State Banks’ Crypto Plans Face Hurdles After New Fed Policy

The Federal Reserve is sending a clearer message to state banks on crypto — Go easy.

State banks under its oversight should limit their crypto involvement largely to custody services, and avoid issuing asset-pegged stablecoins or holding crypto as principal, the Fed said in its Jan. 27 policy statement. Bank of New York Mellon Corp. already offers crypto safekeeping for institutional clients, and State Street Corp. is planning to offer similar custody services.

Given the crypto market meltdown, the policy seems like an inevitable follow-through. But the central bank’s moves highlight the Biden administration’s increased skepticism and concerns about some state banks’ continued and bold dabbling in cryptocurrencies, and states’ efforts to regulate it.

The policy statement, along with other federal government actions, intimates a wall of regulators’ opposition for banks if they proceed with ambitious crypto expansions.

“It seems that they’re very skeptical about crypto-first, or crypto-primarily, business plans,” said Julie Hill, a professor at the University of Alabama School of Law.

‘Presumptive’ No

The Fed issued its policy as it declined Custodia Bank’s application to be a member of the Federal Reserve system. The Federal Reserve Bank of Kansas City also denied Custodia’s application for a master account.

The moves denied the Cheyenne, Wyoming-based bank access to the Fed’s payment system and other services.

Custodia is one of several state banks that have plans to expand aggressively into crypto business lines. Industry observers saw its application as a litmus test on the Fed’s appetite for letting crypto-focused banks into the federal banking system.

One of the biggest issues addressed in the policy statement was whether issuing stablecoins—which are a type of blockchain-based cryptocurrency pegged to a traditional currency, gold or other assets—is a safe and sound banking activity. The Fed also heavily weighed whether state bank charters are sufficient in guarding against crypto risks.

The central bank’s answer to both of those questions was no.

It left a bit of room for stablecoin-related activities. The Fed said that the issuance of stablecoins is not considered safe and sound banking activities. That would indicate the Fed doesn’t want to see state banks under its oversight to issue them.

But the Fed also said that it would review banks’ documentation if they get approval from the Office of the Comptroller of the Currency or the Federal Deposit Insurance Corp. for stablecoin, or other crypto, activities.

The Fed will review those applications with a skeptical eye, said Michael Reed, a Covington & Burling LLP partner.

“It’s presumptively no until you prove to us yes,” Reed said of the Fed’s position.

The Fed’s policy statement urges depository institutions under its oversight to avoid issuing stablecoins, but the warning doesn’t apply to the bank holding companies that house some of those banking units, said Todd Phillips of Phillips Policy Consulting LLC, a financial regulatory consulting firm, and a former FDIC official.

A bank holding company could conceivably attempt to issue a stablecoin through a subsidiary separate from its bank. Bipartisan stablecoin legislation introduced last year in the House encouraged such caution with provisions that would allow bank holding company subsidiaries to issue stablecoins.

The cautious position is in line with the Biden administration.

“It seems as though the concern among the banking regulators is shared across the executive branch,” said Kristin Lee, a Morgan Lewis & Bockius LLP partner.

Indeed, on the same day that the Fed issued its policy statement, the White House’s National Economic Council released its own “roadmap” for lowering crypto risks. It included a plea to lawmakers to avoid writing new laws that could deepen “ties between cryptocurrencies and the broader financial system.”

Federal Supremacy

The Fed also sought to put its policy statement in a position to essentially supersede state regulation.

The Fed said that any state bank that’s a Fed member seeking to engage in crypto activities must first make sure that the proposed business complies with federal laws and regulations put out by the FDIC and OCC. Complying only with state rules and oversight wouldn’t cut it for the Fed.

“The Federal Reserve does not want to encourage a ‘race to the bottom’ among states trying to create bespoke regulatory regimes for crypto firms,” said Hilary Allen, a professor at American University Washington College of Law and a leading crypto skeptic.

According to the Fed, requiring approval of crypto activities at the federal level promotes a “level playing field” for all the banks it oversees.

Given the recent spectacular collapses at FTX and other cryptocurrency exchanges and regulatory pressure, it’s unlikely that many banks are interested in doing more than providing crypto custody services now, Hill said.

But setting up these barriers may make it harder for regulators to police the industry in the future, said Matt Homer, a venture capitalist who advises crypto firms.

“These actions are adding explicit fuel to the creation of a shadow banking system,” Homer, the former head of innovation at the New York Department of Financial Services, which was the first state regulator to issue a crypto charter, said.

But keeping crypto out of the system may be the Fed’s ultimate goal, given that the central bank and other regulators have touted the banking system’s strength in the face of the crypto meltdown.

“They seem to think that they’re going to be able to completely insulate banks from all of this, and that seems to suggest that they think they can divide off crypto from the rest of the financial system,” Hill said.