From dirt roads with pushcart vendors to bustling streets dominated by automobiles – the transformation of our city streets reflects society’s adaptive nature. Just as the 1920s saw cars revolutionizing transportation amidst growing concerns and regulatory challenges, the rise of crypto and distributed ledger technologies is heralding a similar transformation for the financial sector today. But, banking agencies’ statements on crypto indicate worrying prospects for the future of finance.
Historical Context: When Cars Were Intruders
Not so long ago, our city streets were primarily dirt roads, for pedestrians, pushcart vendors, and horse-drawn carriages. Then came the car. As more people drove cars in the 1920s, accidents and deaths skyrocketed. Local governments responded, creating laws to police this novel activity. And yet it’s hard now to imagine anything else. In the United States, for better or worse, we primarily view streets as a place for cars and sidewalks as a place for pedestrians.
Back in the 1920s, cities like New York, Philadelphia, and Chicago treated cars as dangerous intruders. In Chicago in 1926, as in most cities, “nothing” in the law would “prohibit a pedestrian from using any part of the roadway of any street or highway, at any time or at any place as he may desire.” Battles were waged in these cities’ courts, legislative halls and in the public “courts”, the newspapers. In New York City’s traffic court in 1923, a judge explained that “Nobody has any inherent right to run an automobile at all.” How did legislators respond? In the UK, and in states like Vermont, “red flag laws” required someone to walk in front of the vehicle carrying a red flag, to warn everyone of its impending arrival. The back and forth may have been dramatic, but it was also consequential. Ultimately, the automotive industry and its consumers made their case, the cars ruled the roads – a revolution in transport was made safer through improvements in technology as well as in law, and a dramatically new way of ordering things became the accepted norm for generations.
Today: Banking agencies and crypto
We are at a similar crossroads today with the transformation of money and assets, and their overall implications for the financial services sector and society at large. The rise of the internet and advances in modern computing power have led to the creation of blockchain and other types of distributed ledger technologies. They have also led to the unbundling of financial services and fintech firms finding innovative ways to disintermediate, providing services and tokenizing assets along the financial services stacks. Make no mistake, this is a revolution.
This revolution also comes with risks. Last year, we saw some of the worst hacks and scams in crypto history. According to Chainalysis, consumers lost $3 billion to crypto hacks, including the Wormhole Crypto Bridge, Axie Infinity and the most high profile of all – the bankruptcy of FTX.
Following the events of last year, we have seen a series of strongly-worded policy statements from US federal banking agencies on crypto released in recent weeks:
1. US Banking Agencies’ Joint Statement on Crypto-asset risks to banking organizations
2. Federal Reserve Board’s denial of application by Custodia Bank, Inc. to become a member of the Federal Reserve System
3. Federal Reserve Board’s policy statement to promote a level playing field for all banks with a federal supervisor, regardless of deposit insurance status
Worrying prospects for the future of finance
It is not hard to hear echoes from initial responses to the revolution in transportation. Together, these banking agencies’ policy statements present a worrying prospect for the financial ecosystem for a number of reasons.
First, the Joint Statement could be viewed as a warning to banks not to support the crypto industry, which will effectively de-bank the crypto industry and drive it to the shadows.
Second, the Fed’s policy statement sets out a “rebuttable presumption” under section 9(13) of the Federal Reserve Act that state member banks, regardless of deposit insurance status, are limited to activities permissible for national banks. This presumption can be rebutted if there is a “clear and compelling rationale” for the Fed to deviate in regulatory treatment among federally supervised banks and state banks. The Fed goes on to state that it “has not yet been presented with facts and circumstances that warrant rebutting its presumption.”
The Fed then explains why national banks (and therefore state banks) are not currently permitted to engage in crypto-asset activities.
The Fed’s main argument is that there is no federal statute or rule that expressly permits either national banks or state banks to hold most crypto-assets. But this reasoning is simply arbitrary. Congress passed the Federal Reserve Act in 1913 – the same year Henry Ford began mass producing automobiles. The National Bank Act was signed into effect by President Lincoln in 1863 – long before the advent of the computer, internet and crypto. Needless to say, it would be unrealistic to expect legislative drafters to include express permissions of crypto activities, but Hollywood has portrayed President Lincoln as a time traveler – so who knows!
The Fed is not waving a red flag in front of a moving automobile, it is building a brick wall.
Furthermore, this policy stance further segregates crypto finance from traditional finance, dangerously bifurcating our financial system as it continues to grow and transform. This could lead to distortions in market integrity and efficiencies. We may end up with part of the economy transacting in Fed-sanctioned US dollars while the other part transacts in non-USD digital assets outside the governance and monitoring of the Fed. As this shadow economy grows, the Fed loses more and more of its ability to effect effective monetary policies and economic stability.
Finally, this leads us to the Fed’s denial of Custodia Bank’s application for a master account with the Federal Reserve System, and thereby denying it access to the Federal Reserve System. A number of reasons were raised by the Fed as to why Custodia’s application was “inconsistent with the required factors under the law”:
- Custodia does not have federal deposit insurance
- Custodia proposed to engage in novel and untested crypto activities that include crypto-assets on open, public and/or decentralized networks
The Fed then proceeds to conclude that these inconsistent factors presented “significant safety and soundness risks.” The Fed also found that “Custodia’s risk management framework was insufficient to address the heightened risks associated with its proposed crypto activities, including its ability to mitigate money laundering and terrorism financing risks.”
