Stablecoins are Most Suitable for the Essence of Banking Business and Currently Have the Clearest Entry Path
Author | Chen Zhitang
Recently, the European Cloud Chain Research Institute released a heavyweight report "Global Cryptographic Map of the Banking Industry 2023", which has attracted widespread attention from the banking industry and financial regulatory agencies. By dissecting the cryptographic layout of more than 70 banks worldwide, the report believes that with the increasing adoption rate and the maturity of related technologies, cryptographic assets have become an innovative field that the banking industry cannot ignore and cannot miss.
As a senior practitioner in traditional financial institutions, Mr. Chen Zhitang not only has decades of banking experience, but also has in-depth research and unique insights into Web3 and cryptographic assets. In line with the European Cloud Chain Research Institute, Mr. Chen Zhitang also believes that cryptographic assets are an unavoidable market for banks, and Hong Kong can become an experimental field for cryptographic asset innovation, continuing to play the role of a bridge between the East and the West.
Based on continuous research and contemplation of virtual assets, Web3.0, and the banking industry, Mr. Chen Zhitang recently completed an article "Digital Transformation Thinking: Web3.0 and Banking". In the article, Mr. Chen Zhitang stated that compared to virtual asset investment and RWA direction, stablecoins are most suitable for the essence of banking business and currently have the clearest entry path. Hong Kong banks can participate in stablecoin business, provide stablecoin-related services to individual customers, provide bank settlement services to qualified virtual asset service providers (VASPs), and, with an increasing customer base, establish a payment settlement system similar to Silvergate Bank's SEN system.
In Mr. Chen Zhitang's view, banks' participation in cryptographic asset layout can not only gain brand promotion effects but also improve customer structure and enrich sources of income. More importantly, the introduction of cryptographic assets will completely reshape the product system of banks. These thoughts are in line with the conclusions in the "Global Cryptographic Map of the Banking Industry 2023" report by the European Cloud Chain Research Institute.
This article is published to benefit the readers.
The following is Mr. Chen Zhitang's article (with some deletions).
Tracing the Policy Context of Web3 by the Hong Kong Government
The Hong Kong government is pushing forward the establishment of the world's virtual asset center at an unusual speed and attitude.
According to PANews, the Hong Kong government has introduced policies related to virtual assets since 2018, but before 2023, these policies did not attract much attention from the market. However, after 2023, due to the positive shift of the Hong Kong government towards virtual assets and Web3.0 policies, the Hong Kong government and various institutions, including regulatory agencies such as the Hong Kong Monetary Authority and the Securities and Futures Commission, have intensively released practical declarations and policies, and have promoted the implementation of virtual asset business in practice, which has greatly attracted the attention of participants in the Web3.0 industry worldwide.
The promotion of virtual asset policies in Hong Kong stands out against the backdrop of the strict prohibition of cryptographic asset trading in mainland China and the strict regulation of virtual asset exchanges in the United States. Therefore, it is inevitable to speculate whether the Hong Kong government has communicated with the central government about the development of virtual assets. Furthermore, against the historical background of the decoupling between China and the United States, whether Hong Kong can continue to break through as an international financial center relying on virtual assets is a question. The government's unified policy promotion at least demonstrates the courage and determination of the ruling authorities, which is very unexpected for traditional financial institutions and Web3 institutions. This has also led to the rare call from the Hong Kong Monetary Authority for banks to provide account opening services for cryptographic asset service providers, but there are still few responders.
In the shadow of the policy, there are also cryptographic currency or stablecoin exchange shops in Hong Kong. The nature of these exchange shops is no different from the regulatory scope announced by the Hong Kong Monetary Authority and the Securities and Futures Commission, but there has been no mention of the need to apply to the above-mentioned regulatory agencies for these exchange shops. This is related to the regulatory agencies for traditional exchange shops, such as the Hong Kong Customs.
Reactions and Actions of Different Institutional Entities towards Virtual Assets
On August 7, 2023, the U.S. payment giant PayPal announced the launch of its stablecoin PayPal USD (PYUSD), becoming the first technology giant to issue a stablecoin. Patrick McHenry, Chairman of the U.S. House Financial Services Committee, stated, "This is a clear signal that stablecoins (if issued within a clear regulatory framework) are expected to become the cornerstone of our 21st-century payment system."
The choices of asset management giants and payment giants indicate the attractiveness of virtual assets to the traditional financial industry. In the banking industry, both traditional commercial banks and modern technology banks have pioneers actively laying out.
