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Fed examines ramifications of U.S. central bank digital currency
On January 20, the Federal Reserve Board published a discussion paper, Money and Payments: The U.S. Dollar in the Age of Digital Transformation, which calls for public comments on questions related to the possibility of a U.S. central bank digital currency, or CBDC. “The introduction of a CBDC would represent a highly significant innovation in American money,” the Fed said, although the agency noted that it “does not intend to proceed with issuance of a CBDC without clear support from the executive branch and from Congress, ideally in the form of a specific authorizing law.” The paper examines the pros and cons of a potential CBDC and outlines a series of potential benefits, including faster payment options between countries. Among the various CBDC structures the Fed is considering is an intermediated model through which the private sector would facilitate the management of CBDC holdings and payments through accounts or digital wallets. Potential intermediaries could include commercial banks and regulated nonbank financial service providers. Such a model “would facilitate the use of the private sector’s existing privacy and identity-management frameworks; leverage the private sector’s ability to innovate; and reduce the prospects for destabilizing disruptions to the well-functioning U.S. financial system,” the Fed said. Additionally, a potential CBDC would also need to be readily transferable between customers of different intermediaries and must be designed to comply with rules regulating money laundering and the financing of terrorism (including the identification of persons accessing CBDC).
While a CBDC could improve cross-border payments and increase financial inclusion, the Fed warned that a CBDC may also yield potential negative effects, including affecting monetary policy implementation and interest rate control, as well as illicit finance controls and operational resilience. Consumer privacy could also be a concern, the Fed stated, noting that “any CBDC would need to strike an appropriate balance between safeguarding consumer privacy rights and affording the transparency necessary to deter criminal activity,” as the infrastructure of a CBDC could create opportunities for hackers since it would “potentially have more entry points than existing payment services.” The CBDC model under consideration would have intermediaries leverage exiting tools to address privacy concerns.
Feedback on the paper will be received through May 20.
OCC’s Hsu discusses bank cryptocurrency regulation
On January 13, acting Comptroller of the Currency Michael J. Hsu spoke before the British American Business Transatlantic Finance Forum’s Executive Roundtable to discuss stablecoins and other crypto-assets regulations. In his remarks, Hsu described stablecoins as “the oxygen of the crypto ecosystem,” noting that they help link cryptocurrencies to fiat currencies. Hsu noted that crypto has “gone mainstream,” providing the example that “[s]ixteen percent of U.S. adults say that they have owned, traded or used some form of cryptocurrency.” In discussing the underbanked and minorities interested in crypto, Hsu quoted a survey finding that “37 percent of the underbanked indicated that they own cryptocurrency, compared to 10 percent of the fully banked.” Hsu argued that banking regulations are designed to mitigate run risks for stablecoins, stating that “[s]tablecoin issuers subject to bank regulation would give holders of those stablecoins confidence that those coins were as reliable and ‘money good’ as bank deposits,” and that “[s]trong, targeted federal regulation of money and banking can help establish a solid foundation for the economy enabling healthy innovation and growth.” While Hsu expressed his excitement for “the pace of innovation in crypto,” he warned that “a careful approach is warranted,” as a result of the “lack of standards and controls in the crypto space.” Hsu also expressed that “bank regulation would give credibility to the ‘stable’ part of stablecoins,” and stressed the need for a coordinated and collaborative regulatory approach “with regards to large crypto intermediaries, which are increasingly operating globally and across a wide range of activities.”
FSOC highlights potential risks in 2021 annual report
On December 17, the Financial Stability Oversight Council (FSOC) released its annual report highlighting significant financial market and regulatory developments, potential financial risks, and recommendations for promoting U.S. financial stability. The report focused on several recommendations that FSOC member agencies should take to mitigate systemic risk and ensure financial stability.
