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NY Fed to participate in proof-of-concept shared ledger project
On November 15, the Federal Reserve Bank of New York announced that the New York Innovation Center (NYIC) will participate in a proof-of-concept project to explore the feasibility of an interoperable network of central bank wholesale digital money and commercial bank digital money operating on a shared multi-entity distributed ledger. As previously covered by InfoBytes, the NYIC was launched in 2021 to advance the partnership with the Bank for International Settlements (BIS) Innovation Hub. The NYIC is intended to, among other things: (i) identify and develop insights on financial technology trends associated to central banks; (ii) examine the development of public goods to increase the global financial system function; and (iii) “advance and support expertise in the area of central bank innovation.” According to the recent announcement, the U.S. proof-of-concept project is exploring the concept of a regulated liability network and will “test the technical feasibility, legal viability, and business applicability of distributed ledger technology to settle the liabilities of regulated financial institutions through the transfer of central bank liabilities.” The New York Fed noted that the NYIC will coordinate with private sector organizations to provide a public contribution to the body of knowledge on the application of new technology to the regulated financial system as part of the 12-week project. The New York Fed also noted that the project will be conducted in a test environment, and the results of the pilot project will be released to the public.
Fed releases Supervision and Regulation Report
Recently, the Federal Reserve Board released its Supervision and Regulation Report, which summarizes banking system conditions and the Fed’s supervisory and regulatory activities. The current report noted that even though the “vast majority of firms maintained capital above regulatory minimums,” and loan delinquencies were historically low with liquidity levels generally remaining high, increasing economic uncertainty “may create new risks for firms to manage.” In response, firms increased credit loss provisions during the first half of 2022 and started taking measures to prepare for weaker economic conditions. The report also revealed that while the financial condition of large banks generally remains sound, firms should take steps to ensure their stress analyses, liquidity, and capital positions are able to adjust to developing market conditions. The report also highlighted recent regulatory actions, including supervisory guidance issued in August for banks seeking to engage in crypto-asset-related activities (covered by InfoBytes here). The Fed commented that it will continue to work with the OCC and FDIC on crypto-asset-related policy initiatives. The report also discussed operational risks related to the transition from LIBOR to an alternative interest rate benchmark and measures to address climate change implications for banks.
California DFPI concludes MTA licensure not required for crypto exchange
On November 3, the California Department of Financial Protection and Innovation (DFPI) released a new opinion letter covering aspects of the California Money Transmission Act (MTA) related to a cryptocurrency exchange’s transactions. The redacted opinion letter examines whether the inquiring company’s proposed business activities—which “will offer the purchase, sale, and trading of various cryptocurrencies using a platform provided by its affiliate and in conjunction with another affiliate that is a . . . registered broker-dealer”—are exempt from the MTA. Transactions on the company’s platform will involve the use of the company’s tokenized version of the U.S. dollar. Customers will deposit U.S. dollar funds into a company account where an equivalent amount of tokens will be created and used to facilitate a trade for cryptocurrency. The tokens can also be exchanged for U.S. dollars, or customers can hold the tokens in their wallet. According to the letter, the company says it “does not take custody of its client’s currencies or offer digital wallets,” but rather a “client’s digital wallet is directly linked to the platform and transacts on a peer-to-peer basis with other clients.” In addition to trading cryptocurrencies, the company also plans to allow customers to “trade in cryptographic representations of publicly listed securities,” thereby permitting customers to purchase, sell, or trade the securities tokens on the platform. The company will also be able to transfer customers’ shares of securities tokens from the platform to a customer’s traditional brokerage account. The company explained that these transactions of securities tokens will be covered by the company’s affiliate’s broker-dealer license.
DFPI concluded that because the Department has not yet “determined whether the issuance of tokenized versions of the U.S. Dollar or securities, or their use to trade cryptocurrencies, is money transmission,” it will not require the company to obtain an MTA license in order to perform the aforementioned services or to issue tokenized version of the U.S. dollar or securities. DFPI noted, however, that its conclusions are subject to change, and emphasized that its letter does not address whether the proposed activities are subject to licensure or registration under other laws, including the Corporate Securities Law of 1968.