In 2020, DBS Bank announced the launch of the "DBS Digital Exchange" to create a comprehensive digital asset ecosystem for corporate and institutional clients and qualified investors, including services such as tokenized securities issuance, digital currency trading, and digital custody services.
In terms of technology banks, despite the failure during this year's U.S. dollar interest rate hike cycle, both Silvergate Bank and Signature Bank have had successful experiences in the cryptographic asset industry, making them important models for banks to participate in the cryptographic asset industry.
For example, Silvergate Bank did not start in the cryptographic currency field but actually started as a bank specializing in real estate financing. In January 2014, Silvergate Bank saw the opportunity when most banks were unwilling to provide services related to cryptographic assets, a situation very similar to the current situation in Hong Kong:
At that time, most banks were unwilling to deal with cryptographic assets. If they found that individual customers were transferring funds to or from cryptographic currency exchanges, they would even close the accounts of individual customers.
Buying and selling cryptographic currency in U.S. dollars is a 24/7 global activity, but the buying and selling of U.S. dollars requires the use of traditional financial systems, which is very slow and requires compliance with official working hours of the clearing system.
As a result, Silvergate Bank created a real-time payment system, the "Silvergate Exchange Network" (SEN), to facilitate cryptographic currency transactions, allowing easy transactions between bank accounts 24/7, immediately and at any time for settlement payments between the two parties, which is completely different from traditional banks that cannot handle cross-border business after work hours, attracting a large number of institutional traders and cryptographic currency exchanges.
The SEN system allows customers to voluntarily deposit billions of U.S. dollars without requiring Silvergate to pay interest, bringing a large amount of zero-cost and low-cost deposits. Since 2017, Silvergate Bank's customer deposits have grown nearly sevenfold, peaking at over $11 billion.
Signature Bank has also developed a similar real-time payment system, Signet.
Even if the above two banks declared bankruptcy in 2023, the low-cost fund precipitation and profits brought by cryptographic-friendly banks are tempting cakes for every bank.
In the local market in Hong Kong, according to Bloomberg, ZA Bank, the largest virtual bank in Hong Kong, is promoting the exchange service between cryptographic currency and fiat currency. Yao Wensong, CEO of ZA Bank, stated in an interview on April 11 that ZA Bank will act as a settlement bank, allowing customers to deposit cryptographic tokens at licensed exchanges and withdraw them in Hong Kong dollars, U.S. dollars, and other currencies.
Participation Directions Available to Hong Kong Banks
This business model is already operational at HashKey and OSL, which are currently the two most well-known licensed cryptographic currency exchanges in Hong Kong. ZA Bank will also provide the same services to other exchanges after obtaining licenses.
Main Participation Directions for Hong Kong Banks
From the policy orientation in the Hong Kong region and the business direction of large overseas entities, virtual asset investment, stablecoin business, and Real World Asset (RWA) tokenization are the three main business directions. From the perspective of banks, stablecoins are most suitable for the essence of banking business and currently have the clearest entry path.
There are currently three mainstream development methods for stablecoins, namely asset-backed stablecoins represented by USDT and USDC, cryptocurrency collateralized stablecoins represented by DAI, and algorithmic stablecoins represented by UST.
Each stablecoin design has its unique flaws. In the industry, these trade-offs are usually referred to as the "impossible triangle of stablecoins" because it is impossible to achieve all three characteristics in one design: pegged stability, decentralization, and capital efficiency. Currently, stablecoin projects can only prioritize two of the three characteristics, meaning that stablecoin projects inevitably have to compromise on the third aspect. In summary:
Asset-backed stablecoins, such as USDC and USDT, are known for their stability and capital efficiency, with a 1:1 collateral support, but they are all subject to centralized control, which brings reliance risks, as seen with USDC's exposure to Silicon Valley Bank and USDT's lack of transparency.
Cryptocurrency collateralized stablecoins like DAI bring stability and decentralization advantages, but they require a higher collateralization ratio for minting, making their capital efficiency lower than other options.
Algorithmic stablecoins like UST have decentralization and high capital efficiency advantages, with a unique peg maintenance mechanism, but they all lack operational history, and their mechanisms have inherent issues, leading to potential price instability risks.
Due to the instability of the stablecoin triangle, stablecoins are also known as the "Holy Grail" of Web3, and every stablecoin issuing company is seeking different solutions.
