The Federal Reserve Bank of San Francisco (FRBSF) has penned an informal advisory note to community banks highlighting the potential challenges of working with bitcoin industry firms and consumers.

Written by FRBSF director Wallace Young and published in Community Banking Connections, the note suggested blockchain-based digital currencies are “likely here to stay”. As such, Young argued that community bank professionals should make themselves aware of the potential risks.

According to the FRBSF, these include the compliance risk, reputational risk, credit risk and operational risk of servicing both businesses that provide digital currency services and consumers who want to use such assets as collateral for other financial services.

The last scenario was perhaps the most novel of those listed, with the FRBSF advising caution, but suggesting that community banks should make case-by-case judgements.

Young wrote:

“Caution is appropriate. Bankers 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.”

The FRBSF went on to suggest that given the sometimes extreme fluctuations in the value of digital currencies against the US dollar, banks should strategize ways to supervise any holdings used as collateral.

“In the event of a loan default, the bank would need to take control of the virtual currency. This will require access to the borrower’s virtual wallet and private key. All of this suggests that the loan agreement needs to be carefully crafted and that additional steps need to be taken to ensure the bank has a perfected lien on the virtual currency,” Young continued.

Defined as banks with a maximize asset size of $1bn by the Federal Deposit Insurance Corporation (FDIC), community banks account for 95% of US banking operations. Community banks serve as the main financial services provider for rural communities in the US, serving one in five counties.

Community Banking Connections is a publication providing perspectives of the Federal Reserve staff providing supervisory guidance on challenges and concerns for these institutions.

Reputational risk

The FRBSF suggested that on the business side, community banks that provide services to digital currency firms should be aware of past incidents where such businesses have been the subject of legal scrutiny.

Named specifically was the 2014 insolvency of Japan-based bitcoin exchange Mt Gox, which is estimated to have lost hundreds of millions of dollars in consumer funds.

“Since then, multiple lawsuits have been filed against Mt Gox, with several also naming Mt Gox’s bank as a defendant,” the note continued. “Although the bank never held the bitcoins, it did handle Mt. Gox’s transactional banking needs. At least one of the lawsuits claims that the bank should have known about the fraud and that the bank profited from the fraud.”

As such, the note suggested that community banks weigh the risks of such customers, as well as the potential legal and financial concerns. As for the compliance risks, the FRBSF stated that digital currency firms may present risks similar to traditional money transmitters.

Here, the FRBSF addressed the perceived anonymity of digital currencies, suggesting that higher levels of due diligence and monitoring may be necessary for such firms.

“The less-than-transparent nature of the transactions may make it more difficult for a financial institution to truly know and understand the activities of its customer and whether the customer’s activities are legal,” the note read.

Operational risk

Also discussed was how a community bank should respond to situations where it finds itself the owner of digital currency as a result of the need to collect on debt.

“The most likely scenario in which this could occur is when a bank makes a business loan secured by the borrower’s business assets, which at default include virtual currency. At the moment, such a scenario is unlikely, but its plausibility increases as virtual currency becomes more mainstream,” the article read.

Given the risk of volatility, the FRBSF recommends institutions liquidate these funds “in an orderly fashion”, suggesting internal controls would be needed to mitigate loss.

“Management should establish dual control and access processes, as well as think about how this asset will be valued and accounted for on its financial statements,” it continued.

Further consideration, the report suggested, would need to be given to how the digital currency is held and how it could be kept secure prior to sale.

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