Shadow Banking And Cryptocurrencies

What Is Shadow Banking And Cryptocurrencies?

Shadow banking and cryptocurrencies refer to an arrangement whereby the financial institutions offer crypto banking services, while operating outside the regulatory environment. These banks work in the shadows of traditional regulated financial banks and are not identified or monitored. However, not all shadow banking activities are illegal.

Examples of shadow banks' activities include lending, hedge funds, insurance services, offering financial derivatives, etc. Market participants accept shadow banking due to the benefits it provides. Due to the anonymity associated with cryptocurrency markets, shadow banking poses a high risk to borrowers and investors. As a result, tracing and monitoring the flow of funds in cryptocurrency-based shadow banking activities becomes challenging.

• Shadow banking and cryptocurrencies can be defined as the mechanism of banks offering financial services to crypto users and holders without facing scrutiny and regulation from the government.
• These banks offer regular banking services but have a high tolerance and allow certain financial activities that would not be possible with traditional, regulated banks.
• Shadow Bank's clients are individuals attracted to the many benefits it can offer. But this exposes the banks and clients to higher risk and potential losses.

Shadow Banking And Cryptocurrencies Explained

Shadow banking and cryptocurrencies are increasingly popular concepts. Shadow banking initially existed in legacy finance, as those lenders and investment companies managed to stay off the radar. Their basic activities resembled traditional banks' activities, such as lending, investment services, etc. But they had no one to control or monitor their activities.

The absence of regulation meant they could bend the rules, if not break them. By turning the principles, they could acquire and retain more customers. Cryptocurrencies offer anonymity, i.e., individuals' real identities cannot be recovered quickly. This and shadow banking allow investors and borrowers to use the system.

While there are benefits, the banks and customers are equally exposed to a higher risk. Therefore, shadow banking is a high-risk, high-reward activity. The system allows investors to store assets without disclosing them to the government. It lets them borrow without physical collateral. While a few illegal activities are associated with shadow banking, it need not always be the case. 

Due to the high risk and nature of unregulated activities that allow some to profit at the expense of others, governments worldwide are trying to make some sense of shadow banking in cryptocurrencies. The process is tedious and demands a lot of investment, effort, and time.

Examples

Here are a few examples of shadow banks and cryptocurrencies.

Example #1

Kane is a crypto investor who borrowed a large sum from a shadow bank. Initially, he got high returns, but his investments started underperforming two months later. Kane incurred losses and defaulted on his payments to the bank. Six months later, the bank seized his crypto assets, which were his collateral.

Example #2

Crypto skeptic Molly White said in the annual Southwest Festival, Texas, that the crypto industry would have a tough time without banks such as Silicon Valley, Signature, and Silvergate. These banks had recently collapsed owing to a choice of bad investments and lending. Few regulated, traditional banks offer services to the crypto industry. Now, it will become more difficult due to the lending risk and shortage of banks. Therefore, the industry will mostly resort to shadow banks.

Benefits

Shadow banking in cryptocurrencies has become prominent due to its benefits for investors, borrowers, and banks. So, let's see what exactly attracts individuals.

1. Unregulated – The mere fact that shadow banks in cryptocurrency networks cannot be regulated easily paves the way for people to do otherwise monitored and controlled activities. For instance, it helps people maintain assets outside their accounts.
2. Profits – Shadow banks provide higher returns for their customers. These banks also offer higher leverage, so investors only need to take a little money out of their pockets. 
3. More options – Shadow cryptocurrency banks offer their investors many trading options not usually available in traditional investing. For instance, traditional banks will not accept crypto assets as collateral, but shadow banks will. 
4. Credit facilities – Borrowers need not borrow loans from traditional banks, subject to stringent norms and constant monitoring by the government. Shadow banks will offer loans with digital collateral and less strict requirements.
5. Speed – Shadow banks have faster processing times. These banks are efficient in acquiring and retaining their clientele. Due to their online presence, they can be highly quicker and more responsive.
6. Lower cost – This is a distinct advantage of shadow banks, which charge less for banking activities that use cryptocurrencies. However, other activities which cannot be quickly done through traditional banks will attract higher interest and fees.

Risks

The higher degree of risk in shadow banking and cryptocurrencies is why users should be demotivated from resorting to them.

1. Fraud – No scrutiny allows scammers and fraudsters to attract individuals with higher returns and appealing offers. Once the client has invested a sufficient amount, they disappear. The anonymity offered by cryptocurrencies will only make this worse.
2. Risky practices – Shadow banks promise high returns and profits. They also lend money when there is sufficient risk. It leads to the borrowers and lenders both being exposed to a higher risk that could have been avoided in the first place.
3. Insufficient protection – Due to lack of regulation and scrutiny, the borrower and lenders will face greater risk and still not receive any protection. They will not be able to recover the losses.
4. Instability – Unregulated practices done with each individual's self-interest lead to crypto market instability. The risk and losses further increase, and there is no authority to control the situation.

Frequently Asked Questions (FAQs)

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