CFPB analyzes crypto complaints
On November 10, the CFPB released a consumer complaint bulletin analyzing consumer complaints related to crypto-assets that the Bureau received from October 2018 to September 2022. According to the report, the Bureau received more than 8,300 complaints, with the greatest number of complaints coming from California. Among the complaints, the most common issue consumers identified was fraud and scams, followed by transaction issues. Additionally, analysis suggests that complaints related to crypto-assets may increase when the price of Bitcoin and other crypto-assets increase. The report noted that consumers had issues with accessing funds in their accounts due to identity verification issues, security holds, or because of technical issues with platforms. The Bureau also reported that customer service issues also were a common theme across crypto-related complaints. Other highlights of the report included, among other things, that: (i) crypto-assets are often targeted in romance scams, where scammers play on a victim’s emotions to extract money; (ii) crypto-assets are a common target for hacking; (iii) older consumers report a higher rate of crypto-asset related frauds and scams compared to complaints overall; and (iv) crypto-asset complaints and fraud reports have also been increasing at the FTC and SEC. The Bureau also provided steps for consumers to take to protect themselves, such as watching for signs of a scam, reporting suspicious FDIC insurance claims, and submitting a complaint to the CFPB.
District Court says blockchain network’s token is a security
On November 7, the U.S. District Court for the District of New Hampshire ruled that digital tokens sold by a blockchain network qualify as securities under the Securities Act of 1933. The SEC sued the company in 2021, claiming that by issuing the tokens, the company conducted an unregistered offering of securities. The company countered that its tokens are not securities because they are not being offered as an investment opportunity on its platform, but rather are designed to be used by content creators and users. The company also argued that the tokens are not securities because they function as “an essential component” of the company’s blockchain and that investors acquired them for use on the company’s network, rather than with the intention of holding them as an investment. Further, the company claimed that it did not receive fair notice that its token offerings are subject to securities laws.
In determining whether the tokens are securities, the court relied on the U.S. Supreme Court’s definition of an investment contract in SEC v. W.J. Howey Co., focusing on the issue of “whether the economic realities surrounding [the company’s] offerings of [the tokens] led investors to have a ‘reasonable expectation of profits to be derived from the entrepreneurial or managerial efforts of others.’” According to the court, multiple statements made by the company led potential investors to reasonably expect the tokens to grow in value as the company continued to oversee the development of its network. “[P]otential investors would understand that [the company] was pitching a speculative value proposition for its digital token,” the court said, rejecting the company’s argument that it had informed some potential investors that the company was not offering its token as an investment. “[A] disclaimer cannot undo the objective economic realities of a transaction,” the court stated, adding that “[n]othing in the case law suggests that a token with both consumptive and speculative uses cannot be sold as an investment contract.” Additionally, the court explained that, while this may be the first instance where securities laws are being “used against an issuer of digital tokens that did not conduct an ICO, [the company] is in no position to claim that it did not receive fair notice that its conduct was unlawful.”
OFAC updates FAQs related to sanctioned virtual currency “mixer”
On November 8, the U.S. Treasury Department’s Office of Foreign Assets Control (OFAC) published one new and three amended cyber-related FAQs related to sanctions issued in August against a virtual currency mixer accused of allegedly laundering more than $7 billion. As previously covered by InfoBytes, OFAC claimed the company “repeatedly failed to impose effective controls designed to stop it from laundering funds for malicious cyber actors on a regular basis.” Newly added FAQ 1095 clarifies that a designated “person” under Executive Order 13722 or 13694 is a “partnership, association, joint venture, corporation, group, subgroup, or other organization.” Amended FAQs 1076, 1078, and 1079 (i) explain how persons can complete transactions or withdraw virtual currency without violating U.S. sanctions regulations; (ii) clarify whether OFAC reporting obligations apply to “dusting” transactions (wherein “certain U.S. persons may have received unsolicited and nominal amounts of virtual currency or other virtual assets from [the sanctioned company’s] smart contracts”; and (iii) outline prohibitions resulting from the sanctions.
