The industry needs access, but US regulators keep digital assets in check

Crypto cannot become what many of its advocates want it to be without banks, but US regulators circle the wagons around the banking system they oversee. That barrier is only getting bigger as the Federal Reserve and other agencies turn away crypto firms that try to plug into the traditional financial system.

Several recent regulatory actions – including the Federal Reserve Board’s (FRB) decision in January to reject crypto-focused Custodia Bank’s application for membership – indicate that federal regulators are coordinating policies aimed at demarcating crypto from the broader US banking system, experts say.

The FRB’s rejection of Custodia’s membership application came hours after the Biden administration released a statement urging Congress to “step up its efforts” to regulate the crypto industry and, when crafting new legislation, avoid “greenlighting regular institutions … for diving headlong into cryptocurrency markets” ,” which the statement warned would be a “serious mistake” that “deepens the ties between cryptocurrencies and the broader financial system.”

Shortly after Custodia’s membership application was rejected, the Federal Reserve Bank of Kansas City dealt another blow to the crypto bank, rejecting its long-pending application for a main account.

Less than two weeks after Custodia’s double rejection and the White House’s warning against crypto contagion, fresh rumors about several crypto banks have begun to circulate.

On Wednesday, Fortune reported that the Office of the Comptroller of the Currency – the independent wing of the Treasury Department that oversees the national banking industry – is rumored to be poised to reject two crypto companies’ applications for a national trust bank charter.

Paxos and Protego both received conditional approval to convert to a nationally chartered trust bank in early 2021, but the final status of their applications has hung in the balance for longer than the 18-month deadline allowed.

Both institutions told Fortune that the rumors were false, and a source with knowledge of Paxos also confirmed with CoinDesk that Paxos had not been asked by the OCC to withdraw its application, nor had its application been denied. But over the weekend, Paxos announced that it would stop offering the Binance USD stablecoin at the direction of the New York Department of Financial Services.

Crypto lobbyists and industry leaders spent years trying to sell the benefits and credibility of digital assets and blockchain technology to US lawmakers and regulators. Then 2022 rolled around.

“A lot of that is out the window, and it’s very frustrating,” said Georgia Quinn, general counsel for Anchorage Digital, which has bristled over the U.S. regulators’ latest maneuvers. “I am very disheartened by all the recent statements and positions.”

Still, she said she hopes crypto-focused banking can find its place.

“I want more regulated institutions, not less,” she said. “You don’t address risks by pretending they don’t exist.”

In order to achieve a future of widespread, mainstream adoption of crypto’s innovations, the industry must connect with regulated US banking. This is how people come off the sidelines and adopt digital tokens, virtual properties and smart contracts as part of their daily financial lives, when their trusted financial institutions can interact directly with all the new products.

But 2022 was a poisoned pill that could knock digital assets down for a long time. A general reaction by US regulators to step back from 2022’s chaos of giant hacks, bad ideas, laundered money, manipulated prices and gross fraud is becoming politics.

Inertia is a powerful thing in Washington, DC When momentum builds in one direction, it tends to continue. Stopping it and reversing it can take a massive effort.

Mick Mulvaney, a former acting White House chief of staff under former President Donald Trump, has watched as the federal government stiffens its crypto opposition following the FTX crypto exchange failure in November. But he believes that the federal position is not yet calcified, and that the most important answer may ultimately come from lawmakers on Capitol Hill, where he used to be a congressman.

“I don’t think it’s set in stone,” Mulvaney, who now advises Swiss crypto startup Astra Protocol, said in an interview. “There’s a lively debate on the Hill right now.”

Whether the administration’s momentum will be controlled by any legislation that takes into account crypto-innovations, he said, “But the gut feeling is that Congress will win.”

So far, however, regulators have had the first say.

“Agencies have been quite open about the fact that they are coordinating and working together on crypto and digital asset issues,” said Grant Butler, a Boston-based partner at law firm K&L Gates.

“There is a lot of caution and skepticism from banking regulators around cryptocurrency and the exposure to it in the financial system,” Butler added.

Regulators, Butler said, want to avoid crypto-focused banks with different charters or different primary regulators, making it harder to consistently track them and spot potential problems.

“Banking regulators have long been wary of allowing non-traditional activities into the banking system because it introduces risk, and that risk is ultimately borne by the public when things go south,” Chris Odinet, a professor of commercial law at the University of Iowa College of Law, told CoinDesk.

And that risk, as Joseph Lynack, a Washington, DC-based partner at Dorsey & Whitney, pointed out, could be enormous.

“Considering that the crypto industry lost roughly $2 trillion in a few months last year, the federal agencies are right to take a slow approach — or at least it’s understandable,” Lynack said. “Can you imagine what would happen to the banking system if the banks lost a similar amount of capital in such a short time?”

