On January 27, 2023, the Federal Reserve Board (FRB) announced its denial of Custodia Bank, Inc.’s (Custodia) application—a cryptocurrency-focused bank from Wyoming—to join the Federal Reserve System. Custodia is chartered under Wyoming state law as a “special purpose depository institution,” a new banking framework approved by the Wyoming legislature in 2019 in an effort to make the state a crypto-friendly jurisdiction. According to its website, Custodia’s aim is to “be a compliant bridge between digital assets and the US dollar payments system.” The FRB determined, however, that Custodia’s novel and untested cryptocurrency business model presented “significant safety and soundness risks,” and raised concerns related to Custodia’s “ability to mitigate money laundering and terrorism financing risks.” The FRB’s denial of Custodia’s application to join the Federal Reserve System signals that regulators are carefully considering cryptocurrency-related risks and will increasingly apply traditional regulatory frameworks to the companies that operate in the cryptocurrency industry.
Protecting the banking system from cryptocurrency risks
In January 2023, the Board of Governors of the Federal Reserve System, the Federal Deposit Insurance Corporation, and the Office of the Comptroller of the Currency (the Banking Agencies) issued a Joint Statement regarding “crypto-asset”-related risks facing the banking system. The Banking Agencies outlined a cautious approach on current and proposed crypto-related activities in the banking system and detailed steps to help ensure “that risks related to the crypto-asset sector that cannot be mitigated or controlled do not migrate to the banking system.” For instance, the Banking Agencies encouraged banking organizations to ensure that crypto-asset-related activities comply with applicable laws and include appropriate controls.
Although the FRB denied Custodia’s application to join the Federal Reserve System, regulators are not wholesale opposed to cryptocurrencies: In October 2022, the Bank of New York Mellon Corp. (BNY Mellon)—the oldest bank in the United States and the first of the eight largest US banks to store digital assets for its customers—received approval by New York state regulators to hold cryptocurrencies alongside traditional investments. The FRB’s denial of Custodia’s application, however, demonstrates that regulators are particularly skeptical of new industry entrants whom they perceive to combine novel asset categories with impermissibly risky activities. Such perceived risks are all the more heightened in light of last year’s string of high-profile collapses of cryptocurrency companies. Longstanding market participants may receive more favorable treatment because they are more likely to have invested in extensive compliance programs, which have been demonstrated to be increasingly effective. Start-ups and other new cryptocurrency projects that do not implement robust risk management and compliance programs are more likely to face an uphill battle in obtaining regulatory licenses and approvals for crypto-related activities.
Additionally, on January 27, 2023, the Biden Administration released a Roadmap to Mitigate Cryptocurrencies’ Risks, which argued that the benefits of cryptocurrencies cannot be realized without mitigating its risks. The Roadmap states that, while cryptocurrencies and the distributed ledger technology they are built on are new, many of the risks they raise are not, including cybercrime, fraud, money laundering, and terrorist financing.
The Biden Administration further warned that “some cryptocurrency entities ignore applicable financial regulations and basic risk controls—practices that protect the country’s households, businesses, and economy.” Accordingly, regulatory scrutiny in the digital asset space will likely continue to escalate as a defined priority of the Biden Administration.
Next steps for cryptocurrency companies in the banking industry?
New entrants into the cryptocurrency space, however, should not lose hope. Concurrently with its denial of Custodia’s application, the FRB issued a policy statement outlining a general legal framework for cryptocurrencies that it would apply to national and state banks. In a press release, the FRB explained that its denial of Custodia’s application “would not prohibit a state member bank, or prospective applicant, from providing safekeeping services, in a custodial capacity, for crypto-assets if conducted in a safe and sound manner and in compliance with consumer, anti-money laundering, and anti-terrorist financing laws” (emphasis added). For startups and longstanding institutions alike, the FRB’s statement suggests that cryptocurrency services should be matched with risk-based sanctions, AML, and anti-terrorist financing controls.
The US government is sensitive to financial risks and does not appear to be prepared to reduce its expectations regarding sanctions, AML, and anti-terrorist financing controls, especially in light of domestic economic challenges and conflicts abroad with Russia, North Korea, and others. Ensuring financial stability and curtailing foreign adversaries’ ability to launder money and evade sanctions is likely to remain a top priority for this Administration. Accordingly, cryptocurrency companies may find it necessary to continue to increase investments in internal risk management and compliance structures in the face of this likely scrutiny.