by Michael Held, Tiffany J. Smith, Franca Harris Gutierrez, Cory C. Hansen, and Andy V. Reynolds

(photos courtesy of WilmerHale) From left to right: Michael Held, Tiffany J. Smith, Franca Harris Gutierrez, Cory C. Hansen, and Andy V. Reynolds

A flurry of activity on January 27 signaled continued skepticism from the Federal Reserve of crypto-asset-related activities generally and open, public or decentralized networks in particular.

• The Board of Governors of the Federal Reserve System (Board) issued a Policy Statement on Section 9(13) of the Federal Reserve Act (Policy Statement) that ties the Federal Reserve’s approach to crypto activities by state member banks to the approach by the Office of the Comptroller of the Currency (OCC) for national banks.
• The Board announced that it had denied the application of Custodia Bank (Custodia), a Wyoming special purpose depository institution, for membership in the Federal Reserve System.
• The Federal Reserve Bank of Kansas City (Kansas City Fed) denied Custodia’s application for a master account.
• The Board and the Kansas City Fed jointly filed a motion to dismiss Custodia’s lawsuit in the US District Court for the District of Wyoming regarding its application for a master account.[1]

The Policy Statement

The Policy Statement is designed to prevent regulatory arbitrage by leveling the playing field for all federally supervised banks, Federal Deposit Insurance Corporation (FDIC) insured and uninsured state member banks and national banks alike. It does so by establishing a rebuttable presumption that activities conducted as principal that are impermissible for national banks or insured state banks are similarly impermissible for all state member banks (SMBs)—including SMBs without FDIC insurance. The presumption may be overcome by a clear and compelling rationale. The Policy Statement explains that “[t]he Board generally believes that the same bank activity, presenting the same risks, should be subject to the same regulatory framework” and “equal treatment helps to level the competitive playing field among banks with different charters and different federal supervisors.” Additional key takeaways include:

• Reliance on Section 9(13) of the Federal Reserve Act. Under Section 9(13), the Board “may limit the activities” of SMBs as compared with state law. Section 9(13) is similar to and directly references Section 24 of the Federal Deposit Insurance Act, which prohibits insured state banks from engaging as principal in activities not permitted for national banks unless approved by the FDIC.
• Required adherence to OCC terms, conditions and limits. To determine permissibility, the Board points to federal statutes, OCC regulations and OCC interpretations applicable to national banks. Terms, conditions and limitations placed on national banks by the OCC for a given activity would be applicable to SMBs to the same extent.
• FDIC authorization must be by rule. FDIC rules are sufficient to authorize SMB activity. FDIC permission for a particular bank to conduct an activity, however, would require Board approval for other SMBs to conduct the same activity.
• Application to crypto-asset-related activities. The Board states that it did not identify authority for national banks to hold most crypto-assets as principal. Therefore such activities are also presumptively impermissible for SMBs. To hold stablecoins for payment activity, an SMB would be required to notify the Federal Reserve and receive a written non-objection similar to the requirements imposed by OCC on national banks. The requirement of a written non-objection represents a departure from previous Federal Reserve guidance, which only required prenotification. The Policy Statement also states that it does not affect any preexisting authority that banking organizations may have to provide safekeeping or custodial services.
• Risks from open, public or decentralized networks. The Board notes in the Policy Statement that “[t]he Board generally believes that issuing tokens on open, public, and/or decentralized networks, or similar systems is highly likely to be inconsistent with safe and sound banking practices” due to operational and cyber risks. The Board notes acute illicit finance risk if a bank cannot properly identify the parties to a transaction, including parties using unhosted wallets, because “tokens could circulate continuously, quickly, pseudonymously, and indefinitely among parties unknown to the issuing bank.”

Actions taken with respect to Custodia

The Federal Reserve put words into practice and disclosed that the Board and the Kansas City Fed, respectively, denied the applications of Custodia to obtain membership in the Federal Reserve System and a master account. Custodia is an uninsured special purpose depository institution chartered under Wyoming law to conduct crypto activities. In the announcement about the membership application, the Board cites the previously issued joint statement by the federal banking agencies to support finding “significant safety and soundness risks” from the “novel and untested crypto activities that include issuing a crypto asset on open, public and/or decentralized networks.” The Board also points to Custodia’s risk management framework, which was deemed insufficient. The Board’s order setting out details on its rationale is forthcoming.

The decision to deny the application for a master account by the Kansas City Fed came to light in a motion to dismiss as moot the lawsuit by Custodia against both the Board and the Kansas City Fed for unnecessarily delaying a decision on its master account application. Custodia filed the lawsuit in June 2022 to compel a decision on its master account application and cited the application for membership—which would result in supervision by the Federal Reserve if granted—as evidence of appropriate risk management. Having decided both applications, the defendants now seek dismissal of the lawsuit as moot.

Key observations:

• De-risking: These latest actions support the prediction in our previous client alert, Prudential Regulators Issue New Guidance on Crypto-Assets, that the federal banking agencies have reached a consensus that crypto-related activities should not be allowed into the regulated financial system. This will likely contribute to further de-risking of all crypto-related activities by traditional banking organizations. To survive the wave of de-risking and be well positioned for crypto-related opportunities in the future, both traditional and nontraditional 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.
• Fortifying the regulatory perimeter: The announcement of the Policy Statement and the actions with respect to Custodia on the same day, following the joint supervisory guidance issued on January 3, would appear to send a clear signal to traditional finance and the crypto-asset sector that the regulators have come to the view that crypto-asset activities are better kept outside the regulatory perimeter. In the absence of new legislation, the regulators are committed to using all their currently existing authority to ensure that this objective is met.
• Implications for bank holding companies or nonbank affiliates: As Section 9(13) is applicable to SMBs, it does not directly apply to bank holding companies or nonbank affiliates. The Policy Statement, therefore, might not end inquiries to the Federal Reserve about conducting crypto-asset-related activities as principal. It might merely shift the source of interest to the bank holding company or nonbank affiliate. It remains to be seen whether the Federal Reserve will publicly adopt new interpretations of its other authorities to address potential activities by bank holding companies and nonbank affiliates.
• The importance of state regulation: The continued absence of a federal regulatory framework for the crypto sector means that states will continue to lead with respect to crypto regulation. The New York Department of Financial Services continues to build a regulatory framework for crypto-asset-related activities as explained in our recent alert, New York Department of Financial Services Issues Virtual Currency Custody Guidance.

Footnotes

[1] Joint Mot. of Defs. Fed. Reserve Bank of Kansas City and Fed. Reserve B. of Governors to Dismiss the Compl. as Moot, Custodia Bank, Inc. v. Fed. Reserve Bd. of Governors, No. 22-CV-125-SWS, 2022 WL 16901942 (D. Wyo. Jan. 27, 2023).

Michael Held, Tiffany J. Smith, and Franca Harris Gutierrez are partners Cory C. Hansen is a senior associate, and Andy V. Reynolds is an associate at Wilmer Cutler Pickering Hale and Dorr LLP.  This post first appeared on the firm’s blog.

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