Subscribe to our InfoBytes Blog weekly newsletter and other publications for news affecting the financial services industry.
On March 27, the California Department of Financial Protection and Innovation (DFPI) announced that a New Jersey-based crypto lending platform has agreed to provide more than $100,000 in refunds to California residents. The refunds, subject to bankruptcy court approval, stem from the lender’s conduct following the collapse of a major crypto exchange last November. As previously covered by InfoBytes, in December, DFPI moved to revoke the lender’s California Financing Law license following an examination, which found that the lender “failed to perform adequate underwriting when making loans and failed to consider borrowers’ ability to repay these loans, in violation of California’s financing laws and regulations.” At the time the lender announced it was limiting platform activity and pausing client withdrawals. The lender eventually filed a petition for chapter 11 bankruptcy. An investigation also revealed that due to the lender’s failure to timely notify borrowers that they could stop repaying their loans, borrowers remitted at least $103,471 in loan repayments to the lender’s servicer while they were unable to withdraw funds and collateral from the platform. A hearing on the lender’s petition to direct its servicer to return borrowers’ loan repayments is scheduled for April 19.
The lender agreed to an interim suspension of its lending license while the bankruptcy and revocation actions are pending. It also agreed to a final order to discontinue unsafe or injurious practices, as well as a desist and refrain order. Among other things, the lender has agreed to continue to direct its agents to pause collection of repayments on loans belonging to California residents while its license is suspended (including turning off autopay), will continue to set interest rates to 0 percent, and continue to not levy any late fees associated with any payments or report any loans that became delinquent or defaulted on or after November 11, 2022, to credit reporting agencies while the bankruptcy and revocation actions are pending.
On March 23, the Virginia governor signed HB 1727, which amends the Virginia code to allow credit unions operating in the commonwealth to engage in virtual currency custody services, provided the credit union “has adequate protocols in place to effectively manage risks and comply with applicable laws and, prior to offering virtual currency custody services, the credit union has carefully examined the risks in offering such services through a methodical self-assessment process.” The amendments stipulate that in order to engage in such services, a credit union must implement effective risk management systems and controls, confirm adequate insurance coverage, and maintain a service provider oversight program.
The amendments further provide that a credit union may offer such services in a fiduciary or nonfiduciary capacity; however, in order to provide virtual currency custody services in a fiduciary capacity, the credit union must first obtain approval from the State Corporation Commission. Commission approval is contingent upon a credit union having sufficient capital structure to support providing such services, credit union personnel being adequately trained to ensure compliance with governing laws and regulations, and that granting such authority is in the public interest. The amendments are effective July 1.
President Biden recently issued his sweeping economic report, in which the administration’s Council of Economic Advisers addressed numerous economic policy concerns, including the current crypto ecosystem and the perceived appeal of crypto assets. The report discussed claims made about the purported benefits of crypto assets, such as the decentralized custody and control of money, as well as the potential for “improving payment systems, increasing financial inclusion, and creating mechanisms for the distribution of intellectual property and financial value that bypass intermediaries that extract value from both the provider and recipient,” but argued that “[s]o far, crypto assets have brought none of these benefits.” The report countered that, in fact, “crypto assets to date do not appear to offer investments with any fundamental value, nor do they act as an effective alternative to fiat money, improve financial inclusion, or make payments more efficient; instead, their innovation has been mostly about creating artificial scarcity in order to support crypto assets’ prices—and many of them have no fundamental value.”
Arguing that these issues raise questions about the role of regulations in protecting consumers, investors, and the financial system on a whole, the report conceded that some of the potential benefits of crypto assets —including (i) serving as investment vehicles; (ii) offering money-like functions without having to rely on a single authority; (iii) enabling fast digital payments; (iv) improving the underbanked population’s access to financial services; and (v) improving the current financial technology infrastructure through distributed ledger technology—may be realized down the road. However, the report cautioned that “[m]any prominent technologists have noted that distributed ledgers are either not particularly novel or useful or they are being used in applications where existing alternatives are far superior.” Highlighting the risks and costs of crypto assets, the report asserted, among other things, that cryptocurrencies are not as effective as a medium of exchange and do not serve “as an effective alternative to the U.S. dollar” due to their use as both money and an investment vehicle.
