Fed's crypto rules invite dangerous experimentation

Suppose you're a crypto company that wants to own a bank approved to engage in digital-asset activities. Here's the fast-track way you might achieve that, while complying with rules in place since August:

Go buy a bank, any bank. Convert your bank to a Federal Reserve member bank, meaning that your bank's federal supervisor will now be the Fed, not the Office of the Comptroller of the Currency or the Federal Deposit Insurance Corp. Wait a little bit, maybe six months. Then send the Fed a letter notifying it that your bank is going to engage in digital-asset activities and that you have determined the activities your bank will conduct are permissible. Promise that you will soon establish a risk management framework to manage this complex new business. If you're lucky, your bank won't be examined for a year or two. By then, you might have cranked up quite a dumpster fire.

Amanda Gordon/Photographer: Amanda Gordon/Bloo

To be clear, I'm not recommending this. But it appears at least one crypto group has gone this route. The Fed's Supervisory Letter SR 22-6 — "Engagement in Crypto-Asset-Related Activities by Federal Reserve-Supervised Banking Organizations," issued in August — allows Fed-supervised banks to back-door into the digital-asset business simply by giving notice to the Fed. 

SR 22-6 leaves it up to the bank to analyze whether such activity is permissible and doesn't require the Fed to fully vet the bank's business plan, technology, risk management framework or any new management prior to the bank engaging in digital-asset activities.

This guidance is unlike the guidance provided by the OCC and FDIC, which states that these agencies will evaluate a bank's readiness before the bank can engage in digital-asset activities. The OCC goes further in requiring its supervised banks to obtain prior written notification of nonobjection.

The Fed's approach, by contrast, has created regulatory arbitrage not just relative to the OCC and FDIC, but also within the Fed itself because incumbent member banks can wave themselves in while new applicants for Fed membership, including a de novo bank that I advise, Custodia Bank, must wait for Fed permission and be examined first. This approach also creates banking system risk because the Fed has little insight into how much the banks it supervises are engaging in digital- asset activities.

A case in point. In September 2020, the Fed approved Moonstone Bank, located in rural Washington state with just two full-time employees, to be acquired by a Baltimore-based company involving the chairman of a crypto-connected Bahamas bank (who also is the co-creator of the cartoon "Inspector Gadget").

In June 2021, the Fed approved Moonstone Bank to become a Fed-regulated bank with a six-person board that included the above noted Bahamas bank chairman and the chief operating officer of Gemini, a U.S. cryptocurrency exchange. In March 2022, the now-bankrupt Bahamas-based Alameda Research Ventures (a sister company of the also bankrupt FTX) purchased a major stake in the Moonstone organization.

This acquisition almost certainly did not conform to the Fed's 2020 control rules, to which I was a contributor. Alameda very likely should have sought prior approval from the Fed. Alameda and Moonstone seem to have camouflaged the acquisition as "noncontrolling" by giving Alameda only 10% voting control for its more than 80% ownership of the organization's common stock.

It also appears that SR 22-6 has allowed Moonstone Bank to engage in digital-asset activities, including stablecoin issuance, simply by sending the Fed a notice. Now, due to Alameda's recent bankruptcy, almost all of the organization's capital is subject to being clawed back. Hmmm, a shaky foreign company buying a rural bank and starting a crypto business. What could possibly go wrong?

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I suggest the Fed revise SR 22-6 so that prior approval is required for its supervised banks to engage in digital- asset activities. My call for the Fed to improve its oversight is not a call for the Fed to step away from digital assets.

The Fed needs to lean into digital assets, and do it soon. Why? Because big changes are still happening despite the current debacle in crypto lending and trading markets. For example, in the past two weeks the social media giants Twitter and Telegram both announced new crypto initiatives to facilitate payments outside of the banking system. The Fed has two options — bring digital-asset activities into its regulatory perimeter now, or watch as technology companies clear payments with huge platforms outside of the banking system and relegate the Fed to permanently playing catch-up.

How might the Fed lean into digital assets? SR 22-6 covers the traditional bank risks that should be considered for a bank to engage in a new activity. But I suggest that the Fed should fully understand how traditional bank risks such as liquidity, interest rate or credit risk will impact a bank differently when engaging in digital-asset activities.

For instance, the Fed should require banks to conduct a stress test in which all deposits related to digital assets are withdrawn within six hours — reviewing both the intraday liquidity and operational risks of that very realistic scenario.

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Why six hours? Because that's how fast two stablecoins have collapsed this year. Digital assets just don't behave like traditional banking assets. Further, the Fed should know whether the bank or its affiliates will trade in digital assets, and if so, determine how customers' accounts will be safeguarded and not commingled. These aren't insurmountable hurdles, just prudent risk management considerations.

Most important, if a bank has developed secure technology, an adequate risk management framework, and has the management to conduct digital-asset activities in a safe and sound manner, then the Fed should grant approval in a timely manner, whether the bank is de novo or incumbent.

The status quo surrounding Fed-supervised banks' entry into the crypto markets is untenable. Allowing any Fed-regulated bank to just send a notice to the Fed and hoping a dumpster fire doesn't break out before examiners or taxpayers have to come to the rescue is not the answer. That is the plot of a bad "Inspector Gadget" episode.