- Climate-related Financial Risk. FSOC advised financial regulators to “promote consistent, comparable, and decision-useful disclosures that allow investors and financial institutions to take climate-related financial risks into account in their investment and lending decisions.” Taking these steps, FSOC noted, will enable financial regulators to promote resilience within the financial-sector and help support an orderly, economy-wide transition to net-zero emissions. FSOC also recognized the importance of incorporating climate-related risks into risk management practices and supervisory expectations for regulated entities. The same day, acting Comptroller of the Currency Michael J. Hsu issued a statement supporting FSOC’s new Climate-Related Financial Risk Committee, which was announced in October (covered by InfoBytes here). “The CFRC will play an important role in identifying priority areas for assessing and mitigating climate-related risks to the financial system, coordinating information sharing, aiding in the development of common approaches and standards, and facilitating communication across FSOC members and interested parties. Addressing climate-related risks to the financial system requires the collaboration of multiple parties and partnerships, using many strategies and mechanisms.”
- Digital Assets. FSOC recommended that federal and state regulators continue to examine financial risks posed by emerging uses of digital assets and coordinate efforts to address potential issues arising in this space. FSOC advised member agencies to consider the recommendations in the President’s Working Group on Financial Markets’ “Report on Stablecoins” (covered by InfoBytes here), which was published in coordination with the FDIC and the OCC.
- LIBOR Transition. FSOC commended the Alternative Reference Rates Committee’s efforts to facilitate an orderly transition from LIBOR to alternative reference rates, and advised member agencies to “determine whether regulatory relief is necessary to encourage market participants to address legacy LIBOR portfolios.” Additionally, member agencies should “continue to use their supervisory authority to understand the status of regulated entities’ transition from LIBOR, including their legacy LIBOR exposure and plans to address that exposure.”
- Cybersecurity. FSOC advised federal and state agencies to “continue to monitor cybersecurity risks and conduct cybersecurity examinations of financial institutions and financial infrastructures to ensure, among other things, robust and comprehensive cybersecurity monitoring, especially in light of new risks posed by the pandemic, ransomware incidents, and supply chain attacks.”
While noting that financial conditions have normalized since spring 2020, FSOC noted that “risks to U.S. financial stability today are elevated compared to before the pandemic” and that “the outlook for global growth is characterized by elevated uncertainty, with the potential for continued volatility and unevenness of growth across countries and sectors.”
Freddie says cryptocurrency can’t be used for mortgage qualification
On December 1, Freddie Mac released Bulletin 2021-36 to Freddie Mac sellers to provide guidance on selling updates. The bulletin provides guidance on, among other things: (i) 2022 conforming loan limits; (ii) extension of the guarantee fee obligation; (iii) affordable lending; (iv) credit underwriting; and (v) document custody. In order to address uncertainty regarding the treatment of cryptocurrency in mortgage underwriting, the bulletin specifically addresses requirements related to cryptocurrency’s use in the mortgage qualification process. These requirements include, among other things, that income paid to the borrower in cryptocurrency cannot be utilized to qualify for a mortgage and that “[c]ryptocurrency may not be included in the calculation of assets as a basis for repayment of [the] obligation.” Unless otherwise noted, the changes issues in the bulletin are effective immediately.
OCC gives guidance on cryptocurrency, trust bank chartering
On November 23, the OCC issued Interpretive Letter 1179, which clarified and expanded on prior interpretive letters concerning bank engagements in cryptocurrency activities. Interpretive Letter 1179 also addressed the OCC’s authority to charter national trust banks. According to the OCC, national banks and federal savings associations may engage in certain cryptocurrency activities discussed in Interpretive Letters 1170, 1172, and 1174, provided a bank is able to “demonstrate, to the satisfaction of its supervisory office, that it has controls in place to conduct the activity in a safe and sound manner.” Legally permissible activities include those pertaining to (i) cryptocurrency custody services; (ii) the holding of dollar deposits to serve as “reserves backing stablecoin in certain circumstances”; (iii) acting “as nodes on an independent node verification network” to verify customer payments; and (iv) bank engagements with distributed ledger technology to facilitate payment transactions for certain stablecoin activities. A bank intending to engage in such activities must first notify its supervisory office and should not engage in any activity until it receives permission. Supervisory offices must assess whether a bank’s risk management systems and controls are sufficiently adequate for engagement in such activities. “Today’s letter reaffirms the primacy of safety and soundness. Providing this clarity will help ensure that these cryptocurrency, distributed ledger, and stablecoin activities will be conducted by national banks and federal savings associations in a safe and sound manner,” acting Comptroller Michael Hsu stated in an agency press release. “Because many of these technologies and products present novel risks, banks must be able to demonstrate that they have appropriate risk management systems and controls in place to conduct them safely. This will provide assurance that crypto-asset activities taking place inside of the federal regulatory perimeter are being conducted responsibly.”
