Hello, World! (and updates on recent activity in banking and crypto)

Hello, World!

Welcome to Legal-tender: Your fin-tastic guide to the legal side of crypto and fintech. My name is Andrew Grant, and I’m thrilled to introduce myself as a new partner at Ketsal PLLC (website profile in progress!). I’m passionate about staying on top of the latest developments in financial services, eCommerce, and virtual assets. I’ve been writing about these topics for some time, most recently at DLA Piper.

One thing I’ve discovered is that I learn more about these industries by writing about what I read. And having written formal newsletters for a while, I figured why not continue this tradition through my own newsletter? I consistently learn from so many in this space—some of whom I note below—and hope that my newsletter makes a small contribution to that discussion.

I plan to cover a wide range of topics in varying depths. Sometimes, articles will be longer and cover a topic in-depth, while other times, I'll just highlight some recent items that caught my attention. Often, my newsletter will be a blend of both. Being a lawyer, my topics will usually have a legal focus, but I’m exceedingly interested in the business and technological aspects of these industries. So some articles will just be my thoughts—and questions!—as I work my way through new developments in this industry.

My approach to reading and learning about these industries follows the Lester Freamon approach: All the pieces matter.

And please, if anyone has feedback or wants me to cover any particular issues—at least a high-level; this newsletter is not legal advice and just my personal thoughts and opinions¹—please reach out. And hope you enjoy (and if you do, please share! 🙏 And if you don’t enjoy it, I guess share with someone you dislike??)

---

Because it’s been a few months since I’ve written anything, I’ve got a lot on my mind! So my first few issues will be published pretty close together, but will get into a regular cadence after that. This newsletter will cover:

1. Crypto and banking: So, I had this section written earlier this week. But then Friday, the Federal Reserve Board (“Board”)² made it even more interesting (and not in a good way results-wise). The Board denied Custodia Bank’s application for membership to the Federal Reserve System. I was planning to write a separate newsletter on Custodia’s application for a master account with the Federal Reserve and subsequent lawsuit over the delay. So that may still happen, but for now, I will summarize the Board’s decision and the accompanying Board Policy Statement. Also, I’ll summarize:

   1. the recent regulatory statement from the Board, the Office of the Comptroller of the Currency (“OCC”), and the Federal Deposit Insurance Corporation (“FDIC”) (which the Board addresses in its Policy Statement),

   2. how this statement thematically relates to conditions the OCC imposed on a recent bank merger,

   3. as well as activities by banks themselves related to the virtual asset sector. Busy space!

2. Money transmission updates: Two states’ money transmission laws went into effect addressing virtual assets plus a recent opinion from Arkansas on the FBO model.

3. What I’m reading/listening to: For this first issue, I'll link to the newsletters that, for me, are essential reading (and I cite a couple in my writing below) as well as recent podcasts that I’ve found interesting. But this is by no means an exhaustive list and I will frequently be recommending interesting writers and podcasts. So many smart and interesting people operating in this space right now!

   ---

Crypto and banking

So. A lot of activity happening!

In short:

• The Federal Reserve Board (“Board”) denied Custodia Bank’s (“Custodia”) application to be a member of the Federal Reserve System. Also, Custodia is in a lawsuit with the Board and the Federal Reserve Bank of Kansas City (“FRBKC”) over Custodia’s application for a master account with the Federal Reserve. Custodia plans to continue its lawsuit for access to a master account, but the Board and FRBKC moved to dismiss the same day as the Board denied Custodia’s application to be a member of the Federal Reserve System.

• The Board’s actions tie directly into a statement issued by the Board, the FDIC, and the OCC warning the banks they supervise that engaging in crypto-related activities may be inherently an unsafe and unsound banking practice. This includes issuing stablecoins or tokenizing deposits, for example.

• Further, banks who engaged heavily in various crypto-related activities have lost significant sums of money, seen deposits drop, or both.

• Finally, hanging over all of this is the specter of “operation chokepoint.” Even if there is no DOJ involvement and it is more of an informal approach from regulators or even industry-directed, industry may have concerns over whether banks will seek to “choke” off banking services (e.g., depository services) to entities engaged in crypto-activities.

• Whew.

Board denies Custodia’s application to be a member of the Federal Reserve System

On January 29, 2023, the Board announced it denied Custodia’s application to become a member of the Federal Reserve System. The Board emphasized that Custodia’s “novel business model and proposed focus on crypto-assets presented significant safety and soundness risks.” In doing so, the Board referenced its earlier statement with the FDIC and OCC (covered below). Unfortunately, the press release was pretty sparse on details and we’ll need to wait for the Board to release the order, which it will do after reviewing for confidential information.

