The role of shadow banking in the cryptocurrency industry

Shadow banking is now a $52 trillion business, posing a risk to the traditional financial industry, but what is its role in cryptocurrency?

While many cryptocurrency companies are still testing the boundaries of legality, banks are unwilling to open accounts for them.

Whilst progress is being made in countries like Switzerland, Lichtenstein, and France, opening an account overseas isn’t convenient for many. This has unsurprisingly given rise to shadow banking in the cryptocurrency industry. But just how much of a role does it play?

What is shadow banking?

So what exactly is shadow banking? As the name suggests, shadow banking is a banking system that operates outside of the same strict boundaries of the traditional financial system. This means that it is not subject to regulatory oversight.

When we talk about shadow banking, we’re not only referring to mortgage lenders, insurance companies, hedge funds, payday lenders, and the like. Shadow banking also applies to unregulated activities that regulated institutions engage in, such as unlisted derivatives and credit default swaps.

That isn’t to say that shadow banking is illegal (it can be, but certainly isn’t always). However, it does come with a much higher level of risk for all participants involved. This is simply because it manages to remain outside the purview of regulators. How? Because it does not accept traditional bank deposits.

Shadow banking institutions often offer higher credit without having the necessary recovery mechanisms in place in case of a default. This was clearly demonstrated in the subprime market meltdown in 2008 when shadow banking caught the attention of more regulators around the world.

How big of an industry is shadow banking?

Despite the global financial crisis triggered in 2008, the shadow banking industry has grown exponentially since then. In fact, CNBC reports that it has grown by some 75% since then and is now a massive $52 trillion industry, placing traditional financial institutions at risk.

Because shadow banking institutions have less rigid rules to follow, they can serve some of the people that may be excluded by the banks. This includes people with bad credit history, low capital, and (you guessed it) cryptocurrency companies.

Despite being made up of a myriad of service providers from mortgage lenders to money market funds, loan sharks, and even pawn shops, the majority of activity is focused on short-term lending. This is generally done through collateralised loans and repurchase agreements.

Peer-to-peer loans and non-bank lenders are also gaining a larger share in facilitating mortgages around the world.

Shadow banking in the cryptocurrency industry

Given the dearth of credit following the financial crisis, shadow banking meets a crucial need for credit around the world. From the smallest micro-enterprise in a developing country to the largest cryptocurrency exchange or cannabis company, shadow banking is ideal for those rejected from the traditional financial system.

In fact, with companies such as BlockFi and Celsius Network offering crypto lending services, some cryptocurrency companies are even becoming part of the shadow banking industry themselves.

While shadow banking isn’t illegal in itself, some of the companies operating under that term are conducting illegal activities. On April 30th 2019, the US Department of Justice – thanks to the FBI and IRS – jointly charged two individuals with providing shadow banking services illegally.

The pair were allegedly operating an unlicensed money transmitting business. Additional bank fraud charges were also involved.

Both individuals (a US man and an Israeli woman) claimed to work for a company that provided “fiat currency banking services to various cryptocurrency exchanges”. However, they were doing so under the ruse of complying with AML/KYC practices (they were not actually compliant).

They were also making false statements in order to open bank accounts for individuals to purchase cryptocurrency. According to the statement:

“Reginald Fowler and Ravid Yosef allegedly ran a shadow bank that processed hundreds of millions of dollars of unregulated transactions on behalf of numerous cryptocurrency exchanges.”

The indictment claims the duo falsely described the nature of their business and that many of their operations were illegal.

The takeaway

When banks refuse to cooperate with individuals, they have to seek alternative means of finance. The same is true with cryptocurrency companies who need banking services to be able to operate. Many have no choice but to trust in shadow banking institutions.

This may solve their problem in the short term. But it also leaves them at risk of bad actors, as the above example illustrates. Since the shadow banking industry is lightly or hardly regulated around the world, it leaves cryptocurrency companies exposed.

However, strict regulation around banks has also encouraged plenty of innovation. Shadow banking (when you remove the undesirables from the picture) is enabling many people and businesses around the world to flourish. And, along with cryptocurrency, it may indeed present a rather large threat to traditional finance.

Disclaimer: The views and opinions expressed by the author should not be considered as financial advice. We do not give advice on financial products.

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