Auckland, New Zealand – 29 March 2023
Marvin Yee, Partner @ Crown Private & Crown Capital
A war is underway and it is not the one you think. In this issue of the Global Investor, Marvin offers insight and analysis on the sudden failure of three significant U.S. banks. He also delves into what is yet to come, and he provides guidance on how to invest amidst the chaos before us.
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‘Regulators wanted to send anti-crypto message”
To say that the past week has been turbulent is an understatement.
There seems to be a sustained and methodical war against crypto. It is not by accident that the three banks – all three primary bankers of the crypto industry – are not being bailed out. Albeit the depositors are going to be made whole regardless of the FDIC limit.
It is worth noting in the case of Signature Bank, regulators have not sighted insolvency as a reason for taking over the bank. ‘I believe it was probably to send the message that even though we were doing crypto stuff responsibly, they don’t want banks doing crypto’, said Barney Frank [1].
Frank’s hypothesis was further strengthened when the FDIC announced that Flagstar Bank will assume all Signature Bank’s cash deposits except those of crypto companies.
The latest Wells notice (intention to commence enforcement action) on Coinbase, combined with the latest shorting of Block, one of the few payment platforms that will provide payment rails to crypto exchanges has accentuated a concerted effort to ‘de-bank’ the already difficult banking environment facing crypto companies and exchanges.
Signature and Silvergate bank, for those who are unaware are the foremost bankers of the crypto industry in the U.S.
Shutting those two down means cutting off local rails for most small to medium crypto exchanges that are still some way off from being able to deal with the large Wall St firm.
I was advised by a trusted Panamanian resident that a particular bank in Panama is prepared to take crypto company deposits but only with a fee of 2% for each incoming deposit!
Consider the irony of such a lack of confidence in the crypto sector considering the latest crypto rally.
Those same investors buying crypto are now doing so with much smaller financial institutions in non-mainstream jurisdictions that have no FDIC whatsoever.
Furthermore, in the example of that Panamanian bank, the funds are held in a country that has constantly alternated between the grey and blacklist for most regulators. This means their access to international corresponding banking is tedious at best and impossible at worse.
It will not surprise me if the next crisis will be a drop of confidence in the crypto industry because they will – if they haven’t already – been forced to bank with smaller niche players from jurisdictions which while free, are not renowned for their financial robustness.
The industry, largely under the guise of AML\CFT (Anti-Money Laundering and Countering the Financing of Terrorism) laws or securities regulations is slowly but surely being driven into the shadows, which is a very bad position for institutions handling money.
This time when a crisis occurs, unlike the banks, I suspect that there will be no hesitation in allowing the industry as a whole to fall flat on its face.
Why does the establishment not like crypto?
The reasons are varied and not as simple as some pundits would make it out to be.
Let’s start with the obvious. It is hard to control mainstream finance when crypto was intentionally designed to exist independent of mainstream finance. As such it is only a crisis of confidence that will remove it from mainstream usage.
The less obvious reason the establishment does not like crypto is that considerable fraud occurs in the crypto industry, and crypto is increasingly the transaction method of choice for fraudsters.
This matters to regulators and in turn banks. When people lose money – even for legitimate transactions – they do not blame themselves, but instead feel that the government should have done more to protect them.
The U.S. Supreme Court utilizes the Howie Test to define a security. Basically, if it walks like a duck and quacks like a duck… or simplistically, if the financial instrument has the characteristics of a security, it is a security.
Much of the drive by the U.S. SEC in requiring crypto exchanges to register with them is to regulate their offerings to investors.
These very offerings are being contested on what constitutes a security and thus require a regulated process.
If crypto offerings are considered securities, this entire industry will fall under the regulator, which in the US is the SEC. That would also mean that violations of the way in which these securities are marketed will be subject to SEC enforcement actions as would any other investment offering.
AML\CFT laws play a large part in putting pressure on financial institutions and particularly banks for how they handle crypto related businesses.
Fundamentally, to properly comply with legislation, banks need to peel back multiple layers of a transaction to be able to report on it. This is a cumbersome and thankless task that has high administrative overhead and is ultimately not very profitable. It has little upside and large downsides if done improperly.
While the crypto industry would argue that access to banking infrastructure is a fundamental right, it has always been the case that access to a bank account is at the discretion of the bank. Regulators, even if they were friendly to the crypto industry will argue that they cannot require a bank to provide its services to any one entity or sector.