Board policy statement on Section 9(13) of the Federal Reserve Act

On January 29, 2023, the Board also issued a policy statement interpreting section 9(13) of the Federal Reserve Act (“Statement”). The Statement sets out a rebuttable presumption that the Board will exercise its discretion under section 9(13) to limit state member banks to engage as principal in only activities that are permissible for a national bank unless such activities are permissible for a state bank by federal statute or relevant FDIC regulations.³

What is section 9(13)?

You may be asking what is section 9(13). Section 9 of the Federal Reserve Act addresses state banks as members of the Federal Reserve System. Subsection (13) address which laws such state banks will be subject to. Fully quoting statutes is not ideal, but I think it's helpful here. Section 9(13) states “Subject to the provisions of this Act and to the regulations of the board made pursuant thereto, any bank becoming a member of the Federal Reserve System shall retain its full charter and statutory rights as a State bank or trust company, and may continue to exercise all corporate powers granted it by the State in which it was created, and shall be entitled to all privileges of member banks, except that the Board of Governors of the Federal Reserve System may limit the activities of State member banks and subsidiaries of State member banks in a manner consistent with section 24 of the Federal Deposit Insurance Act.”

Okay - so what does section 24 of the FDIA say? It states that “an insured State bank may not engage as principal in any type of activity that is not permissible for a national bank unless,” basically, the FDIC approves. So, mostly, insured state banks can engage as principal in only those activities permissible for national banks (unless state law otherwise limits them, but then there’s “wild card” statutes; for a bit more information on “wild card” statutes, and the dual-banking system overall, this CRS report is helpful).

The Statement addresses the italicized portion of subsection 13, which grants the Board discretion to limit a state member bank’s activities. Now back to the Statement.

The Statement reiterates to state member banks that having statutory legal authorization is only a prerequisite condition for engaging in a particular activity. It is not a sufficient condition. Instead, the state member bank must always conduct its activities in a safe and sound manner.

After reviewing proposals from banking organizations to engage in crypto-asset activities and given risks that the Board, FTC, and OCC identified in their letter—covered below—the Board released this Statement to clarify its authority under section 9(13) and set out a rebuttable presumption for how it will exercise its authority. The Statement also provides examples of how the Board intends to apply this presumption to certain crypto-asset-related activities.

Statement Background and Effect

The Board generally believes that the same bank activity, which presents the same risks, should be subject to the same regulatory framework, no matter which agency supervises that bank. Regulatory parity. The Board believes this will help level the playing field and mitigate risks of regulatory arbitrage.

The Board states that this Statement applies to insured and uninsured state member banks (see my link below to an excellent blog that explains why this matters better than the Board did). So the following is the waterfall to determine whether an activity is permissible for insured and uninsured state member banks:

• Federal statutes, OCC regulations, and OCC interpretations to determine whether national banks can engage in that activity.

• If those sources do not authorize the activity, then state banks need to look to see whether they can engage in that activity under other federal law or FDIC regulations (specifically part 362).

• If those sources do not provide the state bank with authority to engage in the activity, the state member bank cannot engage in the activity unless the Board permits it to do so (under Regulation H).

That takes us to the Statement (parts of which are added to Regulation H). The Statement explains how the Board will exercise its authority in assessing the permissibility of an activity.

• The Board will rebuttably presume that the state member bank is prohibited from engaging in any activity as principal that is impermissible for national banks, unless other federal law or FDIC regulations permit the activity.

• That said, the state member bank can rebut this presumption if (i) it provides a clear and compelling rationale to the Board that will allow the Board to deviate in the regulatory treatment among federally supervised banks, and (ii) the state member bank has a robust plan for managing the risks of the proposed activity in a safe and sound manner.

The Board emphasizes that when a state member bank makes the independent determination that an activity is permissible under federal statute, OCC regulations, or OCC interpretation, that bank must adhere to terms necessary for a national bank to engage in such activity. For example, if the national bank must get a written nonobjection from the OCC, then the state member bank must get a written nonobjective from the Board.

Examples of applying the criterion to crypto-related activity

The Board addressed a bank’s permissibility to conduct three crypto-asset services. Of the three, the guidance about “issuing dollar tokens” is unfortunately vague. Many developments are occurring and a vast literature exists in this area that the Board did not publicly address.

• Providing custody for crypto-assets: The Board emphasizes that the Statement does not “prohibit a state member bank, or an applicant to become a state member bank, once approved, from providing safekeeping services for crypto-assets in a custodial capacity if the bank conducts such activities in a safe and sound manner and in compliance with consumer, anti-money-laundering, and anti-terrorist-financing laws.”

