Kraken and the Future of Crypto Banking

Kraken got its own’s Fed account last week. It was a big news story but may be less of a crypto milestone than a payments and banking infrastructure shift. It was also the topic of the latest ‘From the Block’ podcast episode, in which PYMNTS CEO Karen Webster discussed the development with Citi’s Ryan Rugg. Together they unpacked what could be the first test of whether digital asset institutions can plug directly into the U.S. financial system.

Transcript

Narrator 0:01

Welcome to From the Block, where Ryan Rugg, City's Global Head of Digital Assets, and Karen Webster, CEO of Payments, unpack the real questions CEOs and CFOs are asking about stable coins. From infrastructure to innovation, it's the practical path from concept to competitive advantage. In this episode, Karen Webster and Ryan Rugg discuss Kraken and the future of crypto banking.

Karen Webster 0:30

Hey Ryan, this is a special edition of From the Block. I'm excited to chat with you about the latest news to hit digital assets, crypto, and financial services all at one time. So are you ready to dive in? It's been a big week. Huge week of news. So here's what we're talking about today. The Federal Reserve Bank of Kansas City said that it was granting a master payment account to Kraken Financial. That's the banking arm of the crypto exchange by the same name. By the way, a little deviation. Do you know what Kraken, the origin of the name Kraken? I do not. Well, it's it's a Norwegian mythical sea monster with large tentacles that drag ships to the bottom of the ocean. I just want you to keep that in mind as we talk about this. Okay. Okay. So images in my head and everyone else. Images in your head. And it's kind of what their logo is. Anyway, back to the topic at hand. This is the first time in history that a digital asset company has been given direct access to the Fed's payment rails. It's a tier three institution, the hardest category, strictest supervisory rules, vetting rules, and all of that. So I guess today's conversation starts out by trying to make sense of it all. What does this really mean? Is this the moment that crypto becomes core financial infrastructure? Or is this a signal about where crypto and banking really intersect for the future? So, Ryan, I'm going to pose that question to you. How do you break it down?

Ryan Rugg 2:20

So, first off, this is really big news for the crypto market. And this is not new. It's been in the work for five years. And fun fact, the Speedy Agreement, which is a special purpose depository institution that Kraken is filed under, when I was at IBM five years ago, back in 2020, we helped the state of Wyoming write the Speedy. Um, so Kraken has like, this was really the first piece of legislation out there on crypto. And like the Speedy is really important to kind of like understand what it is and how it's gumbered. So it's like, you know, it's a state chartered bank right now. You know, they can custody assets, they can provide banking-like services, and they operate under banking regulation, but not without traditional lending. So there's some really key nuances that you have to pick up in that legislation of what Kraken, you know, filed under. And, you know, and back in 2020, Wyoming is really trying to become that like that US hub for digital asset companies. So they passed a series of legislations between 18 and 20 to really kind of help, you know, formulate that. But I would say like picking up on some of the nuances on this, like has a hundred percent reserve requirement. So speedies must hold 100% against their deposits, which, as we both know, is not traditional, um, you know, in traditional banking. You know, they can't lend against it, really reducing that like kind of run risk as well as their custody access. But again, like huge news for Kraken, really kind of this limited purpose account that they were able to get, like really the first one of merging the gap, I would say, with traditional banking rails and you know, the crypto industry. So, congratulations to Kraken Honest. I know it's been a long five years. You know, the promontory folks advised you back in the day on this initial one. So congratulations.

Karen Webster 4:10

But this is supposed to be the hardest approval to get, right? Tier three, strictest review, custodia was denied the same request three years ago. So, what's actually changed? The administration or the tolerance for risk related to the digital asset and crypto space?

Ryan Rugg 4:29

That's a really important kind of nuance that you picked up on. You know, no, they did not grant a full master account, right? It appears to be structured in like this limited type of account, meaning that they have access to the rails such as Fedwire, but not the traditional, I would say, privileges like earning on interest or reserves or accessing emergency lending. And again, like the exact details are a hundred percent not, you know, like clear right now. This is just based on like kind of what I've read in the market. But, you know, it really seems to be, you know, I would say boxed with the term. It's a year long and has, you know, really, I would say, stricter restrictions than some of the traditional like master accounts because of that tier three, as you said, because they're viewed as highly risk.

