Guest Post: The Fed’s New Oversight of Crypto and Fintech Activities
Mark August provides another guest post, this time looking at new Fed programs
One of the many joys of working in web3 is the enthusiasm of young professionals, looking to learn what they need to learn to dive into this exciting and developing space. In that vein, I have the opportunity this summer to work with Mark August (a current JD candidate at the University of Denver - Sturm College of Law), as an extern with BSL Group, where he is working to support our clients by, among other things, researching emerging regulatory regimes, including the subject of this post - the approch BigTech is taking to broach the ever-shifting regulatory regime surrounding web3 projects and cryptocurrencies.
So, without further ado, I give you Mark:
The Federal Reserve has recently announced a targeted program aimed at monitoring and regulating innovative activities in the banking sector. This includes cryptocurrencies, blockchain technology, and partnerships between banks and tech companies. Innovation brings benefits like lower costs and better accessibility but comes with risks that may not be covered by existing regulations.
The Novel Activities Supervision Program
The newly introduced Novel Activities Supervision Program aims to manage emerging risks properly. The program focuses on crypto-assets, distributed ledger projects, fintech partnerships, and provision of traditional banking services to crypto entities. The program entails collaboration with current oversight teams and adjusting supervision based on a bank's engagement with these “innovative activities”.
The goal is to encourage innovation with safeguards in place to protect consumers, individual banks, and overall financial stability. By monitoring activities and requiring banks to show how they can manage the risks, regulators intend to prevent problems before they begin.
Example: Banks dealing with cryptocurrencies may need to show control over operational controls, cybersecurity measures, and compliance with Anti-Money Laundering (AML) laws.
Stablecoins and Compliance
The additional guidance highlights that member banks must acquire a letter of supervisory non-objection from the Federal Reserve before engaging with stablecoins.
A member bank in the context of the Federal Reserve is a banking institution that holds stock in one of the twelve Federal Reserve Banks within the United States. The Federal Reserve System, often referred to as the Fed, is the central banking system in the U.S., responsible for regulating the money supply and maintaining the stability of the financial system. When a national bank receives its charter from the Office of the Comptroller of the Currency (OCC), it automatically becomes a member of the Federal Reserve System. State-chartered banks can also choose to become members if they meet certain requirements.
Member banks have various responsibilities and privileges within the Federal Reserve System. They must hold a specific amount of non-interest-bearing stock in their respective Federal Reserve Bank. This stock cannot be sold or traded and is a reflection of their membership. Member banks play a vital role in the functioning of the monetary policy and the broader financial system. They have access to Federal Reserve services such as discount window lending, which provides short-term loans to banks in need of liquidity. They also play a part in the process of setting the direction of monetary policy by electing six of the nine members of their regional Federal Reserve Bank's Board of Directors. For example, a member bank in Denver, Colorado, would fall under the jurisdiction of the Federal Reserve Bank of Kansas City. This membership allows the bank to participate in the broader monetary policy of the country and gives it access to services provided by the Federal Reserve System.
To get approval for stablecoin use, banks must display satisfactory risk management across operations, cybersecurity, liquidity, and consumer compliance. This ensures that banks have the necessary controls in place, as stablecoins come with unique risks compared to traditional offerings.
Implications for Blockchain-based Businesses
The guidance has significant effects on blockchain businesses integrating with traditional finance. It outlines a process and risk management expectations for banks engaging with activities like:
Providing custody/storage solutions for crypto assets;
Validating and recording crypto transactions on a distributed ledger;
Issuing stablecoins backed by fiat currencies like the US dollar;
Lending services where crypto assets are used as collateral; and
Facilitating trading between crypto and fiat currencies
For blockchain companies, this integration offers the possibility of easier mainstream adoption. However, the costs of developing Know Your Customer (KYC) infrastructure and compliant AML practices could prevent early-stage startups from meeting expectations.
Challenges and Potential Solutions
Smaller firms may lack legal and compliance expertise to interpret regulatory guidance and implement controls. Requirements around liquidity planning and stablecoin governance further burden startups. Novel elements of decentralized networks, such as unproven consensus models like proof-of-stake, also present challenges.
Regulators must balance skepticism with room for innovation. Prudent experimentation can generate the data needed for informed oversight. Open questions around decentralized systems require collaboration between developers, users, and policymakers. These partnerships could pave the way for innovative practices that comply with regulatory demands without stifling growth.
Conclusion
The ability to comply with regulatory requirements may become a major competitive advantage in the blockchain space, potentially driving industry consolidation towards businesses that can handle these burdens.
In summary, the Federal Reserve’s guidance offers a thoughtful balance between fostering innovation and ensuring risk management. The challenges, particularly for smaller entities, are substantial but not insurmountable. Collaborative efforts between stakeholders might be the key to unlocking the full potential of these emerging technologies while ensuring that they are governed responsibly.
This program represents an important step in the ongoing dialogue between the financial industry and regulatory bodies, with the shared goal of shaping a financial landscape that is both dynamic and secure.
What kind of lawyer would I be without a disclaimer?
Everything I post here constitutes my own thoughts, should only be used for informational purposes, and does not constitute legal advice or establish a client-attorney relationship (though I am happy to discuss if there is something I can help you with). I can be reached via email at dlopezkurtz@crokefairchild.com or david@bsl.group on telegram @davidlopezkurtz on twitter @lopezkurtz and on LinkedIn here.