• Holding crypto-assets are principal: This is basically a hard no. “The Board has not identified any authority permitting national banks to hold most crypto-assets, including bitcoin and ether, as principal in any amount, and there is no federal statute or rule expressly permitting state banks to hold crypto-assets as principal.”

• Issuing Dollar Tokens: The Board's statement is vague. "Certain state member banks have proposed to issue dollar- denominated tokens (dollar tokens) using distributed ledger technology or similar technologies. The permissibility of the issuance of dollar tokens to facilitate payments for national banks is subject to OCC Interpretive Letters 1174⁴ and 1179,⁵ including the conditions set out therein...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...Importantly, the Board believes such risks are pronounced where the issuing bank does not have the capability to obtain and verify the identity of all transacting parties, including for those using unhosted wallets."

  • I find both this language and a Footnote in the Statement problematic for a few reasons. The Board’s statements seem more permissive than the OCC’s obligations imposed on Flagstar’s merger with New York Community Bank (while the OCC is a separate agency, the Board’s intent behind the Statement is to ensure like institutions are subject to like oversight). The OCC’s conditions—as addressed more fully below—require Flagstar to divest its interest in USDF Consortium LLC unless the OCC gives written permission to continue. With those conditions, the OCC appears to find problematic tokens issued on closed networks where the issuing bank can verify all transacting parties. The Board’s stance on this issue, however, is unclear other than it belonging in the general category of risk associated to all crypto-asset activity.

  • The Board, in addressing the conditions the OCC imposed on Flagstar, only mentions restrictions and divestiture of “Hash,” a crypto-asset. It does not address USDF. Presumably, this omission is intentional. But it is unclear what it means. Is there a difference of opinion between the Board and the OCC on this topic? If so, how will that impact the Board's goal of treating institutions similarly? While understanding that agencies are not uniform in their interpretations of issues, or even monolithic on their views internally,⁶ these inconsistent statements (and potential treatment) on such a vital issue for crypto-assets is disappointing. Hopefully, the agencies will release further clarity on this topic.

What else to read on the Statement? Glad you ask! Bankregblog.substack.com is a tremendous read, and he or she had incisive thoughts on the Statement, including a helpful overview of banking background in the U.S. The author made an astute point regarding the differences between state insured and uninsured banks and the potential regulatory arbitrage: "This could, in theory, create a potential gap in the law, as uninsured state banks (like Custodia, for example), are not subject to Section 24 of the FDIA. That could mean that some state member banks supervised by the Board are not subject to the same restrictions on activities as other member banks supervised by the Board or as national banks or non-member banks." The Board stated this concept, but not as clearly as the bankregblog author did. 

Prudential regulator statement

On January 3, 2023, the Board, the FDIC, and the OCC issued a joint statement on crypto-asset risks to banks. The regulators appeared to be aware of how their statement might read in relation to operation chokepoint. They stated, “[b]anking organizations are neither prohibited nor discouraged from providing banking services to customers of any specific class or type, as permitted by law or regulation.” “[A]s permitted by law or regulation,” however, gives bank regulators potentially significant leeway in determining what activities they considered to be “permitted” (as shown by the Board’s Statement above).

The regulators, however, then stated: “the agencies believe that issuing or holding as principal crypto-assets that are issued, stored, or transferred on an open, public, and/or decentralized network, or similar system is highly likely to be inconsistent with safe and sound banking practices. Further, the agencies have significant safety and soundness concerns with business models that are concentrated in crypto-asset-related activities or have concentrated exposures to the crypto-asset sector.” (Emphasis added).

This language (1) emphasizes that the agencies believe issuing crypto-assets, e.g., stablecoins, is “highly likely” not to be a safe and sound banking practice; and (2) having concentrated exposures to the crypto-asset sector is a significant safety and soundness concern. This statement accords with the OCC’s position on crypto-asset activities when it approved Flagstar’s proposed merger in late October with New York Community Bank.

The merger approval was subject to the following conditions related to crypto-asset activity:

• Flagstar NA must divest its interest in USDF Consortium LLC, and any related holdings of Hash, within two years from the merger’s consummation unless the OCC gives written authorization to continue. Flagstar NA also cannot increase its membership interest in USDF Consortium LLC or its Hash holdings, or holdings of any other crypto-related currency or token, unless the OCC determines that the membership interest and Hash or other crypto-related holdings are permissible for a national bank.