Commissioner says CFTC should take a “same risk, same regulatory outcome” approach for addressing crypto risks
On October 26, CFTC Commissioner Christy Goldsmith Romero spoke before the International Swaps and Derivatives Association’s Crypto Forum 2022, where she presented thoughts on the financial stability risks of cryptocurrency assets. Romero cautioned that the “rapidly developing crypto market” is facing similar financial stability risks as the traditional financial system, including parallel themes from the 2008 financial crisis. She highlighted events such as those that happened earlier in the year where an algorithmic stablecoin and related crypto-asset collapsed and triggered a broad sell off of cryptocurrency that spread losses to several institutions who abruptly cut off lending. These vulnerabilities serve as a warning for growing intra-market risks, Romero said, explaining that “[j]ust as regulators could not see the true exposures or risk in 2008 due to unregulated companies and products, [regulators] cannot see that today with unregulated crypto markets.” Moreover, without additional regulatory authority, the CFTC’s ability to monitor these risks is hampered, she said, adding that “[f]inancial stability risk will increase, and could rise to the level of systemic risk if in the future there are greater interconnections between the crypto industry and traditional finance players performing critical market functions.”
Romero recognized that novel technologies bring novel risks, and said that the CFTC should address these risks by using its existing authority to follow a “same risk, same regulatory outcome” approach and establish customer protections and guardrails that investors and customers are familiar with and have come to expect from other regulated financial products and markets. She emphasized that financial institutions interested in entering the digital asset space “should undertake substantial due diligence to determine vulnerabilities” in areas such as cyber theft, money laundering, and sanctions evasion; fraud, scams, and market manipulation; customer asset segregation; and conflicts of interest.
FDIC’s Gruenberg discusses the prudential regulation of crypto assets
On October 20, FDIC acting Chairman Martin J. Gruenberg spoke before the Brookings Institution on the prudential regulation of crypto-assets. In his remarks, Gruenberg first discussed banking, innovation, and crypto-assets, which he defined as “private sector digital assets that depend primarily on the use of cryptography and distributed ledger or similar technologies.” He stated that innovation “can be a double-edged sword,” before noting that subprime mortgages, subprime mortgage-backed securities, collateralized debt obligations and credit default swaps were considered financial innovations before they were “at the center of the Global Financial Crisis of 2008.” Gruenberg further discussed that such innovations resulted in catastrophic failure because, among other things, consumers and industry participants did not fully understand their risks, which were downplayed and intentionally ignored. He then provided an overview of the FDIC’s approach to engaging with banks as they consider crypto-asset related activities, and the potential benefits, risks, and policy questions related to the possibility that a stablecoin could be developed that would allow for reliable, real-time consumer and business payments. He stated that “[f]rom the perspective of a banking regulator, before banks engage in crypto-asset related activities, it is important to ensure that: (a) the specific activity is permissible under applicable law and regulation; (b) the activity can be engaged in a safe and sound manner; (c) the bank has put in place appropriate measures and controls to identify and manage the novel risks associated with those activities; and (d) the bank can ensure compliance with all relevant laws, including those related to anti-money laundering/countering the financing of terrorism, and consumer protection.”
