What fintech startups can learn from cannabis banking

The just-published NYT Sunday Magazine article about Safe Harbor Private Banking should be required reading for startups in the digital currency space.  To be sure, neither virtual currency nor distributed ledgers are illegal under federal law in the same manner as cannabis.  But it’s fair to say that purveyors of blockchain-tied assets experience many of the same troubles in accessing traditional financial services when faced with the threat of being “de-risked” (read: dumped) by their bankers and brokers.

Virtual currency companies get de-risked for a variety of reasons.  First, the inherent decentralization and assumed anonymity surrounding many virtual currencies makes customer on-boarding and mandatory surveillance required of financial institutions a lot more complicated.  What’s more, as detailed in an article published by ACAMS member Marion Keyes, applying related compliance program obligations like risk assessment, audit, training, and internal controls is difficult at best in a distributed ledgers space that values decentralization, transactions without borders, privacy, and self-governance.  Second, much like in the cannabis space, traditional regulators and bankers tend to raise their eyebrows in industries that resemble the wild west and feature more than a few former crim…er, vociferous libertarians.  Finally, for smaller institutions faced with the idea of serving wholesale customers that are themselves financial institutions of a sort, those smaller traditional banks and brokers often conclude that “the squeeze ain’t worth the juice.”

Federal and state officials are another contributing factor.  One Colorado-based compliance professional recently told me that when her regulator showed up for a periodic examination, the question of whether any block chain startups were on the books was the second inquiry after a similar question about cannabis clients.  So to avoid the rabbit hole and associated costs, her institution opted to simply close the accounts of virtual currency companies once they found them.

But for financial institutions and software providers willing to take on virtual currency startups, there may be a lucrative albeit risky fee pool.  Remind you of anything?

All of this is not to say, however, that the state of affairs in either industry will remain unchanged.  In fact, it may get worse.

On the cannabis side, the Justice Department announced today that five Obama-era guidance memos that provided certain safe harbors against prosecutions involving pot banking will instead be rescinded to permit prosecutorial discretion.  It should be noted that such discretion will only permit prosecutions based on recreational marijuana use, however, as the Rohrabacher-Blumenauer amendment continues to prevent the DOJ from using appropriated funds to prosecute medical marijuana licensees until January 19th, 2018.  What’s more, any federal prosecutor in one of the several states to legalize recreational cannabis will face an uphill battle convincing a jury to convict someone based on public sentiment towards cannabis and the current administration’s policies towards it.  That said, I would not be surprised if cannabis bankers/credit unions start to push recreational licensees (or their vendors/affiliates) off the books or encourage dual-licensed companies to shift back to medical cannabis for the time being.  Indeed, if I was their lawyer (and I’m not), I would encourage them to do so if Rohrbacher-Blumenauer isn’t expanded in the next budget bill to cover recreational cannabis.

On the virtual currency side, I would expect banks, securities brokers, and exchanges to continue to shift virtual currency companies off their books and (where appropriate) into commodities markets where it makes sense to do so.  After all, the SEC continues to deny or table all proposals involving exchange-traded funds holding bitcoin assets based on concerns over fraud and lack of regulation, and has warned investors that SEC enforcement may not generate any recoveries.  The CFTC, by contrast, announced today a series of committee meetings that will meet to consider the Commission’s oversight responsibilities in the area of virtual currency and related futures. What’s more, the CFTC Chair issued a statement that included the following quotation:

One thing is certain: ignoring virtual currency trading will not make it go away. Nor is it a responsible regulatory strategy. The CFTC has an important role to play. The CFTC seeks to promote responsible innovation and development that is consistent with its statutory mission to enhance derivative trading markets and to prohibit fraud and manipulation in connection with commodities in interstate commerce.

So if I were advising a broker-dealer, a securities exchange, or one of their affiliated banks on how to minimize risks associated with virtual currency companies, I would encourage them to connect their clients with an introducing broker in commodities or a futures commission merchant and restructure their offering in a manner intended to fall within the realm of CFTC regulation.

On a related note, I would encourage virtual currency startups to start looking for good commodities lawyers and brokers, as well as more risk-tolerant banks like Safe Harbor.  They are few and far between, and they are expensive, but their service may prove invaluable.