• Within 30 days of consummating the merger, Flagstar NA must submit a written request for supervisory non-objection under OCC Interpretive Letter 1179 if Flagstar is engaged in any crypto-asset, distributed ledger, or stablecoin activities addressed in OCC Interpretive Letters 1170, 1172, or 1174. Unless the OCC provides a non-objection to the request, Flagstar NA will have to cease and divest of these activities within two years from the merger’s consummation.

(The Clearing House recently published an interesting White Paper on an OCC regulated bank’s authority to issue stablecoins. “Bank Issuance of Stablecoins and Related Services: Legal Authority and Policy Considerations.”)

Reading Break

What is the USDF Consortium, anyway?

The USDF Consortium is a collection of FDIC-insured financial institutions that is seeking to tokenize deposits of its member banks. The USDF token would be a digital representation of a customer’s existing fiat deposit. Customers could move USDF among customers of USDF Consortium member banks. Member banks then settle their net obligations over Fedwire Funds or FedACH.

The founding members include New York Community Bank, thus the OCC’s interest in Flagstar's involvement.

Bank activity

There have been some banks with significant exposure to crypto-asset activities and they have been working to reduce their exposure.

• Silvergate Bank needed to cover around $8.1 billion in withdrawals. It appears to have done so by selling assets at a steep loss and receiving $4.3 billion in short-term advances from the Federal Home Loan Bank of San Francisco.

• Signature Bank likewise increased its advances from the Federal Home Loan Bank of New York—to $11.3B in the fourth quarter—as it reduces its exposure to crypto deposits. From a press release: “[T]he Bank announced a plan to purposely decrease deposits in the digital asset banking space by reducing the size of relationships…Signature Bank is replacing these deposits primarily with advances from the Federal Home Loan Bank of New York (FHLBNY) in the short-term.”

  • Seemingly because of this decision, Binance user transactions involving Signature Bank were affected. Binance stated that Signature would “only handle user transactions of more than $100,000 as the bank decreases its exposure to digital-asset markets.”

• Provident Bancorp, the parent of BankProv, filed its Q3 10-Q late because, in part, it lost money from “borrowers who hold digital asset mining loans” (as disclosed during an earlier 8-K filing). Here, just read Bank Reg Blog (again, essential reading for anyone interested in bank regulation) and Fintechbusinessweekly (also essential reading for anyone interested in fintech) for greater background and analysis on this issue.

Is the CFPB doing anything in the virtual asset space?

Short answer - unknown? The CFPB has released nothing further I’m aware of about any investigation into any crypto-asset entity since the CFPB denied Nexo Financial LLC’s petition to modify the civil investigative demand it received in December 2021. (Note that the SEC recently fined Nexo $45 million for an unregistered offering of a crypto asset lending product).

What was the CFPB investigating? According to the CFPB’s denial, its CID into Nexo “sought to determine three related questions: (1) whether subject entities were engaged in conduct that is subject to federal consumer financial law (specifically, the Consumer Financial Protection Act and Regulation E, which implements the Electronic Fund Transfer Act); (2) whether those entities had violated the CFPA and Regulation E; and (3) whether a Bureau enforcement action would be in the public interest.”

Takeaways

Regulatory scrutiny for banks engaging in crypto-asset activity will likely see heightened review for some time. Despite the potential improvements that distributed ledger technology can bring to banking operations—see J.P.Morgan’s Onyx for a prominent example—the U.S. risks ceding this area to other jurisdictions if regulators adopt a restrictive stance on bank usage and integration of blockchain technology. While new technologies present additional risks, the bundling of the fallout from Luna and FTX, for example, to mean that all crypto-asset activity is inherently risky and an unsafe and unsound practice is short-sighted.

Further, banks themselves—whether because of regulatory or examination scrutiny or for internal reasons—may further withdraw from the sector. Many smaller banks that got involved with crypto assets no doubt suffered losses. Whether this reticence will last or involve the larger segments of the banking industry remains to be seen.

Money Transmission

States continue to adapt to licensing virtual currency activity in the money transmission space. And states continue to enforce their money transmission laws against entities that fail to acquire required licensure.

Revisions to state money transmission laws: At least two states have revised their money transmission laws effective January 1, 2023 to expressly incorporate virtual currency.

• First, Florida revised its money services business law in response to a 2019 case in the Third District Court of Appeals (State v. Espinoza). In Espinoza, the court took two important positions: first, bitcoin was both “monetary value” and a “payment instrument,” and second, Florida’s money services business law did not contain a third party transmission requirement. The new law includes virtual currency within “monetary value” but not as a “payment instrument” and requires that third party transmission occur - to be a money transmitter requires that the intermediary “has the ability to unilaterally execute or indefinitely prevent a transaction.” Florida’s Office of Financial Regulation can be aggressive in its enforcement authority, and it will be curious to see what actions it may take in response to this new law.

