Custodia Bank was denied Federal Reserve membership, while certain crypto principal activities are deemed presumptively not appropriate for member banks.

On January 27, 2023, the Board of Governors of the Federal Reserve System (Federal Reserve) took two actions, clarifying that it considers many cryptocurrency activities to be inconsistent with the business of banking. First, the Federal Reserve announced that it had denied the application of Custodia Bank, Inc. (Custodia) to become a member of the Federal Reserve System. Second, using its authority under Section 9(13) of the Federal Reserve Act, it issued a policy statement (Policy Statement) whose purpose was to “level the playing field” for state and national banks with respect to “novel activities.”

With these actions, and the current cautious attitude toward cryptocurrency at the Office of the Comptroller of the Currency (OCC), state banking supervisors will likely be the ones advancing new developments in crypto activities.

Denial of Custodia Federal Reserve Membership

Under the Federal Reserve Act, all national banks — including uninsured national trust banks like Anchorage Digital — automatically become members of the Federal Reserve System. State banks and trust companies, by contrast, must apply. Custodia is a Wyoming-chartered “SPDI,” a special purpose depository institution uninsured by the Federal Deposit Insurance Corporation (FDIC).

Under Section 9(4) of the Federal Reserve Act, in determining whether to accept a state institution for membership, the Federal Reserve must “consider the financial condition of the applying bank, the general character of its management, and whether or not the corporate powers exercised are consistent with the purposes of th[e] [Federal Reserve Act].”

Although the Federal Reserve did not release its actual order on January 27, 2023, its press release stated that Custodia’s “application as submitted [was] inconsistent with” the foregoing factors. The press release noted that Custodia “proposed to engage in novel and untested crypto activities that include issuing a crypto asset on open, public and/or decentralized networks. [This] novel business model and proposed focus on crypto assets presented significant safety and soundness risks. The [Federal Reserve] has previously made clear that such crypto activities are highly likely to be inconsistent with safe and sound banking practices. The [Federal Reserve] also found that Custodia’s risk management framework was insufficient to address concerns regarding the heightened risks associated with its proposed crypto activities, including its ability to mitigate money laundering and terrorism financing risks.”

Policy Statement Limiting the Activities of State Member Banks

The Federal Reserve has the authority under Section 9(13) of the Federal Reserve Act to “limit the activities of state member banks and subsidiaries of state member banks in a manner consistent with section 24 of the Federal Deposit Insurance Act.” Section 24 states that an FDIC-insured state bank may not engage as a principal in any activity that is not permissible for a national bank, unless the FDIC determines that the activity would not pose a significant risk to the Deposit Insurance Fund and the insured state bank is, and continues to be, in compliance with applicable capital standards prescribed by the appropriate federal banking agency.

While the FDIC implemented Section 24 by issuing a regulation subject to notice-and-comment, the Federal Reserve proceeded by policy statement rather than by seeking to amend its Regulation H, which implements the Federal Reserve Act.

The Policy Statement governs “novel activities” that both FDIC-insured state member banks and non-insured state institutions (that may be admitted to Federal Reserve membership) may propose. A state member bank must first consult federal statutes, OCC regulations, and OCC interpretations to determine whether national banks are permitted to undertake the activity. If none of the sources authorizes the activity, then state member banks must investigate whether federal statute or part 362 of the FDIC’s regulations gives state banks permission to engage in the activity. If no authority for a state bank exists, a state member bank may not engage in the activity unless it has received the Federal Reserve’s permission under Section 208.3(d)(2) of Regulation H. Under that provision, a state member bank may not, without Federal Reserve permission, change the general character of its business or the scope of the corporate powers it exercised at the time of its admission to membership.

The Federal Reserve stated in the Policy Statement that it will “rebuttably presume that a state member bank is prohibited from engaging as principal in any activity that is impermissible for national banks, unless the activity is permissible for state banks under federal statute or part 362 of the FDIC’s regulations.” It will also require a clear and compelling rationale, and robust plans for managing attendant risks, before allowing the proposed deviation in treatment.

The Federal Reserve also reiterated that legal permissibility is a necessary, but not sufficient, condition: a state member bank must always conduct its business and exercise its powers safely and soundly. With respect to any novel and unprecedented activities, such as those associated with crypto assets or use of distributed ledger technology, the Federal Reserve stated that the bank must use appropriate systems to monitor and control risks.

Holding Crypto Assets as Principal

At the end of the Policy Statement, the Federal Reserve discussed how its approach to novel activities applied to several crypto activities:

1. Holding crypto assets as a principal: The Federal Reserve stated that it “had not identified any authority permitting national banks to hold most crypto assets, including bitcoin and ether, as principal in any amount, and there is no federal statute or rule expressly permitting state banks to hold crypto assets as principal.” Therefore, the Federal Reserve would presumptively prohibit state member banks from engaging in such activity under Section 9(13), a presumption it believed that safety and soundness concerns bolstered.
2. Issuing dollar tokens: The Federal Reserve stated that the OCC had permitted national banks to issue dollar tokens to facilitate payments. A state member bank seeking to issue a dollar token would need to adhere to all the conditions the OCC has placed on national banks with respect to such activity, including demonstrating that the bank uses controls to conduct the activity in a safe and sound manner, and receiving a supervisory nonobjection before commencing such activity. The Federal Reserve reiterated its view that issuing tokens on open, public, and/or decentralized networks raised significant concerns related to operational, cybersecurity, and run risks, and significant illicit finance risks.
3. Providing safekeeping for crypto assets in a custodial capacity: The Federal Reserve did, however, acknowledge that providing such safekeeping was not presumptively prohibited. Member banks could conduct safekeeping as long as it was done so in a safe and sound manner and in compliance with consumer, anti-money-laundering, and anti-terrorist-financing laws.

Takeaways

The Federal Reserve’s two actions guarantee that, in the absence of new legislation, state banking supervisors will advance most future crypto developments at banking institutions (as opposed to nonbank affiliates) under licenses and charters such as New York’s BitLicense and nondepository trust company charter. Such licenses and charters generally hold neither FDIC insurance nor access to the Federal Reserve System and its payment system. It is not surprising, therefore, that supervisors like the New York Department of Financial Services (NYDFS) continue to develop their regulatory guidance for crypto firms. For further information on NYDFS’ efforts, see this Latham blog post and this post.