The White House and regulators have come together on crypto in a way rarely seen outside of a financial crisis. President Joe Biden started it with an order issued last March. After that, the Ministry of Finance and the banking agencies went largely in the same direction.

The high-profile collapse of FTX gave new energy, and some rethinking of the government’s stance. On January 3, the Fed, the OCC and the Federal Deposit Insurance Corp. (FDIC) issued a joint statement warning banks about the risks of working with crypto companies. On January 27, the Biden administration warned against the possibility of crypto contagion, egging on regulators.

That same day, the Fed announced a new policy that effectively insisted that any firm seeking access to the Fed system (think: Custodia) must face the same crypto restrictions as any other bank — including a formal sign-off from their federal regulator. time they want to engage in activity with digital assets. That policy went into effect on February 7.

Banks that have been closely allied with the crypto sector have begun to distance themselves as their US watchdogs made it clear that they would see crypto as a danger. Moonstone Bank, in which Sam Bankman-Fried’s trading firm Alameda Research had a stake, said it is pulling back from crypto and returning to its old community bank identity. And Signature Bank said it is limiting crypto-linked deposits, which represent about a quarter of its business.

“I think the Biden administration was not super enthusiastic about private crypto before [FTX]”, said Julie Hill, a professor of banking and business law at the University of Alabama School of Law. “But I think the FTX collapse has made them even more worried.”

In addition to the concerns raised by FTX’s implosion in November, Hill suggested that part of the Federal Reserve’s decision to reject Custodia’s membership application may be related to its plans to issue a stablecoin. Paxos, one of the companies rumored to be facing its own rejection by the OCC, also has its own stablecoin. Stablecoins are cryptocurrencies whose value is linked to the value of another currency, commodity or financial instrument.

When the US regulators first weighed in on stablecoins, they argued that future policy should insist that issuers either be banks or be regulated as a bank. They have changed that tune and are now suggesting that issuing stablecoins could risk an institution’s safety and soundness.

“It seems like [the FRB is] very concerned about the Custodia plan to issue a stablecoin. It seemed like that was part of the motivation behind their decision not to let them be a member, Hill said. “I think other crypto-first companies hoping to issue stablecoins should be nervous.”

However, Butler does not see much truth in theories that Custodia’s rejection was due to fears that its stablecoin would compete with a future digital central bank currency (CBDC).

“I don’t think that’s what this is,” Butler said. “I don’t think regulators are comfortable with [stablecoins] or with the banks that wish to issue them. There is a degree of discomfort there. But I don’t think so [the rejection] run by competition with a digital coin from the central bank. I think it’s a broader risk concern.”

Several figures in the crypto industry, including investor Nic Carter, have made compelling comparisons between the current crackdown on crypto banking and Operation Choke Point.

Choke Point was a secretive initiative of the Department of Justice (DOJ) during Barack Obama’s presidency. Federal officials improperly pressured banks to close the accounts of legitimate businesses such as gun and ammunition dealers and moneylenders.

Butler said he could see why people would make comparisons, but he doesn’t think the current crypto bank is as bad as Choke Point.

“Obviously a couple of people have gotten into trouble, but [regulators] don’t say, ‘Hey, you can’t beat these customers, they are verbotenButler said. “They’re definitely trying to avert that … but I think it’s a little bit of a difference, and a different kind of substantiation of the actions than there was in the Operation Choke Point situation.”

Banking experts told CoinDesk that they don’t see regulators trying to cut crypto out of the banking system entirely. Instead, they believe regulators are trying to drive crypto against established banking institutions that are already heavily regulated.

– The banks must be able to offer traditional custody services and safekeeping services. Admittedly, they have to meet a very, very high standard of safety and soundness around it [but] use a bank for custody [crypto] doesn’t seem out of the question,” Butler said.

However, Butler expects that the ability to use a bank charter as a run-off from fiat to digital currencies will be reduced until there is more regulatory clarity.

“I think [the current crackdown] is probably going to affect the ability to get banking, but I think there are going to be people out there to service the industry,” Butler said. “As far as doing it through a bank or being a new bank doing this — no, I think it’s going to be pushed out of the banking sector.”

While being pushed out of the banking industry isn’t exactly a death knell for crypto, it could pose a significant obstacle to crypto moving into the mainstream.

“Regulators’ stiff-arming is a problem for crypto because being tied to banks will lend legitimacy to crypto in the minds of ordinary Americans,” said Ian Katz, a banking policy expert at Capital Alpha.

“Perhaps if the crypto world stabilizes, over time regulators will become more willing to allow crypto into the heavily regulated banks,” Katz added. “But for now, it seems like regulators want to put a wall between crypto and banks. And that’s likely to contribute to the feeling among many consumers that crypto is too risky or niche for them to get involved in.”