Federal Reserve Issues New Restrictions on Crypto Banking

The Federal Reserve Board warned member banks that it intends to presumptively prohibit a large portion of cryptocurrency banking activity, as the demand for more guidance over digital assets has grown following rampant instances of fraud. 

Outlined in a final rule published on Tuesday, the Board of Governors of the Federal Reserve System offered an interpretation of section 9(13) of the Federal Reserve Act to govern the use of digital assets within the federal banking ecosystem. That section specifically applies rules set by the Federal Reserve for member banks, dictating the banking activity state depository institutions are legally able to conduct as only that which is also permissible for national banks. 

Federal Reserve member banks consist of financial institutions at the state level that meet the operational requirements of the Federal Reserve System, and are overseen by the 12 designated regional banks across the U.S.  

The rule issues two directives pursuant to the Federal Reserve’s existing laws: that the Board will “presumptively prohibit” member banks from holding most crypto assets, and that member banks wishing to utilize dollar tokens will need to prove certain security measures and receive formal approval prior to its use in banking transactions.

Both rules cite the “significant risks” associated with the cryptocurrency sector, including fraud, legal ambiguity and volatility. 

“With respect to any novel and unprecedented activities, such as those associated with crypto-assets or use of distributed ledger technology, it is particularly important for a state member bank to have in place appropriate systems to monitor and control risks,” the rule reads, noting the ways in which most digital assets inherently prevent banks from ensuring such security. 

“The Board believes this presumption is bolstered by safety and soundness concerns,” the Board notes. “The Financial Stability Oversight Council has observed that, in the absence of a fundamental economic use case, the value of most crypto-assets is driven largely by sentiment and future expectations, and not by cash flows from providing goods or services outside the crypto-asset ecosystem.”

The final rule continued that the volatility in most decentralized digital assets prevents financial firms from taking the necessary risk-management procedures associated with other forms of capital. Additionally, the inherent anonymity in cryptocurrency user transactions also poses security risks, particularly along distributed ledger technologies like blockchain.

Despite largely concurring that employing digital assets in the U.S. banking system poses security threats, the Board offered some avenues for potential incorporation. 

The final rule notes that issuing dollar tokens along decentralized ledgers was also likely unsafe. However, member banks are eligible to receive a “supervisory nonobjection” from the Board provided they can demonstrate the ability to conduct safe banking with dollar tokens.

Commonly referred to as stablecoins, dollar denominated tokens differ from traditional cryptocurrencies in that they are pegged to the U.S. dollar, thereby presenting a lower risk in price volatility. Deploying dollar tokens along a distributed ledger software still poses a significant amount of cybersecurity and operation risks, according to the Board, namely among illicit finance activity.

“The Board generally believes that issuing tokens on open, public and/or decentralized networks or similar systems is highly likely to be inconsistent with safe and sound banking practices,” it said. 

This decision opens a new chapter in the regulatory battle regarding the digital asset and crypto industry. President Joe Biden recently issued an executive order that spurred more research into cryptocurrencies’ effect on the broader economy, and money laundering via digital assets amid the ongoing Russia-Ukraine war has spotlit the security risks within the emerging technology.  

The Board’s final rule regarding state bank operations with digital assets diminishes hopes of incorporating cryptocurrencies into the regulated economy, and is consistent with other recent actions of the Federal Reserve. In late January, the agency rejected digital asset transaction firm Custodia Bank for membership as a subsidiary bank. 

“Custodia actively sought federal regulation, going above and beyond all requirements that apply to traditional banks,” the bank said in a statement. “The Board’s denial is unfortunate but consistent with the concerns that Custodia has raised about the Federal Reserve’s handling of its applications, an issue we will continue to litigate.”