Let’s examine each alleged inconsistent factor.
No FDIC insurance
For a bank to be eligible for the Fed’s lender of last resort protections, it must be insured by the FDIC. But Custodia was applying only for a Fed master account, which does not require FDIC insurance. The Fed provided no explanation as to why it required federal deposit insurance of Custodia.
More importantly, would deposit insurance be needed if the bank is 100% backed by highly liquid assets and does not make loans, as Custodia was proposing? In the early 1930s, Congress debated how to deal with bank runs.There were two options, 100% liquid reserves (narrow banking) or deposit insurance (fractional reserve banking). Congress chose deposit insurance, allowing banks to continue to lend out their deposits. However, if a bank is fully backed by highly liquid assets and does not engage in maturity transformation, then deposit insurance would be entirely unnecessary.
Novel and untested crypto activities
Custodia proposed to be a crypto custody bank that could issue fiat-backed stablecoins backed by deposits (ie, narrow banking). What is novel about Custodia’s business proposal is that lending was not an important part of its business model. This means the riskiest part of banking – credit intermediation – did not exist. Custodia was proposing to be a utility bank – one that holds deposits to be tokenized in fiat-backed stablecoins and custodies crypto-assets for customers. Both lines of business are far less risky than credit intermediation.
Open, public and/or decentralized networks
The Fed presumes that open, permissionless blockchains are a risk factor without explaining why. The internet is an open and public network upon which information travels freely. As explained by Chris Dixon in his blog, developers building on closed, centrally-controlled platforms can risk having the platforms unilaterally change their rules. As a society, we give up rights over our personal data and expose ourselves to security breaches on such centralized platforms.
Open-source, permissionless networks are more transparent, have fewer information asymmetries and operate via more democratic governance. They allow for a virtual cycle in blockchain innovation. Open, public decentralized networks facilitate innovative and collaborative uses for the network, which leads to greater user access and user demand, which in turn contributes to improvements to the public network and then more innovation in the network. The Internet is an obvious example. As Peter Van Valkenburgh explains, “anyone can design, build, and utilize hardware or software that will automatically connect to the Internet without seeking permission from a network gatekeeper, a national government, or a competitor.”
Risk management system
I cannot comment on Custodia’s risk management system without a deeper dive into its architecture and risk controls. But it should be noted that a new generation of crypto-native banks will be more innovative and tech-savvy and can take advantage of the myriad new technologies available for identifying illicit financial activities.
Finally, Fed Chair Jerome Powell remarked that if the Fed had approved Custodia, then the Fed would be flooded with similar bank applications, and then who would do the lending? Chair Powell’s fear is not listed as one of the reasons why Custodia’s application was denied, but it sounds like it may be an underlying cause. It seems premature to deny Custodia’s application on an unfounded fear that there would be a tidal wave of narrow bank applications.
Other central banks are experimenting with crypto activities themselves*. Mainstream commercial banks are also entering the chat.** I commend these institutions for their efforts to engage with crypto technologies. Ultimately, chilling innovation harms not only private sector innovation but public sector innovation as well. Instead, at a minimum, the Fed could allow a pilot of a few narrow banks and see how they fare. The opportunity to engage collaboratively between banking agencies and crypto industry experts could allow for education on both sides, while widening the aperture of innovation in the United States.
Looking Back to Look Ahead: Banking agencies and crypto
We now look back on the “Red Flag Laws” of the early 1900s as quaint and amusing. Let’s hope our children can afford to feel the same way when they look back at US banking agencies’ fear of embracing technological developments that are transforming money and assets in 2023.
* Other central banks are experimenting with crypto activities themselves. Project Dunbar, led by the BIS Innovation Hub in partnership with the Reserve Bank of Australia, Central Bank of Malaysia, Monetary Authority of Singapore, and South African Reserve Bank, is testing the use of central bank digital currencies for improving international settlement. Another example is Project Mariana, a joint project between the Switzerland, Singapore, and Eurosystem BIS Innovation Hub Centres, the Bank of France, the Monetary Authority of Singapore and the Swiss National Bank, is exploring the use of DeFi for the cross-border exchange of hypothetical Swiss franc, euro and Singapore dollar wholesale CBDCs between financial institutions to settle foreign exchange trades in financial markets.
**Mainstream commercial banks are getting into the fray as well. The New York Fed and the Regulated Liability Network (RLN) banks are exploring how to use bank deposits to tokenize money. The RLN includes Citi, BNY Mellon, Wells Fargo, HSBC and Mastercard are among the participants. Another project is Project Guardian – a collaborative initiative with the financial industry that seeks to test the feasibility of applications in asset tokenization and DeFi while managing risks to financial stability and integrity. DBS, JP Morgan and SBI Digital Asset Holdings explored how they were able to launch the first industry pilot where the banks conducted foreign exchange and government bond transactions against liquidity pools comprising of tokenized Singapore Government Securities Bonds, Japanese Government Bonds, Japanese Yen (JPY) and Singapore Dollar (SGD) on public blockchain networks.