• Second, Alaska revised its regulations and considers a person to be engaged in licensable activity if the person conducts money transmission and the activity is in the form of virtual currency being transmitted to, from, or within the state.

Money transmission licensure and use of FBO accounts: In October, the Arkansas Securities Department (“Department”) issued a no-action letter to an entity that provides payroll services. The payroll services provider maintains an independent contractor relationship with a bank, which transfers the funds to the payee. The payroll services company’s customers’ funds are held in a bank account titled in the bank’s name. Based on these facts, the Department stated that it would not take an enforcement action against the payroll services company if it did not obtain a money transmission license.

The FBO model is common in the BaaS industry; so any industry guidance on this model is welcome (even if it is limited to the specific facts at issue in a no-action letter).

Enforcement actions: Texas entered into a consent order with Paxful USA, Inc. and found that Paxful “provides money transmission services in connection with virtual currency exchange…[Paxful] received stable coin from customers in Texas and elsewhere and promised to retain, return, or transmit that stablecoin as ordered by the customer.” Paxful represented to the Texas Department of Banking that it ceased new stablecoin transfers for custody and further transmission in March 2021.

What I’m reading and listening to

I consider the following substacks/newsletters to be essential reading and strongly recommend following them if you’re not already doing so.

• Fintech business weekly: The author does an outstanding job identifying interesting issues to write about each week and does so with fresh perspectives and clear writing.

• Fintech Takes: As a friend noted, this newsletter “drips with alpha.”

• Bankregblog: I cited to this blog a couple of times above; was only introduced to it a few months ago, but it quickly became essential reading.

• Fintech Blueprint: Provides timely stories on not just fintech but the crypto ecosystem as well.

I’ve found these podcasts to be interesting:

• Unchained: Consistently interesting podcast on crypto ecosystem with great guests.

• Fintech Takes, season 2: Same author as the newsletter above; Season 2 hasn’t started yet, but will be sure to listen when it does!

• Blockworks Bell Curve: While they have topical shows, they also have “seasons,” with this season discussing the rise of AppChains. Very curious about this development, and whether we’ll see AppChains dominate or whether monolithic chains will still dominate. Like most things, believe we’ll ultimately see a mix.

• Payments on Fire: Great podcast on all things payments.

As my substacks are fintech focused while my listening is crypto focused. If anyone has suggestions for readings and podcasts to even that out, please let me know!

1. I am providing this information generally; this information is not legal advice and not intended to apply to any specific legal or factual situation. By reading or subscribing to this newsletter, you are not forming an attorney-client relationship with me, or with Ketsal PLLC. These views are my own—especially the wrong ones—and do not represent Ketsal. If you need legal advice or have questions requiring an attorney, please reach out to an attorney you trust.

2. It’s a habit for me to define terms…and I may footnote (or at least, Substack calls them “footnotes” but these are endnotes) a lot. Unfortunately, not artfully like Nabokov or David Foster Wallace and more pedantic-like, similar to a law review article 🤷.

3. Substack doesn’t allow for normal formatting tactics, so I can’t easily set off sections that are not essential—well, I guess none of it is essential—but some readers may still be interested. So I’ve used the capabilities Substack offers to at least visually show that the sections in “code” are just background.

4. Relevant excerpt from Interpretive Letter 1174: “Likewise, a bank may use stablecoins to facilitate payment transactions for customers on an INVN, including by issuing a stablecoin, and by exchanging that stablecoin for fiat currency.”

5. Relevant excerpt from Interpretive Letter 1179: “In addition, Interpretive Letter 1174 concluded that, just as banks may buy and sell electronically stored value (ESV) as a means of converting the ESV into dollars (and vice versa) to complete customer payment transactions, banks may buy, sell, and issue stablecoin to facilitate payments.”

6. See the Brief Remarks on the Economy and Bank Supervision by Governor Michelle W. Bowman At the Florida Bankers Association Leadership Luncheon Events, Miami, Florida from Jan. 10, 2023:

• “But the bottom line is that we do not want to hinder innovation. As regulators, we should support innovation and recognize that the banking industry must evolve to meet consumer demand. By inhibiting innovation, we could be pushing growth in this space into the non-bank sector, leading to much less transparency and potential financial stability risk. We are thinking through some of these issues and what a regulatory approach could look like.”

It is unclear to me that the Board’s Statement reflects this approach recommended by Governor Bowman regarding supporting innovation.