The Shadow Banking Revolution: Why Cryptocurrencies Thrive Outside the Bank Vaults
The last decade has witnessed a phenomenal surge of interest in cryptocurrencies and Decentralized Finance (DeFi) from the general public, businesses, and financial markets alike. Starting as niche technological innovations, these digital assets have grown rapidly, driven by investors searching for alternative opportunities in a low-yield environment. This growth, however, has been characterized by high market volatility and record-high market valuations. The massive capitalizations achieved by cryptocurrencies like Bitcoin (BTC) and Ethereum (ETH) have raised crucial questions about their overall "footprint" on the existing global financial system. Are traditional financial giants—the banks—embracing this new technology, or are new, less-regulated entities taking over?
The evidence gathered from a novel global supervisory database suggests an answer: the world of cryptocurrencies largely operates in the shadow of established banking institutions, forming an emerging "shadow crypto financial system". While established banks remain cautious and minimally exposed, a new set of lightly regulated crypto exchanges and investment funds has emerged as the dominant force, handling massive trading volumes and asset custody for both retail and institutional clients. This evolving landscape demands a proactive, holistic, and forward-looking approach to regulation to ensure stability and a level playing field.
The Institutional Footprint: Banks Stand on the Sidelines
Despite the explosive growth of the crypto market, traditional, globally active banks have maintained very modest levels of exposure to cryptocurrencies thus far. The initial motivation behind Bitcoin’s creation was, in part, to establish a substitute for fiat money and commercial banking, envisioning a decentralized exchange resistant to censorship by established institutions. While this original vision suggested a sharp departure from the existing financial ecosystem, the current generation of cryptocurrencies is not marking such a break; rather, it is relying on intermediaries outside the traditional banking system.
Based on global supervisory data available as of the end of 2020, only a handful of internationally active banks reported holding any cryptocurrency exposures. Their average exposure was extremely small, amounting to less than 0.02% of their risk-weighted assets (RWAs), and no single bank reported exposures greater than 0.05% of RWAs. The total reported exposure of large internationally active banks was merely $188 million at the end of 2020.
When banks do engage in crypto activities, their involvement is primarily client-led. The bulk of banks’ crypto exposures relates to trading on client accounts (52.4%), followed by those due to the clearing of futures referencing cryptocurrencies (24.4%). Banks did not report having outright cryptocurrency holdings (such as proprietary trading or long-term investments) or using crypto for internal operational purposes at the end of 2020. Geographically, banks reporting crypto exposure were limited to just a few jurisdictions, including Canada, France, South Korea, the United Kingdom, and the United States.
The Dominance of the Shadow Crypto Financial System
The limited adoption by traditional banks means the responsibility for market access, storage, and transaction scale has been assumed by novel "crypto exchanges". These exchanges provide platforms where users can trade and store cryptocurrencies. Importantly, these entities remain largely unregulated to date, essentially constituting the "shadow crypto financial system".
Compared to existing, regulated exchanges for traditional financial assets, the regulatory and supervisory oversight of these crypto exchanges is often patchy at best. This gap includes areas critical for financial stability, such as consumer protection, market integrity, trading disclosure, and anti-money laundering (AML) and combatting the financing of terrorism (CFT) standards. For example, reports suggest that on unregulated crypto exchanges, an average of 70% of reported volumes might be due to "wash trading," where investors simultaneously sell and buy the same assets to artificially inflate volumes.
Despite these regulatory concerns, the business of crypto exchanges has mushroomed, supported by strong customer demand. The physical holdings illustrate this dominance: the total number of Bitcoins held in custody by exchanges has tripled since 2017, accounting for roughly 14.5% of the total issuance. The trading activity remains concentrated, with Coinbase accounting for approximately one-third of total Bitcoin holdings, though new competitors continue to gain market share. Exchange activity, gauged by aggregate turnover, is particularly high in regions like China, North America, the UK, and Russia.
The Institutional Gateway: Investment Funds and Fiduciaries
Cryptocurrencies have successfully captured the interest of institutional investors—such as asset managers, hedge funds, and fiduciaries—who view them as tools for portfolio diversification or as an alternative store of value. For these institutional players, investing in crypto is not straightforward; they require certainty regarding the asset’s valuation, reliable custody service providers for safe storage, sufficient liquidity to transact in size, and legal/regulatory certainty.
Due to operational complexities and the need for safety, institutions are likely to invest via financial intermediaries rather than holding cryptocurrencies directly. Outsourcing custody services, for instance, is far more cost-efficient than building appropriate infrastructure and expertise internally. Accounting rules also play a role; under US GAAP, unrealized gains from direct Bitcoin holdings cannot be accounted for on an investor's balance sheet, unlike gains on shares of investment funds that hold crypto.