On March 15, U.S. law enforcement, along with German criminal authorities, disabled a darknet cryptocurrency “mixing” service used to allegedly launder more than $3 billion in cryptocurrency underlying ransomware, darknet market activities, fraud, cryptocurrency heists, hacking schemes, and other activities. According to the DOJ’s announcement, law enforcement agencies seized two domains and back-end servers, as well as more than $46 million in cryptocurrency. The DOJ claimed the mixing service allowed criminals to obfuscate the source of stolen cryptocurrency by commingling users’ cryptocurrency in a way that made it difficult to trace the transactions. In conjunction with the action taken against the mixing service, a Vietnamese national responsible for creating and operating the online infrastructure was charged with money laundering, operating an unlicensed money transmitting business, and identity theft connected to the mixing service. Separate actions have also been taken by German law enforcement authorities, the DOJ said. “Criminals have long sought to launder the proceeds of their illegal activity through various means,” Special Agent in Charge Jacqueline Maguire of the FBI Philadelphia Field Office said in the announcement. “Technology has changed the game, though[.] In response, the FBI continues to evolve in the ways we ‘follow the money’ of illegal enterprise, employing all the tools and techniques at our disposal and drawing on our strong partnerships at home and around the globe.”
On March 9, the New York attorney general filed a petition in state court against a virtual currency trading platform (respondent) for allegedly failing to registeras a securities and commodities broker-dealer and falsely representing itself as a cryptocurrency exchange. The respondent’s website and mobile application enable investors to buy and sell cryptocurrency, including certain popular virtual currencies that are allegedly securities and commodities. The AG noted that this is one of the first times a regulator is making a claim in court that one of the largest cryptocurrencies available in the market is a security. According to the announcement, this cryptocurrency “is a speculative asset that relies on the efforts of third-party developers in order to provide profit to the holders.” As such, the respondent was required to register before selling the crypto assets, the AG said, further maintaining that the respondent also sells unregistered securities in the form of a lending and staking product. According to the AG, securities and commodities brokers are required to register with the state, which the respondent allegedly failed to do. Additionally, the respondent claimed to be an exchange but failed to appropriately register with the SEC as a national securities exchange or be designated by the CFTC as required under New York law. Nor did the respondent comply with a subpoena requesting additional information about its crypto-asset trading activities in the state, the AG said, noting that the respondent has already been found to be operating in multiple jurisdictions without proper licensure. The state seeks a court order (i) preventing the respondent from misrepresenting that it is an exchange; (ii) banning the respondent from operating in the state; and (iii) directing the respondent to undertake measures to prevent access to its mobile application, website, and services from within New York.
Last month the AG filed a similar petition against another virtual currency trading platform alleging similar violations (covered by InfoBytes here).
On March 14, Federal Reserve Governor Michelle W. Bowman presented thoughts on innovation trends within the U.S. financial system during a conference held by the Independent Community Bankers of America. Bowman commented that innovation has always been a priority for banks of all sizes and business models, and that regulators—often accused of “being hostile to innovation” within the regulated financial system—are continually trying to learn and adapt to new technologies, which often introduce new risks and vulnerabilities. In order to address these challenges, which are often amplified for community banks, Bowman said banks must be prepared to make improvements to risk management, cybersecurity, and consumer compliance measures, and regulators—playing a complementary role—must ensure rules are clear and transparent. She further stressed that “[i]t is absolutely critical that innovation not distract banks and regulators from the traditional risks that are omnipresent in the business of banking, particularly credit, liquidity, concentration, and interest rate risk.” Noting that these types of risks are present in all bank business models, Bowman said they “can be especially acute for banks engaging in novel activities or exposed to new markets, including crypto-assets.”