Gruenberg pointed to an April financial institution letter from the FDIC (covered by InfoBytes here), which requested banks to notify the agency if they engage in crypto asset-related activities. He added that as the FDIC and other federal banking agencies develop a better understanding of the risks associated with crypto-asset activities, “we expect to provide broader industry guidance on an interagency basis.” Regarding crypto-assets and the current role of stablecoins, Gruenberg noted that payment stablecoins could be significantly safer than available stablecoins if they were subject to prudential regulation, including issuing payment stablecoins through a bank subsidiary. He cautioned that disclosure and consumer protection issues should be “carefully” considered, especially if custodial wallets are allowed outside of the banking system as a means for holding and conducting transactions. Specifically, he said that “payment stablecoin and any associated hosted or custodial wallets should be designed in a manner that eliminates—not creates—barriers for low- and moderate-income households to benefit from a real-time payment system.” Gruenberg added that if a payment stablecoin system is developed, it should complement the Federal Reserve's forthcoming FedNow service—a faster payments network that is on track to launch between May and July of next year—and the potential future development of a U.S. central bank digital currency. In conclusion, Gruenberg stated that although federal banking agencies have significant authority to address the safety, soundness and financial stability risks associated with crypto assets, there are “clear limits to our authority, especially in certain areas of consumer protection as well as the provision of wallets and other related services by non-bank entities.”
Dems ask regulators to address crypto’s “revolving door”
On October 24, Democratic lawmakers sent letters to the leaders of the SEC, CFTC, Treasury Department, Federal Reserve, FDIC, OCC and CFPB regarding concerns about “the revolving door between [] financial regulatory agencies and the cryptocurrency (crypto) industry.” In the letters, the lawmakers argued “that the crypto revolving door risks corrupting the policymaking process and undermining the public’s trust in our financial regulators.” The letters also noted that Treasury saw the most movement from the Treasury Department, with 31 former employees joining the crypto industry. The SEC was second with 28 former employees, according to Tech Transparency Project. The lawmakers argued that “Americans should be able to trust that financial rules are crafted to reduce risk, improve security, and ensure the fair and efficient functioning of the market,” and that “Americans should be confident that regulators are working on behalf of the public, rather than auditioning for a high-paid lobbying job upon leaving government service.” The letters requested that the agencies provide information by November 7, including answers to inquiries about each agency’s ethics guidelines and polices in place to protect the agency from being influenced by current or former employees’ potential conflicts of interest.
Fed governor “highly skeptical” of U.S. CBDC
On October 14, Federal Reserve Governor Christopher J. Waller spoke during the “Digital Currencies and National Security Tradeoffs” symposium presented by the Harvard National Security Journal regarding the U.S. dollar and central bank digital currencies (CBDC). Waller said that he is “highly skeptical of whether there is a compelling need for the Fed to create a digital currency.” Regarding foreign CBDCs, Waller first considered the emergence of foreign CBDCs in a world without the U.S. CBDC. He noted that “advocates for a CBDC tend to promote the potential for a CBDC to reduce payment frictions by lowering transaction costs, enabling faster settlement speeds, and providing a better user experience.” Because of “the well-known network effects in payments,” Waller pointed out that “the more users the foreign CBDC acquires, the greater will be the pressure on the non-U.S. company to also use the foreign CBDC.”
However, Waller considered that the broader factors underpinning the dollar’s international role would not change. Waller further noted the possibility that a foreign-issued CBDC could have the opposite of its intended effect and make companies even less willing to use that country’s currency. Waller further noted that creating a U.S. CBDC “would come with a number of costs and risks, including cyber risk and the threat of disintermediating commercial banks, both of which could harm, rather than help, the U.S. dollar's standing internationally.” He said he believes that a U.S. CBDC would raise many issues, including money laundering and international financial stability. Waller also considered a scenario in which a privately issued stablecoin pegged to a sovereign currency is available for international payments. He stated that they may be more attractive than existing options due to their ability to provide real-time payments at a lower cost and their ability to provide a safe store of value for individuals residing in or transacting with countries with weak economic fundamentals. He further warned that stablecoins “must be risk-managed and subject to a robust supervisory and regulatory framework.” Waller reiterated that "no decisions have been made" at the Fed on CBDCs and noted that his remarks are intended to provide a free and open dialogue on their utility. He also noted that he is “happy to engage in vigorous debate regarding my view,” and “remain[s] open to the arguments advanced by others in this space.”