‘Backdoor ban’ against crypto banking? Regulatory statements raise concerns.

Federal regulators say banks are free to serve crypto firms, but some in the industry question how feasible that will be in light of recent guidance.

Federal Reserve, Federal Deposit Insurance Corp. and the Office of the Comptroller of the Currency have released two joint statements this year flagging risks associated with digital assets and setting standards for how to mitigate them.

The agencies have noted that the guidelines are not binding requirements, nor are they intended to steer banks away from crypto firms. Rather, they bill the statements as providing transparency in their evolving assessment of a nascent industry.

Still, some regulatory advocates and industry participants worry that the new statements could create a de facto regulatory framework that blocks crypto firms from the banking sector entirely.

Caitlin Long, founder and CEO of Cheyenne, Wyoming-based Custodia Bank, said the statements mean any attempt to engage with digital assets will be met with more scrutiny from bank examiners. Whether that makes it difficult – or impossible – for banks to take crypto-related deposits will come down to individual supervisory evaluations, all of which will be confidential.

“That’s the question, is this a backdoor ban on banking crypto, or is it [regulators’] overt statements that they don’t ban crypto banking or any other legal industry? We don’t know the answer to that,” Long said. No one knows where the railing is right now.

Guidelines do not change regulatory statutes, so agencies are not required to go through a formal outreach process for public comment — as is required for formal regulations. But because of the sweeping nature of some of the proposals, Long said, the agencies would be better served soliciting input from crypto industry participants more familiar with its underlying technology.

Specifically, she flagged part of one of the statements that warned of the risks of “open, public and/or decentralized networks,” descriptions that could apply not only to crypto networks, but also to widely used systems like the Hypertext Transfer Protocol, or HTTP, which serves as the backbone of the World Wide Web. Similar protocols are used for e-mail, voice over the Internet and other communication systems that convey information about the movement of funds.

“Every bank uses all of these,” Long said. “And yet the statement was drafted so broadly, so quickly and not put out for public comment, that if you take it literally, the banking regulators banned the banks from using the Internet.”

Custodia, which offers digital banking and crypto custody services to corporate clients, is suing the Fed for access to a so-called master account at the Federal Reserve Bank of Kansas City, which would give it access to the central bank’s payment system.

The agencies issued theirs first joint statement on 3 January, noting all the potential dangers that can arise from banks having direct exposure to crypto assets. They said holding such assets as principal, storing them or transferring them was “highly likely to be inconsistent with safe and sound banking practices.”

The 27th of January was The Fed released a separate policy statement that it will treat all the institutions it supervises – regardless of whether they have deposit insurance – equally when deciding whether they can engage in certain activities, including those linked to crypto-assets. The move was aimed at creating a “level playing field among banks engaged in the same activities” and limiting regulatory arbitrage.

Then last week, regulators again joined forces to urge banks to take additional precautions before taking on deposits from crypto-financed firms, noting the threat of runs on banks and other concerns. The statement did not introduce new risk management principles, but rather emphasized existing practices that banks should focus on.

During a press conference Tuesday on other matters, FDIC Chairman Martin Gruenberg said the joint statements were modeled on feedback the three agencies have given to the individual banks they supervise.

“We indicated that as we gain more experience with this case-by-case review, we might issue broader guidance, and that’s actually what we did,” Gruenberg said, adding that the agencies were working together to provide consistency and that further directives could be given. issued in the future.

Still, some in the room say explicit restrictions are unnecessary to curb bank involvement with crypto.

Gabriel Rosenberg, a partner at law firm Davis Polk and Wardell specializing in crypto and financial regulation, said the agencies’ latest joint statement is likely to have a chilling effect on banks taking on crypto deposits.

“What they’re saying in the statement and what they’ve said before is that this is not intended to discourage or encourage any particular bank from having relationships with any particular industry,” Rosenberg said. “But, banks already pay close attention to things like concentration risk, so it’s not clear to me why regulators would put out a joint statement other than to quietly push their investigators and banks away from banking crypto-related companies.”

Political statements have too renewed concern that regulators are trying to de-bank crypto platforms in a method similar to Operation Choke Point, a 2013 initiative in which the Justice Department, FDIC and OCC aimed to pressure banks to distance themselves from certain businesses, such as money lending, arms sales and pornography.

Isaac Boltansky, director of policy research at investment bank BTIG, said recent regulatory pronouncements may have the same impact as Choke Point – less bank engagement with a controversial industry – but they are executed in a much different way.

“First, we think it’s important to note that Operation Choke Point was actually covert, as the pressure was applied at the banking supervisory level. Second, since [the second half of last year] every single banking regulator has expressed concern about digital assets and issued guidelines raising the standard for compliance,” Boltansky wrote in an analyst note. “Banking regulatory actions over the past six months have made access to the financial system more difficult for crypto firms, but it’s important to emphasize that this has been done in the light of day and does not carry either the political or procedural baggage of Operation Choke Point.”

The statements come at a time when many banks are reassessing their exposure to crypto-backed firms in the wake of the collapse last year of FTX, the world’s second largest crypto exchange at the time. The company’s demise triggered the failure of other digital asset firms and led to losses at crypto-linked banks, such as San Diego-based Silvergatewho saw one outflow of 8 billion dollars in deposits in the fourth quarter of 2022.

A report by the FDIC’s Office of Inspector General released last week found that 136 insured custodians are either engaged in digital asset activities or plan to be. It is unclear how this number compares to interest before the FTX collapse, but there is a general feeling among market participants that appetite for crypto exposure has waned.

In that regard, some see the statements from regulators as a positive development for integrating crypto into the banking system.

Alison Hashmall, a banking, finance and fintech-focused lawyer with the firm Debevoise and Plimpton, said the latest joint statement provided useful clarity on how banks can serve crypto customers in a safe and sound manner.

“I always think it’s helpful for regulators to explain their expectations,” Hashmall said. “We didn’t have a lot of guidance before, just statements that these activities are risky and safety issues. This is more constructive. It gives a sense of a road map for how this activity can be carried out going forward. .”

Long said the focus on the risk of runs on deposits in the agencies’ latest statement was a victory for Wyoming’s special deposit institution charter, which prohibits banks from issuing loans with customer deposits to reduce risk.

“The 100% liquid business model was confirmed,” Long said. “It’s implicit in what the banking regulators are saying, that they don’t want the traditional banks that engage in US dollar services for the digital asset industry to do the traditional borrow-short-and-borrow-long strategy.”