Karen Webster 5:15

But is it seems like there's a lack of clarity though. Like if these are TBD things to be worked out, is this really structured so that these guardrails have teeth? Or is it just a talking point to soothe everyone's concerns about allowing access to a Fed payment rail by a crypto bank?

Ryan Rugg 5:42

So we know that the account comes with limitations, but it's hard to say without transparency on like 100% what these limitations are. Like some of the basic account, like you know, what are in regards to how are they gonna have operation and controls? How is supervision gonna work? What is the risk monitoring? Like, and like none of this is like public yet or from like anything that I've seen. So it's hard to say, like to your point, about like what it actually means, a limited purpose. Is it just, you know, what are these limitations? Like, I imagine in the next coming, you know, days, weeks, months, we're gonna get more clarity on what this limited account actually means for the market.

Karen Webster 6:22

So the Kraken co-CEO called this a real convergence of crypto and traditional financial rails. So, what does this now do that wasn't possible before? What's the big unlock here?

Ryan Rugg 6:36

So, I'd be remiss not to mention this is huge news for the crypto industry. I mean, this is huge. This has been a long, long road. As I mentioned, five plus years ago when the speedy agreement was written, you know, there's been multiple, you know, public debates around this with other, you know, crypto companies. Like, this is the first, like Kraken is the first to get direct connectivity to the US payment system. So let's just pause for a second. Like the first exchange to get access, right, to the US payment system. This is changing how firms are going to move money, right? Removing all that reliance on intermediaries, improving on speed, fiat settlement. And really, I would say, for me, the way that I look at it, it's really tighter integration, right, between the digital asset infrastructure and the TradFi rails that like we have not seen, you know, as of like up until this point, where they've had to rely on really those intermediaries to be able to move money. So I think this is a huge move for, you know, I would say the industry, the crypto industry as a whole. What it means, you know, I think, you know, time will tell, to be honest, as we get more clarity on what this, you know, limited account means, how the how the supervision's gonna happen, how the operational, like, you know, the big thing that I've since I've been in this industry, as I continually mentioned for quite some time, is like same risk, same activity, same regulation, like that safety and soundness, we just have to make sure that still exists within our financial service industry, even with this new set of rails.

Karen Webster 8:07

So a couple of things come to mind based on what you just said. Um, is it the same risk, same services, same everything? It seems to me like this is this is quite different. And intermediaries play a role. So intermediaries have AML, KYC, they have fraud, they have a lot of things that are designed to do the very thing that you just talked about, which is protect the safety and soundness. Intermediaries gone. That assumes that this institution, their bank, now can do all of that at the same level or better than what an intermediary used to do for them. Is that fair to say?

Ryan Rugg 8:48

So I would say, like, under the, you know, original legislation around the speedy agreement, right? Like it's structurally different, right? It's not, it's not like a traditional bank. They cannot lend, they cannot pay interest on like customer balances, and they operate with extremely high reserve requirements. So I would say that they're under, like, I would say it's not structurally the same as a bank, but they are getting access to the Fed rails, right? So, you know, this is not accompanied by, you know, it has to be make sure that it has the same oversight regardless of the charter, to make sure, again, going back to that, you know, same activity, same risk, same regulation. And, you know, and the ask from, you know, I would say the industry is just like make sure that we're all on the same playing field, right? That we all have the same activity is regulated the same way, regardless of the type of entity that it's being accessed by. And like, you know, because again, that safety and soundness is so key, especially as we move into large enterprises, you know, we move trillions of dollars a day and like our clients trust us and rely on us for that. And we have to be able to ensure that regardless of what rails we are. And I, you know, that same and the supervision that we're under is, you know, is really important to kind of provide that safety. And I'm hoping that we kind of get that clarity over the next couple of days to weeks on like, what does this kind of mean with this limited purpose? What kind of obligatory oversight, reporting, governance, all the things you do see in the traditional banking system that kind of provides that, like I would say, stability.