The Interpretive Letter also addressed OCC standards for chartering national bank trusts, as previously discussed in Interpretive Letter 1176. The OCC reiterated that it “retains discretion to determine if an applicant’s activities that are considered trust or fiduciary activities under state law are considered trust or fiduciary activities for purposes of applicable federal law.” The OCC further emphasized that the OCC’s chartering authority does not expand or modify current responsibilities under 12. C.F.R. Part 9 for national banks that have already been granted fiduciary powers, and that “national banks currently conducting activities in a non-fiduciary capacity that are not subject to Part 9 have not, and will not, become subject to 12 C.F.R. Part 9 because of the letter.”
Agencies discuss crypto-asset next steps
On November 23, the FDIC, OCC, and Federal Reserve Board issued a joint statement summarizing a recent series of interagency “policy sprints” focused on crypto-assets. During the policy sprints, the agencies conducted preliminary analysis on issues related to banking organizations’ potential involvement in crypto-asset-related activities, and identified and assessed key risks related to safety and soundness, consumer protection and compliance. The agencies also, among other things, analyzed the applicability of existing regulations and guidance on this space and identified several areas where additional public clarity is needed. Throughout 2022, the agencies intend to provide greater clarity on whether certain crypto-asset-related activities conducted by banking organizations are legally permissible. The agencies also plan to expand upon their safety and soundness expectations related to: (i) crypto-asset safekeeping and traditional custody services; (ii) ancillary custody services; (iii) facilitation of customer purchases and the sale of crypto-assets; (iv) loans collateralized by crypto-assets; (v) issuance and distribution of “stablecoins”; and (vi) activities involving a bank’s holding of crypto-assets on its balance sheet. The joint statement, which does not alter any current regulations, also states that the agencies plan to “evaluate the application of bank capital and liquidity standards to crypto-assets for activities involving U.S. banking organizations” and that the agencies will continue to monitor developments in this space as the market evolves.
OCC calls for modernization of financial regulatory perimeter as fintechs/crypto firms increase
On November 16, acting Comptroller of the Currency Michael J. Hsu told attendees at the Federal Reserve Bank of Philadelphia’s Fifth Annual Fintech Conference that the federal banking agencies are “approaching crypto activities very carefully and with a high degree of caution” and “expect banks to do the same.” Hsu pointed out what while changes to the financial regulatory perimeter generally occur as a response to crises and failures, regulatory agencies need to take proactive modernization measures given the astounding growth and expansion of fintechs and cryptocurrencies. Hsu highlighted several important questions that agencies must consider, including whether fintech and crypto firms will start to function like banks and whether bringing them into the bank regulatory perimeter would be the proper solution. He also stated that regulatory agencies must consider whether the risks faced by banks and fintech/crypto firms are the same and, subsequently, whether agencies need to modernize or maintain their status quo. Hsu focused on two specific areas of concern: (i) synthetic banking, or fintechs, operating outside the bank regulatory perimeter but that offer a range of services, including extending various forms of credit and offering interest on cash held in accounts (emphasizing the importance of fintech-bank partnerships); and (ii) the fragmented supervision of universal crypto firms, where Hsu asserted that gaps in supervision are driven by the fact that crypto firms are not subject to comprehensive consolidated supervision.
Hsu announced that the agencies will soon issue a statement conveying results from a recent interagency “crypto sprint,” and that the OCC will also provide clarity on its recently concluded review of crypto-related interpretive letters. Hsu explained that “safety and soundness is paramount” when banks engage in crypto activities and that the agencies’ clarifications “should not be interpreted as a green light or a solid red light, but rather as reflective of a disciplined, deliberative, and diligent approach to a novel and risky area.”