Explaining that transparency is important for promoting a safe, sound, and fair banking system, particularly when it comes to innovation, Bowman stated that insufficient clarity or transparency or disproportionately burdensome regulations may “cause new products and services to migrate to the shadow banking system.” Bowman went on to discuss ways bank regulation and supervision can support responsible innovation, and highlighted unique challenges facing smaller banks, as well as key actions taken by regulators to date relating to crypto assets, third-party risk management, cybersecurity, Community Reinvestment Act reform, bank mergers, and overdraft fees, among others.
On February 22, the U.S. District Court for the Southern District of New York partially granted a cryptocurrency exchange’s motion to dismiss allegations that its inadequate security practices allowed unauthorized users to drain customers’ cryptocurrency savings. Plaintiffs claimed the exchange and its former CEO (collectively, “defendants”) failed to correctly implement a two-factor authentication system for their accounts and misrepresented the scope of the exchange’s security protocols and responsiveness. Plaintiffs filed a putative class action alleging violations of the EFTA and New York General Business Law, along with claims of negligence, negligent misrepresentation, breach of contract, breach of warranty, and unjust enrichment. The defendants moved to dismiss, in part, by arguing that the EFTA claim failed because cryptocurrency does not constitute “funds” under the statute. The court denied the motion as to the plaintiffs’ EFTA claim, stating that the EFTA does not define the term “funds.” According to the court, the ordinary meaning of “cryptocurrency” is “a digital form of liquid, monetary assets” that can be used to pay for things or “used as a medium of exchange that is subsequently converted to currency to pay for things.” In allowing the claim to proceed, the court referred to a final rule issued by the CFPB in 2016, in which the agency, according to the court’s opinion, “expressly stated that it was taking no position with respect to the application of existing statutes, like the EFTA, to virtual currencies and services.” In the final rule, the Bureau stated that it “continues to analyze the nature of products or services tied to virtual currencies.” The court dismissed all of the remaining claims, citing various pleading deficiencies, and finding, among other things, that the “deceptive acts or practices” claim under New York law failed because plaintiffs did not identify specific deceptive statements the defendants made or deceptive omissions for which the defendants were responsible.
On March 6, acting Comptroller of the Currency Michael J. Hsu commented that the collapse of a major cryptocurrency exchange has underscored a need for consolidated supervision of global cryptocurrency firms. Speaking before the Institute for International Banker’s Annual Washington Conference, Hsu offered thoughts on how to build and maintain trust in global banking. “To be trustworthy, global crypto firms need a lead regulator who has authority and responsibility over the enterprise as a whole,” Hsu said. “Until that is done, crypto firms with subsidiaries and operations in multiple jurisdictions will be able to arbitrage local regulations and potentially play shell games using inter-affiliate transactions to obfuscate and mask their true risk profile.” Hsu pointed out that in order to conduct business in the U.S. foreign banks must be supervised by a home country via “a lead regulator with visibility and authority over the entirety of the bank’s global activities.” In contrast, not a single crypto firm is currently subject to consolidated supervision, Hsu said.
Hsu drew comparisons between a now-defunct international bank that led to significant changes in how global banks are supervised and the collapsed crypto exchange, arguing that there are “striking similarities” between the two, including that both (i) “faced fragmented supervision by a combination of state, federal, and foreign authorities”; (ii) “lacked a lead or ‘home’ regulator with authority and responsibility for developing a consolidated and holistic view of the firms”; (iii) “operated across jurisdictions where there was no established framework for regulators to share information on the firms’ operations and risk controls”; and (iv) “used multiple auditors to ensure that no one could have a holistic view of their firms.” To close the gap in the crypto sector, Hsu said action “will have to take place outside of bank regulatory channels,” but noted that the Financial Stability Board and other international bodies have already “recognized the need for a comprehensive global supervisory and regulatory framework for crypto participants.”