Karen Webster 10:22

And how about consumer protection, right? There's no deposit insurance, and there's also no access, at least as it's been reported, to Fed emergency lending in the event that that is needed. So those are two big safety nets that traditional financial institutions have and can provide as a testament to safety soundness that doesn't exist with Kraken's new bank. So it's hard to know. You talk about a level playing field, it doesn't appear that there is a level playing field.

Ryan Rugg 10:57

Yeah, you mentioned like the master account is not FDIC insured, which is the understanding that I have as well. But again, speaking to colleagues in industry, they can apply potentially apply for it if they want to. But we also don't know the other limitations of the oversight the Fed you know has built into this account for, you know, is it state level supervision for BSA and AML compliance, right, for level two? Or is it going to be done by the federal level? So I think it really requires like a broader discussion on this and also understanding of exactly what is part of this limited purpose under kind of the tier three categorization of the Fed.

Karen Webster 11:39

Is this something that is um because the current administration and the regulatory environment is more crypto-friendly that we're seeing these kinds of things happen? And is, and if that's if the answer is yes, is there a risk that this is tied to an administration's policy and is therefore potentially short-lived?

Ryan Rugg 12:03

You know, I think from my perspective, and again, this doesn't feel like it's short by any stretch of the imagination. Like this has been in the works for, you know, five plus years. And I really think, you know, if this works, it really showcases the Fed's ability to balance innovation with safety through tailored risk-based-based access, you know. But there's still a lot of open questions around the operational, the balance sheet, the governance, how it's truly going to operate in this space. So I think that, you know, perhaps it's because of this administration, but I honestly also think it's been a broader discussion, you know, overall with the crypto industry for numerous years in this space. As mentioned, the speedy agreement came out five years ago. So Wyoming has proactively been trying to be like that hub for innovation for crypto accounts for quite some time. And there's been public debates in the market around, you know, what has been going on. So I think that this has been building over time, and there's been a massive amount of work that has been going on in the background that you and I have not seen well before this administration.

Karen Webster 13:08

What does this mean for the other um crypto entities that are in line? Do you expect that approval will accelerate? Um, you know, what about a ripple? What about a circle?

Ryan Rugg 13:21

What about a custodia at this point? So I think this to me like really signifies the Fed's willingness to grant access for these tier three crypto link institutions. You know, I do think that as I mentioned, like the Kraken's approval is as significant as a first, but I don't think it automatically opens a door for everyone, right? I think the Fed has been very clear, you know, it's a case-by-case, right? Evaluating each one. And Kraken's the first one to do, you know, to kind of make their way through the test case per se. But like, I don't know if it's gonna start like this massive wave or is the Fed gonna pause, analyze, put those safeguards in place. But, you know, really time's gonna tell as we kind of learn more about this uh account over time.

Karen Webster 14:07

I mean, I I guess there's also the question of the current limitations as set up by the Fed. And then what happens if clarity does in fact um successfully pass, you know, as codified regulation legislation, and as we get through the rulemaking with um with genius, there has to be some tension there and a lot perhaps a lot of unanswered questions too, right?

Ryan Rugg 14:35

Yeah, and I so I think it's important also, like this is structurally, this approval was for only one year, right? It's limited purpose. It sits within like an evolving policy framework that you're talking about, right? Things are changing around legislation, regulation, what's going on there. So I think like this, you know, one year approval for one year gives them that flexibility to, you know, kind of analyze and change as more legislation comes down, as more regulation comes down, you know, maybe potentially future administration on how like the standards are in this place. Um, so I think that, you know, yes, there's a massive amount of legislation and regulation going on in this space. And with this one-year approval, it really gives that optionality to kind of, you know, I would say mitigate the risk for like a long-term, you know, kind of substantial, you know, I'd say risk for a long-term standpoint.

Karen Webster 15:29

So, Ryan, what what is the talk around the banking water cooler? Um, as you know, you, your colleagues across the traditional financial institution space reflect on this. Does this does this threaten in any way, as many people have reported, even the banking associations have reported, the traditional structure, or is that just a knee-jerk reaction and perhaps a little bit over overplayed?

