The Fed needs to close backdoor to its payment rails

The Federal Reserve payments system has long been a fortress of safe and efficient monetary transfers, benefiting millions of consumers and banks, which only gain access through rigorous and consistent federal oversight.

But those purpose-built high standards to access the nation’s critical payments infrastructure are under attack by new players — including cryptocurrency businesses — looking for a loophole to gain access to the Fed’s payments system.

The Fed should take a very careful look at the risks these firms could pose to the system before allowing them in.

The current situation stems from a movement in the states and within the Office of the Comptroller of the Currency to expand the definition of institutions eligible to receive a bank charter. Such a move, if granted, comes with the opportunity to apply to the Federal Reserve for master account access.

On the surface, that sounds appealing and a chance for new players to enter the highly competitive world of financial services. But there’s a catch.

These entities see the value in getting access to Federal Reserve payments systems like the Fedwire Funds Service and the automated clearinghouse (ACH) network, but do not want to play by the same rules as traditional banks. Finding chartering authorities that are willing to redefine what it means to be a bank introduces risks to the financial system’s safety and soundness, consumer protection laws and international reputation.

In 2019, Wyoming created a special-purpose depository charter (SPDI) targeting cryptocurrency businesses. The state requires these institutions to back up their deposits by holding 100% of their value in reserves, exempting them from the requirement to have insurance from the Federal Deposit Insurance Corp. or federal oversight.

The SPDI charter also prohibits these entities from making loans funded by the deposits. So, if they are not taking insured deposits and they aren’t making loans, why would they want a bank charter? The answer is simple — access to the nation’s payments system with a lower level of oversight.

The lack of FDIC insurance and loan offerings suggests that the SPDIs would not meet the definition of “bank” under the Bank Holding Company Act. This means that related entities would not be subject to consolidated supervision by the Federal Reserve. This is a significant concern as the parent companies operate in the volatile and loosely regulated cryptocurrency space.

Unfortunately, it isn’t just Wyoming. There are legislative proposals currently being shopped in several states that would create similar charter structures.

During the last administration, the OCC also pushed the envelope by attempting to change the definition of what types of entities qualify for a national charter by inviting payments businesses that do not take insured deposits or make loans to apply for a national bank charter, exempting them from FDIC oversight and the Bank Holding Company requirements.

In another misguided stroke, the OCC removed the requirement that trust banks provide fiduciary services in order to be eligible to apply for a charter. This significant policy shift, issued in January through an interpretive letter (without a public comment period) just before the new administration took over, broadened the scope of the types of entities eligible to apply for a trust charter.

The OCC’s interpretive letter also lowered the bar by allowing entities to convert to OCC trust charters if they met a state’s definition of a trust company through providing custody services — not fiduciary services — for cryptocurrency digital assets. The OCC conditionally approved the first applicant of this type just a few days later.

The U.S. banking system is certainly enriched by new entrants, new technology and competition, but its strength and resiliency is derived from the assurance that every financial institution adheres to common regulatory standards and supervisory scrutiny. Applications for master accounts and direct access to the payments system through SPDIs and nontraditional OCC charters present novel and heightened risks that merit thoughtful consideration.

The newly defined OCC charter recipients present an unknown risk because they were converted from state charters with little public information about their business models. The Federal Reserve Board and its central banks (where these applications are processed) are keenly aware of the weight of these decisions, and are carefully considering next steps.

To protect consumers and the financial system, the Fed board should delay granting non-traditional entities like these access to master accounts or its payments services until a uniform policy can be adopted. This policy must first go through public notice and comment, and allow the Federal Reserve banks to use their discretion when evaluating requests from these nontraditional applicants.

The U.S. payments system is safe and secure for the millions of American businesses and consumers that rely on it each day. The Federal Reserve must do everything in its power to keep it that way.