DFPI addresses several MTA licensing exemptions
Recently, the California Department of Financial Protection and Innovation (DFPI) released several new opinion letters covering aspects of the California Money Transmission Act (MTA) related to virtual currency and agent of payee rules. Highlights from the redacted letters include:
- Cryptocurrency and Agent of Payee Exemption. The redacted opinion letter reviewed whether MTA licensure is required for a company’s proposal to offer payment processing services that would enable merchants to receive payments in U.S. dollars from buyers of goods and services, automatically exchange these payments into dollar-denominated tokens on a blockchain network, and to store the tokens in a custodial digital wallet. DFPI currently does not require licensure for companies to receive U.S. dollars from a buyer for transfer to a merchant’s wallet as dollar tokens. DFPI explained that even if it did regulate this activity, the structure of the company’s payment processing services satisfies the requirements of the agent-of-payee exemption, wherein the company acts as the agent of the merchant pursuant to a preexisting written contract and the company’s receipt of payment satisfies the buyer’s obligation to the merchant for goods or services. DFPI further explained that while storing dollar tokens in a custodial digital wallet or making subsequent transfers out of a wallet do not currently require licensure under the MTA, DFPI may later determine the activities are subject to regulatory supervision.
- Asset-Backed Tokens and Other Cryptocurrency. The redacted opinion letter asked DFPI whether an MTA license is required to (i) provide technical services to enable owners of metal to create digital assets representing interests in that metal; (ii) facilitate trading in these digital assets; or (iii) provide digital wallets to customers. The company intends to create a platform to facilitate the creation, sale, and trading of metal asset-backed tokens, whereby a customer purchases metal asset-backed tokens (ABTs) or currency tokens using fiat currency stored in an FBO account. Customers will not be allowed to transmit fiat currency to each other except to facilitate the purchase of ABTs or currency tokens, to receive proceeds from ABTs, or to pay platform fees. DFPI explained that while issuing stored value is generally considered money transmission, “[p]roviding technical services to assist in the creation of a [m]etal ABT and [i]ndustrial [t]okens and issuing a digital wallet holding the [m]etal ABT does not require licensure.” DFPI noted that the company is not itself issuing the ABT or industrial tokens. DFPI further concluded that the company does not need an MTA license to issue a digital wallet holding metal ATBs because the digital wallet is not stored value nor can the wallet’s contents be redeemed for money or monetary value or be used as payment for goods or services. DFPI separately indicated that a license is not currently required to facilitate the sale of ABTs, nor the issuance and sale of currency tokens. However, DFPI warned the company that the opinion only pertains to MTA, and that the company should be aware that metal ABTs and industrial tokens “could be considered a commodity and California Corporations Code section 29520 generally prohibits the sale of a commodity, unless an exception applies.”
- Cryptocurrency-to-Precious Metals Dealer. The redacted opinion letter reviewed whether an online cryptocurrency-to-precious metals dealer, which accepts a variety of different cryptocurrencies in exchange for precious metals and also purchases precious metals from customers using different cryptocurrencies, requires MTA licensure. The company referenced a 2016 decision where DFPI determined that a company operating a software technology platform to facilitate the purchase and sale of gold was not engaged in money transmission, that gold and other precious metals were not payment instruments, that the transactions did not represent selling or issuing stored value, and that “the activity did not constitute receiving money for transmission because the sale or repurchase of gold was a bargained-for-exchange and did not involve transmission to a third party.” The company argued that purchasing and selling precious metals with cryptocurrency is similar and should not trigger MTA’s licensing requirement. DFPI agreed that the company’s business activities do not meet the definition of money transmission because precious metals are not payment instruments, and as such, purchasing and selling precious metals for cryptocurrency does not represent the sale or issuance of a payment instrument. Additionally, DFPI concluded that the company is not selling or issuing stored value, nor do the transactions “involve the receipt of money or monetary value for transmission within or outside the U.S.”