Ryan Rugg 15:58

So, I mean, we're working with several of these different fintechs and exchanges and you know, view it as a massive opportunity to partner with them and scale. You know, with City Token Service, you know, that we built the last like year, I think there's still a gap between the crypto and the trad fi world to have instantaneous settlement that we build building out for tokenized deposits. I still think in return in terms of like a pure competitive threat, like this is limited purpose and appears to be really restricted. Um, but and and operationally it's not scaled yet, right? So I guess, you know, time will tell and still a you know, a test story, you know, where it is in this. But I think that there's also opportunity for us, you know, to collaborate and work together as this kind of collectively grows and moves from, I would say, of a more retail type structure to more institutional.

Karen Webster 16:48

So, last question, because I know that some of this is very hypothetical, right? Because there are a lot of unknowns. There are things that are still being worked out, things that may be worked out, and we're just not aware of the resolution, et cetera. So let's say that after this one year period, things have gone smoothly, there are no problems or challenges, and there's been um clarity, no pun intended, around the rules of the road. Um, what does that do to change how the financial system works and looks like, let's say, in the next five years, in the next 10 years?

Ryan Rugg 17:28

So I think if this works, it showcases that the Fed can innovate with safety through a tailored risk-based access, which is which is huge. And you know, we want to be, you know, continuing to innovate. If it fails, I think it really depends on where the failure occurs. Like, is it a balance sheet failure or is it governance or is it operational? I think you know, there's multiple different types of like quote unquote failures that could happen and you know, what safeguards were put into place. So I think it's a matter of succeeding, huge win for to kind of be able to balance innovation with safety, soundness, and again, showing that new technology can like really rethink the way that we move value across the globe, you know, and again, making sure that we mitigate those, you know, potential for areas for failure, I think is critical, you know, similar to what we do within the traditional systems to make sure, again, that you know, that consumer protection, that safety and soundness for institutions, you know, remains the backbone of our financial industry as a whole.

Karen Webster 18:35

So I said it was the last question, but I didn't really mean that. You're like, I have one more. I have one more. No, I'm I'm thinking as I'm listening to you talk, I'm thinking about so what are the systemic failures that uh threaten this? And and do the and do the regulators, since this is so new, um, even though it's been five years in the making, uh, are the regulators um prepared to evaluate this very different entity in a way that doesn't um I don't want to say overlook, because that's that's not fair, but doesn't anticipate some of the things that may happen, even given the limited scope that uh that is apparently part of this approval.

Ryan Rugg 19:25

So I think that there's you know some safeguards built into our financial system that will, you know, help mitigate some of this. So let's say, for instance, it's an operational fail, you know, payment flows, you know, Fedwire is designed, right? So if that one participant fails, settlement stops at the participant, right? By requiring like pre-funded settlement balances. So this exposure should be limited, you know, because of that kind of account structure. Um, it appears to be like within the kind of constraints of the you know, settlement functions. But, you know, there's so many different potential areas that we could see and it's still evolving and we're still learning about the nuances of it and like also the volumes, right? Like what are, you know, how much volume is going to actually be going through the master account and how many of the settlements are gonna be there. So I think that there's still early days, but you know, massive, massive win for Kraken. So I think that, you know, we'll see over the next year. We'll evaluate. Hopefully, you and I'll be back, you know, the end in a couple months to talk about, you know, kind of what we're seeing here. Is it getting traction? Have we gotten more clarity on it? What it means for others, what it means for institutions, right? What does it mean for like the massive, like, you know, like enterprises, corporates out there now that, you know. So I think there's a lot to be kind of, you know, told discovered over the next year in this space.

Karen Webster 20:48

It's gonna be interesting. And yes, we're gonna talk a lot more about it, but that was my last question, Ryan. Because are you sure? I'm pretty sure now. I'm pretty sure that that was the last one. But I do want you to keep in mind the the myth myth mythical character, sea creature, because I think that's a really interesting analogy. I'm just gonna leave it at that. That's my last word. Ryan, always fun to talk to you. Thanks so much for the time on this important news. Bye now. Sounds good. Bye. Bye.

Narrator 21:19

That's it for this episode of the Payments Podcast, the thinking behind the doing. Conversations with the leaders transforming payments, commerce, and the digital economy. Be sure to follow us on Spotify and Apple Podcasts. You can also catch every episode at payments.com forward slash podcasts. Thanks for listening.