As a result, many banks choose not to bank with this sector. I would consider this a confluence of lazy bank compliance departments, regulatory overhead, and lack of economic motivation.
Where should we invest in this time of crisis?
It is not all doom and gloom for this sector.
When the current turmoil subsides, I believe that a handful of crypto companies will be canonized with the gates to legitimate crypto trading. These will be established players who will register their offerings with the SEC and form the foundations of a safe and regulated trading space.
I would look at Kraken, Gemini and Coinbase (with qualifications).
Kraken
Kraken is slowly emerging as a stable contender in the number 2 crypto exchange spot next to Coinbase. It has settled its regulatory issues with the SEC and has removed its offending ‘staking’ product. It can now look forward to a reasonably regulator interruption-free immediate future.
Commercially, Kraken owns a Special Purpose Depository Charter (similar to a bank) in Wyoming. They are the first cryptocurrency exchange to hold such a charter in the US.
They also have audited proof of funds which provided considerable credibility amidst the volatility triggered by the FTX collapse last year.
Should the current crypto rally continue, Kraken, which has already announced its intention to list on the public markets will likely do so successfully should this rally be sustained.
Gemini
Gemini was one of the few crypto exchanges that was spared by the collapse of Silvergate and Signature banks – attributed most likely to having a strong banking relationship with JP Morgan. Need I say more?
Coinbase
Coinbase is the only publicly listed exchange which in itself holds a degree of credibility.
The company has announced that it intends to establish operations outside of the US, most notably in Brazil, assumingly to evade the clutches of the SEC.
While having a non-U.S. presence will provide its business model some longevity, it would be difficult for a company with the profile of Coinbase – on the NASDAQ – to thumb its nose at regulators and just evade U.S. regulations simply by having an arm of its business in another jurisdiction.
In the short term, this will gain support from crypto purists. In the long run, settling with the SEC is the only sustainable strategy.
Back to the War
To bring this article to a close, I reference back the ‘crypto war’ in the beginning of my article. I also consider the second report on the Virtual Assets and Virtual Assets Providers that was published by the Financial Action Task Force (FATF) in July 2021.
The report highlights areas of deficiencies from an AML\CFT perspective in the banking sector on the treatment of Virtual Assets Providers. Further guidance on the treatment of this industry was published in October last year.
We have since seen a gradual but ongoing level of increased regulatory oversight in this industry which appears to have culminated in these recent events. It is not by any means over.
In February of this year, the three U.S. banking regulators the Federal Reserve, Federal Depositor Insurance Corporation (FDIC) and the Office of the Comptroller of the Currency (OCC) – issued guidance on crypto asset risk to banks.
In their latest release, the regulators specifically referenced deposit accounts for customers of “crypto-asset related entities” and stablecoin reserves.
The warning notes that accounts for crypto companies with customers – such as exchanges – and stablecoin issuers may have volatile movement of funds, and the potential rapid movement of funds increases the liquidity risk for the banks that service the accounts.[2]
As such, it is my opinion that investments in actual crypto currencies will continue to be highly speculative. Banking rails will continue to drive the exchanges and fiat onramps to more and more opaque jurisdictions which will accelerate disrepute in the sector.
What’s a (reasonably) safe bet?
I addressed this question in our January 19 issue of the Global Investor. You may find the article here.
To summarize and expand upon my previous recommendations, investing today requires a great deal of ingenuity, patience and deep diving for the right deals that will bring asymmetrical returns.
Undervalued Equities
Look for undervalued equities – look for deals that are steals.
Short-term Secured Debt
Consider short-term secured debt. The value here is realizing outsized returns with asymmetrical – low – risk.
Our most popular investment product at Crown Capital is our High Yield Debt Fund. The Debt Fund has brought consistent returns averaging nearly 22% over the past three years, and greater returns outside the Covid era.
I could offer several other sectors, but we want to save that for our deep dive on Investing in Difficult times at the Istanbul Obris Meet-up next month.
If you have not registered, do so soon. We will spend three days digging into practical ways to invest amidst the current turbulence and chaos. We will introduce you to investments you can act upon now.
Think about spending three days in Istanbul with a great group of successful and adventurous folks, much like yourself.
Sincerely,
Marvin