From the policy orientation of the Hong Kong Monetary Authority, only asset-backed stablecoins are currently allowed to be operated to ensure the 1:1 price linkage mechanism between stablecoins and fiat currency and to avoid subsequent volatility issues. Asset-backed stablecoins such as USDT, which are issued by unregulated entities, are therefore likely to be excluded, and compliant stablecoin companies such as Circle and Paxos, which have obtained regulatory compliance licenses, will be the preferred partners for banks.
Business Direction and Revenue Analysis for Banks Choosing Stablecoin Business
Banks participating in stablecoin business have the following business directions:
1. Providing Stablecoin-Related Services to Individual Customers
One of the most valuable development scenarios in the cryptographic ecosystem is the entry and exit channels. For individual investors, remittance and exchange services between fiat and stablecoins are highly needed. Currently, apart from ZA Bank, there are no major banks in the Hong Kong region that have made clear statements.
In fact, banks can gradually promote stablecoin services for individual customers. Firstly, there is the remittance business between individual customers and compliant stablecoin issuing companies. Outbound business has the lowest compliance cost, and banks conduct audits of the source of individual funds in accordance with current anti-money laundering/counter-terrorism requirements, and also comply with current anti-money laundering/counter-terrorism requirements when remitting, which is part of traditional fiat remittance business.
Secondly, it is the receipt of U.S. dollar remittances (or future other compliant fiat currencies) from compliant stablecoin issuing companies. Since individual customers at compliant stablecoin companies also need to undergo KYC/AML procedures, compliant stablecoin issuing banks also conduct KYC/AML procedures when remitting, theoretically no different from the current fiat remittance business.
Finally, banks can consider cooperating with compliant stablecoin companies to provide fiat and stablecoin exchange services for individual customers. In this model, compliant stablecoin companies act as counterparties to the bank.
2. Providing Bank Settlement Services to Qualified Virtual Asset Service Providers (VASPs)
Currently, banks in the Hong Kong region are facing a market situation similar to what Silvergate Bank faced in the United States at the time. Banks are hesitant to provide bank accounts to VASPs, and even after two meetings convened by the HKMA, there are still no banks willing to make a clear statement, which is rare in any type of business.
Banks can consider negotiating with Hashkey and OSL, the two licensed exchanges, to provide them with bank accounts, with the main direction being remittance business between compliant stablecoin companies, entry and exit business between individual customers and the two exchanges, and future fund custody business when the exchanges issue stablecoins themselves.
3. Establishing a Class SEN Payment Settlement System Similar to Silvergate Bank as the Customer Base Grows
As the bank's encrypted customer base grows, the bank can consider establishing a class SEN payment settlement system similar to Silvergate Bank. This system is similar in form to the bank's clearing system, and if it is all internal clearing, the initial development cost is not a huge investment for the bank.
Regarding bank revenue, it is reflected in:
1. Clear Brand Promotion Effects
As announced by ZA Bank, under the promotion of major media, positioning itself as a bank friendly to encryption will receive significant exposure and traffic. For traditional small and medium-sized banks, it will be an excellent opportunity to reform their image and enhance their brand, even if they are unable to conduct large-scale business due to compliance costs, they will maintain a clear positioning and first-mover advantage in the industry.
2. Opportunity to Improve Customer Structure
Most investors in the virtual asset industry are young people, especially those born after the 1990s, the Z generation. In the current situation where there are few options for encryption-friendly banks, banks that provide entry and exit services will strongly attract these young customers to open accounts. For traditional small and medium-sized banks that mainly serve middle-aged and elderly customers, this is a very good opportunity to improve their customer structure.
For corporate clients, taking the 150 clients already established in Cyberport as an example, claiming to be a bank friendly to cryptographic currency will completely achieve marketing effects that attract clients from the industry to open accounts.
In terms of cross-border clients, against the background of the prohibition of virtual asset trading in mainland China, opening an account in Hong Kong that has the opportunity to trade virtual assets will be very attractive to residents in mainland China. It is not an exaggeration to predict that the purchase targets of visitors to Hong Kong will change from luxury goods in the past to insurance and time deposits in the present, and will become virtual assets in the future.
3. Potential Stablecoin Profit Opportunities
Setting aside simple exchange rate spread income, which is already very substantial, stablecoins currently offer excellent profit opportunities.