- Virtual Currency Wallet. The redacted opinion letter asked whether an MTA license is required to operate a platform that will provide customers with an account to store and transfer virtual currencies. The company will also provide customers access to an exchange where they can facilitate the purchase or sale of virtual currencies in exchange for other virtual currencies. Fiat currency will not be used on the platform. DFPI stated that it does not currently require companies to obtain an MTA license to operate a platform that provides customers with an account to store and transfer virtual currencies. DFPI further stated that a license is not required to operate a platform that gives customers access to an exchange to purchase or sell virtual currencies in exchange for other virtual currencies.
- Purchase of Cryptocurrency. The redacted opinion letter examined whether a company that offers clients a direct opportunity to buy cryptocurrency in exchange for fiat currency requires MTA licensure. The company explained, among other things, that there is no transmission of cryptocurrency to third parties and that it does not offer money transmission services. DFPI concluded that because the company’s activities are limited to directly selling cryptocurrency to clients, it “does not require an MTA license because it does not involve the sale or issuance of a payment instrument, the sale or issuance of stored value, or receiving money for transmission.”
DFPI reminded the companies that its determinations are limited to the presented facts and circumstances and that any change could lead to different conclusions. Moreover, the letters do not relieve the companies from any FinCEN or federal regulatory obligations.
FATF updates virtual assets and service provider guidance
On October 28, the Financial Action Task Force (FATF) updated pre-existing guidance on its risk-based approach to virtual assets (VAs) and virtual asset service providers (VASPs). The updated guidance revises guidance originally released in 2019. According to FATF standards, countries are required to “assess and mitigate their risks associated with virtual asset financial activities and providers; license or register providers and subject them to supervision or monitoring by competent national authorities.” The guidance includes updates on certain key areas, such as: (i) expanding the definitions of VAs and VASPs; (ii) applying FAFT standards to stablecoins; (iii) adding guidance regarding the risks and the tools available to countries for the purpose of addressing money laundering and terrorist financing risks for peer-to-peer transactions; (iv) revising VASP licensing and registration guidance; (v) adding guidance for the public and private sectors on the implementation of the “travel rule”; and (vi) adding a section for principles of information-sharing and co-operation amongst VASP Supervisors. FATF also noted that the “guidance addresses the areas identified in the FATF’s 12-Month Review of the Revised FATF Standards on virtual assets and VASPs requiring further clarification and also reflects input from a public consultation in March - April 2021.”
OCC says synthetic banking providers require supervision
On November 3, acting Comptroller of the Currency Michael J. Hsu spoke before the American Fintech Council’s Fintech Policy Summit 2021 and warned that “[t]he rebundling of banking services by fintechs and the fragmented supervision of universal crypto firms pose significant medium- to long-term risks to consumers, businesses, and financial stability.” Hsu also noted that large “universal” cryptocurrency firms interested in offering a wide range of financial services should “embrace comprehensive, consolidated supervision” like that given to banks. “Crypto firms today are regulated at most only partially and selectively, with no single regulator having a comprehensive view of the firm as a whole,” Hsu stated, adding “[t]his warrants greater attention as crypto firms, especially the universals, get bigger, engage in a wider range of activities and risk-taking, and deepen their interconnectedness within the crypto ecosystem and with traditional finance.” Warning that these “synthetic banking providers” (SBPs) could create a “run risk” and regulatory arbitrage, Hsu stressed the importance of removing “the disparity between the rights and obligations of banks and the rights and obligations of synthetic banking providers by holding SBPs to banking standards.” He further warned that customers’ needs must be met in a way that is reliable, consistently safe, sound, and fair, and discussed several reasons why more SBPs have not sought to become banks, including that “regulators have been unpredictable with regards to chartering new banks and approving fintech acquisitions of banks.” Establishing a clear, shared approach to the bank regulatory perimeter related to emerging technologies can address this challenge, he advised.
Hsu also announced that the OCC concluded its review of recent bank charter applications and cryptocurrency-related interpretive letters and stated that the agency will communicate its determinations and feedback to bank charter applicants in the coming weeks. Findings from a “crypto sprint” done in conjunction with the FDIC and Federal Reserve will also be communicated shortly. “The content of these communications—on the chartering decisions, interpretive letters, and the crypto sprint—will be broadly aligned with the vision for the bank regulatory perimeter laid out here today,” Hsu stated.