Investment funds dedicated to cryptocurrencies have thus evolved into a key gateway for institutional and retail investors seeking exposure. Flows into closed-end funds focusing on cryptocurrencies have grown quickly since 2020, mirroring the rise in market valuations. Although assets under management (AUM) for these dedicated crypto funds reached around $30 billion by mid-2021, this still represents only a small fraction of the roughly $69 trillion managed by regulated global funds. Looking ahead, the introduction of Exchange-Traded Funds (ETFs) for Bitcoin and related derivatives is expected to pave the way for further institutional engagement.
The institutional shift has fundamentally changed the business of crypto exchanges, making investors like hedge funds and asset managers an increasingly important source of revenue. This requires exchanges to offer new services, such as margin financing, and strengthen their creditworthiness and loss-absorbing capacity, potentially spurring industry consolidation.
The Drivers of Adoption: Innovation and Development
The adoption of cryptocurrencies by both traditional banks and crypto exchanges is not uniform across the globe but is instead linked to specific country characteristics. Formal regression analysis reveals several key drivers:
Innovation and Development: Banks domiciled in economies with higher innovation capacity (such as innovation output scores) and more advanced economic development (measured by GDP per capita and financial development indices) are more likely to engage in cryptocurrency-related customer business.
Public Sector Engagement: Countries actively involved in Central Bank Digital Currency (CBDC) projects show a higher likelihood of banks taking on cryptocurrency exposures.
Financial Inclusion: Greater financial inclusion, measured by account ownership, is strongly associated with a higher likelihood of bank involvement.
Crucially, the factors that facilitate bank involvement are also positively related to the turnover of crypto exchanges. This finding suggests that a market environment conducive to innovation and financial development supports the adoption of cryptocurrencies across all types of institutional players. Conversely, indicators associated with a greater share of the informal economy or high remittances tend to reduce the likelihood of bank exposure, indicating limited bank involvement in crypto-related retail payments in developing countries thus far.
The Regulatory Imperative: Leveling the Playing Field
The sustained growth of the "shadow crypto financial system" and its increasing connection to mainstream finance raise serious policy concerns. The core takeaway is that the current footprint of cryptocurrencies highlights a "decentralization illusion". While cryptocurrencies aim for trust-free, on-chain environments, they rely on centralized intermediaries (crypto exchanges) for convenience and liquidity, much like traditional commercial banking, but without the corresponding regulatory oversight.
This situation necessitates a three-pronged policy approach:
Regulate the Shadow System: New intermediaries, including crypto exchanges and wallet providers, demand closer regulatory scrutiny. These entities should be subject to the same types of regulation and oversight as intermediaries in economically equivalent asset classes. This includes ensuring financial stability, consumer and investor protection, and robust AML/CFT standards.
Mitigate Interlinkage Risks: Risks originating in the unregulated crypto shadow system can quickly transfer to established, regulated banks and financial institutions. Policymakers face a fundamental choice: either strictly separate the two systems or enforce a more level playing field. Given the difficulty of separation on a global level, ensuring a consistent regulatory framework is vital. This means applying a conservative prudential regulatory treatment for banks’ cryptocurrency exposures while enforcing stringent oversight of crypto exchanges.
Address Data Gaps: Significant data gaps risk undermining authorities' ability to holistically oversee and regulate these markets. Enhancing the systematic collection and publication of rigorous cryptocurrency data is essential. Novel solutions like "embedded supervision," which uses information available in distributed ledgers to increase data quality for supervisors and reduce administrative costs for firms, offer a potential path forward.
In conclusion, the institutional adoption of cryptocurrencies reveals a market undergoing rapid metamorphosis. While traditional banks cautiously facilitate client interest, the majority of the activity, volume, and custody rests with a burgeoning, lightly regulated system of crypto exchanges. To manage the risks inherent in this new structure and protect the mainstream financial system, global authorities must act proactively to apply the same standards of safety and oversight to crypto exchanges as are already applied to established financial services.
The relationship between traditional banks and the crypto shadow market is like that of a fortress and the bustling, unregulated market that grows just outside its walls: the fortress (the regulated bank) is heavily guarded but rarely deals directly with the exotic, fast-moving goods. Meanwhile, the outer market (crypto exchanges) handles vast amounts of wealth with great speed but little oversight. The goal now is to build a reliable bridge between them and ensure that the standards of safety and security used inside the fortress are applied to the most critical services offered in the marketplace outside.