Taking Tether, the issuer of USDT, as an example, according to its disclosed Q2 2023 report, the total asset size of USDT has increased from $660 billion at the beginning of the year to the current $860 billion, with over $550 billion of U.S. dollar assets used to invest in risk-free assets such as U.S. bonds, from which most of the profits are derived.
It is reported that Tether achieved over $1 billion in profits in the Q2 quarter, and even achieved $1.48 billion in profits in the Q1 quarter, with Tether expected to earn $4 billion in profits this year. This is more than the profits of the global asset management giant Blackrock, whose employee size is only over 50.
Taking Silvergate Bank as another example, its SEN system absorbs a large amount of deposits at zero cost and low cost, providing significant funding support for its bond investments and loans.
For small and medium-sized banks, there is a significant disadvantage in funding sources compared to large banks, such as a disadvantage in competing for CASA deposits in settlement systems, a disadvantage in loan pricing when competing for deposits from large blue-chip clients, and a credit rating disadvantage in the interbank lending market.
Therefore, if a large amount of low-cost funding can be obtained through the virtual asset industry, it will provide strong support for the development of the bank's asset business, and the net interest margin level will be improved.
4. The introduction of virtual assets will reshape the bank's product system
The operation of the distributed ledger of virtual assets will completely reshape the bank's product system.
In terms of clearing and settlement, stablecoins based on the Ethereum network can operate without relying on the traditional SWIFT system, providing banks with a new way of integrating funds and information flows in traditional clearing and settlement.
In lending, individual lending based on cryptocurrency collateral can improve the personal credit products in the Hong Kong banking market. The main personal credit products of Hong Kong banks are mainly personal credit loans and personal mortgage loans. Even for personal loans with 100% collateralized time deposits, the process is complex and cumbersome. Based on DEFI technology or even Web2.0 technology, cryptocurrency collateralized loans can greatly release the liquidity of personal assets and also bring new asset types and sources of income to the bank.
Asset tokenization can bring interesting changes to bank payments. For example, if time deposits are tokenized, holders can make external payments on a portion of the time deposits, with precise interest attached, achieving the divisibility, transferability, and infinite extensibility of assets.
In terms of bank customer KYC, if the concept of "Soul-Bound Tokens (SBT)" is introduced, relying on the bank's completed KYC results, customers can achieve unified authentication of their identity within the ecosystem formed by the bank and its partners through SBT.
The most traditional safe deposit box business has also undergone new changes after the introduction of virtual assets, such as banks being able to provide custody services for customers' private keys.
All of this, because of the concept of virtual assets, has brought about practical and far-reaching changes.
Risks and Choices
The slow response of the banking industry to virtual assets is not only due to the traditional conservatism of banks under strong regulation, but the following risk factors are also reasons for the indecision of banks.
- Compliance Risk
Virtual assets have higher anonymity than traditional assets, making it difficult to discern the source of customer funds even in simple remittance transactions. Under increasing pressure from anti-money laundering, banks are naturally reluctant to take proactive action due to additional anti-money laundering costs and potential anti-money laundering risks.
In addition to urging banks to provide account opening services, the Hong Kong Monetary Authority should actively discuss anti-money laundering standards for virtual assets with the industry. Regulatory authorities and the industry should jointly develop direct, clear, and executable anti-money laundering guidelines for virtual assets to facilitate banks' business operations.
- Technology Risk
Virtual assets operate in a completely different way, posing new requirements for banks in preventing network fraud, key management, asset custody, and more. At the current stage where bank employees generally do not have a deep understanding of encrypted assets, managing technology risks is a major challenge and has also led to banks being hesitant to enter the virtual asset space.
Banks engaging in such businesses not only need to build up talent reserves within their own organizations but also need to establish supporting services in the industry, such as professional technology companies and systematic asset custody companies.
- Strategic Risk
The strict prohibition of virtual assets in mainland China is one of the factors that Hong Kong banks must consider in their actions. Hong Kong banks basically have business or branch offices in mainland China, and Chinese banks need not be mentioned. Therefore, Hong Kong banks not only need to consider local policies in Hong Kong but also need to take into account policy risks in mainland China.
The Hong Kong government should communicate and report to the central government and clearly convey information to the industry. If Hong Kong banks engage in virtual asset business in the Hong Kong region in compliance with the regulatory framework of the Hong Kong government, it does not violate relevant policies in mainland China, thus addressing the concerns of Hong Kong banks.
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