panicking about the market’s downturn, and some have even suggested that the crash of certain cryptocurrencies may be the canary in the coal mine for crypto. But at the same time, the stock market faces a similar downturn, and few are making that same claim.

Today, there is concern that Bitcoin’s value could dip as low as $20,000. To offer some perspective, $20,000 was an almost unthinkable ceiling for Bitcoin just five years ago. Since the price has dipped, it could even be seen as a buying opportunity, increasing demand.

That’s not to say there is no risk for consumers in this space, especially if they are buying into less established and trustworthy digital assets. If anything, the crashes of TerraUSD and Luna that have scared the market further demonstrate the need for reliable financial partners.

Financial institutions choosing to engage in this space are helping their customers do so safely and avoid scams. Also, the flipside of certain exchanges crashing is that the unstable players are more likely to get weeded out.

What Do the Regulators Say About Crypto Assets?

As the space evolves, regulations governing digital currencies are updated on an ongoing basis. Financial institutions should stay up to date on regulations and instructions from federal regulators regarding both a CBDC and decentralized cryptocurrencies.

Recent guidance from the Federal Reserve, FDIC and OCC has focused on the need for greater clarity, with tentative guidance around:

• Crypto-asset custody
• Facilitation of customer purchases and sales of crypto assets
• Loans collateralized by crypto assets
• Activities involving payments
• Activities that may result in crypto asset holding on an institution’s balance sheet

Institutions should look for additional clarity from the agencies throughout 2022 and beyond to best understand policies, potential gray areas and what might come next. Remember that while there may be risk in emerging spaces, there is also risk in inaction.

Getting Ahead of Digital Currency Trends

We’ve been here before. The adoption of digital banking, bank apps and self-service options shows that financial institutions can adapt to new technological trends. They must now continue to innovate to meet consumer needs in an increasingly competitive landscape.

Fintech challengers are happy to eat away at financial institutions’ customer base and expand their own product offerings. Meanwhile, these technological advancements could also lead to further consolidation of the industry.

As a result, this space deserves continued attention by all financial institutions. It is time to craft a strategy before someone else does it for you.

To gain insight on bankers’ perspectives about the current state of cryptocurrencies, check out this executive report.

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Matt Herren is the Director of Payment Strategy at CSI. With a strong focus on emerging technologies and how they apply to the financial industry, Matt has led CSI’s effort to drive innovation in the payment space. In his role, Matt has worked to enhance customer experience and helped direct innovative product offerings to increase bank profitability, allowing banks to realize industry-leading results and maximize program performance.