Southeast Asian banks’ growing crypto exposure threatens earnings

SECTOR REPORT: CRYPTOCURRENCY IN BANKING Southeast Asian banks’ growing crypto exposure threatens earnings

Banks looking to dabble in crypto face operational, reputational, and legal risks.

The interest of banks in Southeast Asia (SEA) to develop cryptocurrency financial services are unlikely to affect banks’ credit profiles in the near term, but earnings opportunities and risks could grow over time depending on developments in their markets, particularly regulation-wise.

In a report, Fitch Ratings notes that more banks in the region will likely make moves to establish a foothold in the crypto sector in 2022.

Most recently, the UnionBank of the Philippines reportedly planned to offer trading and custodial services for cryptocurrencies. UnionBank also recently joined a sandbox to develop use cases for central bank digital currencies (CBDC).

Other banks have also begun dabbling in cryptocurrency outside their main banking businesses. Singapore’s DBS Bank has, for example, established a wholly-owned cryptocurrency digital exchange platform called DDEx.

Meanwhile, Thailand’s Siam Commercial Bank, through its SCB Securities unit, has acquired a 51% stake in a Thai cryptocurrency trader, BitKub, in November 2021.

These banks are expected to try to curb risks through a series of measures, such as limiting access to accredited institutional investors, dealing only in better-established digital assets, and clearly segregating custodian accounts from trading wallets, the ratings agency noted in a recent report.

It is not just banks that are interested in the potential surrounding crypto. A recent survey by EY found that one in four fund managers expect their exposure to cryptocurrencies to increase in the coming year.

“Digital assets, for example, have become a mainstream trend, with their rise in popularity attracting the attention of both alternative fund managers and investors,” said Christine Lin, EY Greater China

DBS Bank launched a cryptocurrency digital exchange platform in 2021

Christine Lin

Crypto trading and custodial fees can boost and diversify income

Wealth & Asset Management Leader.

It comes as no surprise, then, that banks will follow suit given that cryptocurrency is now very much in the eyes of investors.

Income gains

Crypto trading and custodial fees can boost and diversify income, according to Fitch report.

“Banks may be able to develop competitive advantages in emerging financial service fields or engage with new customer segments, depending on their risk appetite,” Fitch said.

They may also be able to protect their market positions against competitive threats posed by cryptocurrency-focused entities and technologies in segments, such as wholesale clearing and settlement, and cross-border payments.

Higher costs on the horizon

However, regulators’ growing antagonism against cryptocurrencies and crypto-focused entities is developing quickly and may most likely raise costs.

“Changes could raise compliance costs or curb existing or planned business activity, even as tighter regulation helps to contain financial and operating risks, providing greater assurance to potential crypto investors and users,” Fitch said.

Cryptocurrency engagement may also likely expose banks to more legal risks, such as money laundering and terrorism financing.

Banks’ reputations are also at stake should they offer crypto services, even from activity that is legal, warned Fitch. For example, if customers perceive banks have tacitly endorsed crypto trades that subsequently turn sour, this could most likely impact lenders’ reputations.

The higher capital and operational requirements related

Central banks ramp digital banking, currency plans

One risk to consider is the volatility of cryptocurrencies, which could be seen by the steep rise and fall of many cryptos’ market values

to cryptocurrency could hinder wide-scale adoption by banks, which would most likely hold these assets as custodians and not on balance sheets.

“The punitive treatment of cryptocurrencies and their derivatives will likely discourage trading of cryptocurrency, or at least restrict banks to client transactions where exposure is kept neutral,” Fitch said.

Lack of stability

Banks also face operation risks once they get into the crypto sector.

“The sector’s nascent nature means few crypto firms have developed a track record of stability for their systems and platforms. We view cybersecurity threats, such as scams and hacks involving exchanges, as another prominent risk,” Fitch wrote.

The rating agency also warned of possible issues around ESG exposures, given the energy-intensive nature of some cryptocurrency mining and verification operations.

Another risk to consider is the volatility of cryptocurrencies, which could be seen by the steep rise and fall of many cryptos’ market values. This could lead to a growth in the earnings instability of bank revenues, said Fitch.

In an earlier report, Fitch had warned that the rapid development of the asset class and the fast growth of cryptocurrencies that are not stabilised increases material risks for banks with cryptocurrency exposure.

“The extreme price volatility of some of these assets and an unproven track record of liquidity will make it challenging to hedge positions when providing derivative instruments to institutional clients or when manufacturing investment products that reference crypto assets. Allowing less sophisticated retail and private customers access to this asset class also entails substantial reputation and legal risk,” the report read.

CBDC Intermediaries

As for when central bank digital currencies (CBDCs) transform into being the norm in the financial space, banks have nothing to fear for their roles. S&P Global Ratings credit analyst Gavin Gunning sees central banks leaning toward a model where banks and other financial intermediaries continue to play a strong intermediation role, rather than one where central banks alone manage their digital currencies.

Commercial banks play a key role in intermediating between savers and borrowers, and they work closely with central banks in the process, S&P said, and any CBDC models that cut out their middleman roles would weaken existing banks’ business models.

“Depending on the direction that public authorities take, and the direction that the technology allows, CBDCs could potentially have a profound effect on banks’ business models,” said Gunning. “While too early to tell, their evolution may yet change our view of competitive dynamics on the banking landscape or our view of individual banks’ business positions or other rating factors.”

Risk of banks being disintermediated in the next one to two years seems unlikely.

Asian banks plan to launch digital currency and digital banks in Q1 2022

More central banks in Asia ramped up plans in considering the launch of digital currency and digital banks in the first quarter of 2022.

The Bank of Korea (BOK) completed the first phase of its two-step mock test regarding the feasibility of a central bank digital currency (CBDC).

The first phase was launched in August 2021 and completed in December, South Korea’s financial regulator said in a press release. It further shared that the Bank of Korea’s digital currency showed “normal operations” in a cloud-based environment.

Bank of Korea is carrying out the second phase of the test until 22 June 2022.

Down south, the Bank of Thailand (BOT) shared that it is preparing to issue rules for setting up virtual banks by June, according to Assistant Governor Roong Mallikamas said in a virtual briefing on 1 February.

Should it push through, existing and new entities will be allowed to apply for a license.

Bank of Thailand’s assistant governor said that she expects to see more competition and innovations by allowing digital banks.

Mallikamas also shared that BOT is mulling scrapping limitations imposed on commercial banks, which will allow them to invest in financial technology (fintech) companies. This excludes digital assets.

Thailand and South Korea follow in the footsteps of their regional peers Singapore and China, both who are amongst Asia’s leaders when it comes to virtual banking and developing CBDCs.

In a conference held in late 2021, the Monetary Authority of Singapore (MAS) managing director Ravi Menon shared that the Lion City is keener to try wholesale CBDCs than retail CBDCs.

Retail CBDCs refer to digital currency issued by a central bank that can be used by the general public, whilst wholesale CBDCs are restricted for use within the banking system.

Menon warned that the issuance of a retail CBDC may pose significant risks to Singapore’s banking sector by possibly reducing banks’ capacity to give out loans and making money flight easier. The latter could lead to more instability in the banking system during stress periods.