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A flurry of activity on Jan. 27 signaled the Federal Reserve’s continued skepticism toward cryptocurrency-related activity in general and open, public, or decentralized networks in particular.
- The Board of Governors of the Federal Reserve System (Board) has issued a Policy Statement on Section 9(13) of the Federal Reserve Act (Policy Statement) which ties the Federal Reserve’s approach to crypto assets by state member banks to the Office of the Comptroller of the Currency (OCC) approach for domestic banks.
- The board announced that it has denied an application for Federal Reserve System membership by Custodia Bank (Custodia), a Wyoming special depository institution.
- The Federal Reserve Bank of Kansas City (Kansas City Fed) has denied Custody’s request for a primary account.
- The Board and the Kansas City Fed jointly filed a motion to dismiss Custody’s lawsuit in the US District Court for the District of Wyoming regarding its application for a primary account.
The political statement:
The policy statement is designed to prevent regulatory arbitrage by leveling the playing field for all federally controlled banks, insured and uninsured state member banks of the Federal Deposit Insurance Corporation (FDIC), and national banks alike. It does this by establishing a rebuttable presumption that activities conducted in a principal capacity that are ineligible for domestic banks or state-insured banks are equally ineligible for all state member banks (SMEs), including FDIC-uninsured SMEs. Presumption can be overcome by clear and convincing logic. The Policy Statement explains that “[t]The Council generally believes that the same banking business, which presents the same risks, should be subject to the same regulatory framework” and “equal treatment helps create a level playing field between banks with different statutes and different federal supervisors”. :
- Reliance on Section 9(13) of the Federal Reserve Act. Under Article 9(13), the council “may restrict the activities” of SMEs with respect to state law. Section 9(13) is similar to and directly references Section 24 of the Federal Deposit Insurance Act, which prohibits state-insured banks from engaging in principals in activities not permitted by domestic banks unless approved by the FDIC.
- Required adherence to the OCC terms, conditions and limits. To determine eligibility, the Council refers to the federal statutes, OCC regulations, and OCC interpretations applicable to domestic banks. The terms, conditions and restrictions imposed on domestic banks by the OCC for a given activity would apply to SMEs to the same extent.
- FDIC clearance must be standard. The FDIC rules are sufficient to authorize the activity of SMEs. The FDIC’s authorization for a particular bank to carry on a business, however, would require Board approval for other SMEs to carry on the same business.
- Application to cryptocurrency related business. The council says it has not identified the authority for national banks to hold most cryptocurrencies as capital. Therefore such activities are presumptively ineligible even for SMEs. To hold stablecoins for payment activity, an SME would be required to notify the Federal Reserve and receive a written non-objection similar to the requirements imposed by OCC on domestic banks. The requirement for a written no-objection represents a departure from previous Federal Reserve guidelines, which required only prior notification. The policy statement also says it does not affect any pre-existing authority banking organizations might have to provide custodial or custody services.
- Risks from open, public or decentralized networks. The Council notes in the policy statement that “[t]The Council generally believes that the issuance of tokens over open, public and/or decentralized networks or similar systems is very likely to be inconsistent with sound and secure banking practices” due to operational and cyber risks. The Council notes a serious risk of illicit finance if a bank cannot correctly identify parties to a transaction, including parties using non-hosted wallets, because “tokens could circulate continuously, rapidly, pseudonymously and indefinitely between parties unknown to the issuing bank.”
Actions taken against the Custody:
The Federal Reserve has put its words into practice and revealed that the Board and the Kansas City Fed, respectively, have denied Custody’s requests for Federal Reserve System membership and a main account. Custody is an uninsured special purpose depository institution established under Wyoming law to conduct cryptographic business. In its application announcement, the Board cites the joint statement previously released by federal banking agencies to support the search for “significant security and soundness risks” from “new and untested cryptographic assets that include the issuance of an open, public crypto asset and/or decentralized networks.” The Council also underlines the risk management framework of Custody, which was deemed insufficient. The ordinance of the Board specifying the reasons will be soon published.
The decision to deny the Kansas City Fed’s application for a master account came in a motion to dismiss as moot Custody’s lawsuit against the Board and the Kansas City Fed for unnecessarily delaying a decision on its master account application. master account. Custody filed the lawsuit in June 2022 to compel a decision on its master account application and cited the membership application — which, if successful, would involve Federal Reserve oversight — as evidence of adequate risk management. Having decided on both questions, the defendants are now requesting that the case be dismissed as moot.
Key remarks:
- De-risk: These latest actions support the prediction in our previous client advisory, Prudential Regulators Issue New Guidance on Crypto-Assets, that federal banking agencies have reached a consensus that crypto-related activities should not be permitted in the financial system regulated. This will likely help further de-risk all cryptocurrency-related activities by traditional banking organizations. To survive the wave of de-risking and be well positioned for future cryptocurrency-related opportunities, traditional and non-traditional financial organizations must be prepared to invest in highly rigorous and effective risk management programs and demonstrate to regulators that such programs address their concerns.
- Strengthen the regulatory perimeter: The announcement of the Policy Statement and actions against Custody on the same day, following the joint supervisory guidance issued on January 3, would seem to send a clear signal to the traditional finance and cryptocurrency sector that the regulators have arrived to the idea that crypto-asset businesses are best kept outside the regulatory perimeter. In the absence of new legislation, regulators are committed to using all of their currently existing authority to ensure that this goal is achieved.
- Implications for bank holding companies or non-bank affiliates: Since section 9(13) is applicable to SMEs, it does not apply directly to bank holding companies or non-bank affiliates. The policy statement, therefore, may not end demands on the Federal Reserve to conduct cryptocurrency-related business as a principal. It could simply shift the source of interest to the bank holding company or non-bank affiliate. Whether the Federal Reserve will publicly adopt new interpretations by its other regulators to address the potential activities of bank holding companies and non-bank affiliates remains to be seen.
- The importance of state regulation: The continued absence of a federal regulatory framework for the cryptocurrency industry means that states will continue to lead in regulating cryptocurrencies. The New York Department of Financial Services continues to build a regulatory framework for cryptocurrency-related activities, as explained in our recent advisory, New York Department of Financial Services Virtual Currency Custody Guide.
Note
1.Mot. of Def. Powered. Reserve Bank of Kansas City and Fed. Reserve B. Governors to Reject Compl. as Moot, Custody Bank, Inc. v. Fed. Book Bd. of Governors, No. 22-CV-125-SWS, 2022 WL 16901942 (D. Wyo. Jan. 27, 2023).
The content of this article is intended to provide general guidance on the subject. Specialist advice should be sought regarding the specific circumstances.
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