On March 2, Senator Cynthia M. Lummis (R-WY) and Representative Patrick McHenry (R-NC) sent a letter to the Federal Reserve Board, FDIC, OCC, and NCUA requesting input on SEC guidance issued last year that directs cryptocurrency firms to account for customers’ digital assets on their balance sheets. Last April, the SEC issued Staff Accounting Bulletin No. 121 (SAB 121), covering obligations for safeguarding crypto-assets held by entities for platform users. Among other things, SAB 121 clarified that entities should track customer assets as a liability on their balance sheets. “[A]s long as Entity A is responsible for safeguarding the crypto-assets held for its platform users, including maintaining the cryptographic key information necessary to access the crypto-assets, the staff believes that Entity A should present a liability on its balance sheet to reflect its obligation to safeguard the crypto-assets held for its platform users,” SAB 121 explained.
Claiming that SAB 121 “purports to require banks, credit unions and other financial institutions to effectively place digital assets on their balance sheets,” the lawmakers argued that this “would trigger a massive capital charge,” and in turn would likely prevent regulated entities from engaging in digital asset custody. Rather, regulators should encourage regulated financial institutions to offer digital asset services, since they are subject to the highest level of oversight, the letter said. Among other things, the letter asked the regulators whether the SEC contacted them prior to issuing the guidance, and if they have directed regulated financial institutions to comply with SAB 121. The lawmakers also inquired whether the regulators “agree that SAB 121 potentially weakens consumer protection by preventing well-regulated banks, credit unions, and other financial institutions from providing custodial services for digital assets[.]” The letter pointed to the bankruptcy case of a now-defunct crypto lender, which classified all customers as unsecured creditors, as an example of the legal risk of requiring customer custodial assets be placed on an entity’s balance sheet. “SAB 121 places customer assets at greater risk of loss if a custodian becomes insolvent or enters receivership, violating the SEC’s fundamental mission to protect customers,” the lawmakers wrote.
On March 1, Treasury Undersecretary for Domestic Finance Nellie Liang announced that the Treasury Department will lead a new senior-level working group to advance work on a U.S. central bank digital currency (CBDC). As previously discussed in a Treasury report released last September on the future of money and payments (covered by InfoBytes here), Treasury was called to lead an interagency working group to complement work undertaken by the Federal Reserve Board to consider the implications of a U.S. CBDC. The working group will consist of leaders from Treasury, the Fed, and White House offices, including the Council of Economic Advisors, National Economic Council, National Security Council, and Office of Science and Technology Policy. In the coming months the working group “will begin to meet regularly to discuss a possible CBDC and other payments innovations,” Liang said during a workshop titled “Next Steps to the Future of Money and Payments.” The working group will focus on three main policy objectives: (i) how a U.S. CBDC would affect U.S. global financial leadership; (ii) potential national security risks posed by a CBDC; and (iii) the implications for privacy, illicit finance, and financial inclusion if a CBDC is created.
To support discussions on a possible CBDC and other payment innovations, Liang said the working group will develop an initial set of findings and recommendations. Those findings and recommendations may relate to whether a U.S. CBDC would help advance certain policy objectives, what features would be required for a U.S. CBDC to advance these objectives, choices for resolving CBDC design trade-offs, and areas where additional technological research and development might be useful.
Liang commented that the working group will also “engage with allies and partners to promote shared learning and responsible development of CBDCs.” She pointed out that CBDC efforts are already underway in jurisdictions around the world, with 11 countries already having fully launched CBDCs, “while central banks in other major jurisdictions are researching and experimenting with CBDCs, with some at a fairly advanced stage.” Liang stressed that regardless of whether a CBDC is adopted in the U.S., the country “has an interest in ensuring that CBDCs interact safely and efficiently with the existing financial infrastructure; that they support financial stability and the integrity of the international financial system; that global payment systems are efficient, innovative, competitive, secure, and resilient; and that global payments systems continue to reflect broader shared democratic values, like openness, privacy, accessibility, and accountability to the communities that rely upon them.”