During the week of August 15, 2022, the Federal Reserve Board (“FRB”) included digital assets (or, as it refers to them, “crypto-assets”) in various internal and external notices, possibly signaling to the industry the emergence of a coordinated stance. While none of these communications alone provide much clarity, taken together we can begin to hear the FRB’s message: proceed, but with the utmost caution.

August 15 – FRB Guidelines for approving reserve bank accounts

On August 15th, the FRB approved internal guidelines for individual Federal Reserve Banks to use when evaluating reserve bank account requests. This was particularly notable to the crypto-asset industry because of the inclusion of entities with “novel charters,” presumably indicating Wyoming-chartered Special Purpose Depository Institutions (SPDI’s) and New York State-chartered Limited Purpose Trust Companies (LPTC’s).

Designed to “ensure that Reserve Banks apply a transparent and consistent set of factors” when reviewing requests (p. 17), this guidance set forth six principles to consider when granting a master account request. Those include:

  1. The legal eligibility of the institution seeking access;
  2. Whether the request presents undue credit, operational, settlement, or cybersecurity risks to the Reserve Bank;
  3. Whether the request presents an undue risk to the credit, liquidity, operational, settlement, cybersecurity, or other risk to the payments system;
  4. Whether providing the account would present an undue risk to the stability of the U.S. financial system;
  5. Whether providing the account would create an undue risk of money laundering and other illicit activity; and
  6. Whether providing an account would adversely affect the FRB’s ability to implement monetary policy.

Several of these prongs appear to grant Reserve Banks wide latitude to deny requests based on public policy or monetary policy grounds. In a publication this January on the “U.S. Dollar in the Age of Digital Transformation,” the FRB noted (p. 12) that certain crypto-assets, especially stablecoins, present the possibility of “destabilizing runs, disruptions in the payment system, and concentration of economic power.” This means, in theory, that the application of a banking institution that issues stablecoins, or one that custodies the assets backing those stablecoins, could be denied solely based on that activity.

At the same time, it appears the FRB has considered the possibility of granting accounts to institutions engaged in these businesses. That is, the FRB set forth three categories, or tiers, of applicants, with guidance on how applications from each should be reviewed. Tier 1 consists of federally-insured institutions that are relatively low-risk; the process for reviewing Tier 1 institutions is relatively straightforward. Therefore, the process for their approval has been streamlined. Tier 2 consists of banks that are not federally insured, but are supervised prudentially by a federal banking agency. These are entities for which the FRB already has a great deal of information, and generally pose a lower risk; accordingly, their applications will receive a medium level of scrutiny.

Tier 3 entities, on the other hand, consist of institutions that are eligible for a master account, but are not federally insured and are not prudentially supervised by a federal banking agency. The FRB notes that, as these institutions are subject to a different supervisory and regulatory framework, the potential that these are higher risk institutions means that their applications will receive a higher level of scrutiny. This includes entities with “novel charters,” such as SPDI’s and LPTC’s.

Throughout its discussion, the FRB notes that these entities pose novel challenges from a regulatory standpoint, but in response to one comment it also stated that it is not “appropriate to categorically exclude all novel charters from access to accounts and services.” While expressing its concern with the risks associated with the crypto-asset industry, the FRB also seems to be allowing for the possibility that future banks chartered as crypto-banks could be welcomed into the traditional financial system.

August 16 – Guidance on steps regulated banks should take when considering crypto-related businesses

The following day, the FRB issued a supervisory letter, which set forth areas of diligence that a regulated banking institution should conduct prior to engaging in business related to crypto-assets. Noting the potential risks to financial stability and to consumers, the FRB highlighted four areas of additional scrutiny a banking institution should focus on:

  • Technology and operations
  • AML/CT
  • Consumer Protection and Legal Compliance
  • Financial Stability

The guidance also stated that entities considering participation in any of these activities, or partnering with institutions that do, should first contact their lead supervisory point of contact. Those already engaging in such activities should contact them promptly.

The Fed noted that, prior to engaging in these activities, all supervised banking organizations should implement adequate systems and controls designed to mitigate the risks specific to this industry. While it touched briefly on certain types of risks that should be considered, such as operational, financial, legal, and compliance risks, it also stated broadly that any and all other risks should be adequately considered. Theoretically, a regulated institution that adequately mitigates such risks could be approved to conduct such activities.

August 17 – Speech by Governor Bowman on Technology, Innovation, and Financial Services

One day later, FRB Governor Michelle Bowman delivered a speech at the VenCent Conference in Little Rock, Arkansas about the ways technology and innovation are changing the financial services industry. She noted that the FRB has recognized the demand from customers and banks alike to provide banking access to the crypto-asset industry.

Governor Bowman reiterated the FRB’s concerns surrounding the risks within the industry, but she also said that the FRB was working to articulate expectations for banks to custody crypto-assets, facilitate the purchase and sales of these assets, issue loans collateralized by crypto-assets, and issue and distribute stablecoins. She also highlighted the August 15 guidance and briefly discussed the emergence of novel bank charters related to crypto-assets.

What does this mean for banking institutions?

As Governor Bowman noted, one of the most important regulatory tools available to a regulator “is the ability to clearly articulate [their] supervisory expectations.” While one might read the Fed’s recent actions as merely placing more barriers to enter this industry, it might be more accurate to say that it is simply clarifying its existing expectations so institutions may begin meeting them.

This means that banking institutions looking to enter the crypto-asset industry should spend the additional time and resources needed to conduct and document thorough risk assessments, as well as to implement policies and procedures narrowly tailored to address these assessments. It means the FRB is looking for institutions to stay out of the crypto-asset industry until they are ready to provide a level of rigor and scrutiny that will allay some of their concerns. It may be that only the largest institutions will have the time and resources to navigate this process, but it is also possible that there are smaller innovative institutions that will be able to be granted first access, provided they are patient and thorough.