A wave of notoriously risky cryptocurrency businesses could one day be brought into the mainstream banking system under a little-noticed provision in a new bill that is alarming financial experts about the potentially destabilizing consequences.
Crypto Firms Could Access Federal Reserve System Under Senate Bill
Two Wyoming-based crypto firms championed by Lummis stand to benefit. The two companies, Custodia Bank and Kraken Financial, have been locked in bids for key Fed accounts for the past two years. But financial regulators and experts say the impact of the measure would ripple through the industry and beyond.
The push for crypto firms to join the central plumbing of the banking system comes at a difficult time for the industry and its regulators. A sharp sell-off in cryptocurrencies has wiped $700 billion from the digital asset market since early May, forcing a reckoning for some previously high-flying start-ups, including companies trying to bridge the gap between the crypto economy and traditional finance. One such firm, Celsius Network, halted withdrawals last month, citing “extreme market conditions” as it froze up to $8 billion in deposits.
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Even before the latest meltdown, the Federal Reserve had been reluctant to grant prime accounts to crypto-focused banks. In the case of Custodia, Federal Reserve Chairman Jerome H. Powell raised concerns about triggering a tide of other crypto companies offering banking services while lacking federal insurance backing. .
“If we start granting them, there will soon be a few hundred,” Powell told Lummis when she pressed him about it during a January congressional hearing.
Under Wyoming law, these banks can put their reserves in more volatile assets than their federally regulated counterparts – such as corporate and municipal debt – which could trigger a run if they suddenly lost value, said Lee Reiners, a former Fed official who now leads Duke. University’s Global Center for Financial Markets. “The problem is that you could have entities with poor risk management and poor risk controls built into the Fed’s payment system.”
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The longer-term result could be a new buildup of systemic risk similar to what has preceded other financial meltdowns, some experts say. “I am very concerned that uninsured banks of any type would gain access to Fed services and proliferate more widely, because we have had very bad experiences with unfederally insured banks in the past.” said Arthur Wilmarth, a law professor emeritus at George Washington University and an expert on financial regulation. “I fear they will become systemically important, and we may end up having to bail them out if it looks like they are going to fail.”
Proponents counter that giving more companies access to central bank payments infrastructure will have the opposite effect, strengthening the crypto economy by giving federal supervisors a better view of its activity. “Giving more regulated financial institutions access to the payments system reduces risk because it allows greater visibility into who owes what,” said an aide to Lummis. “And if there was a systemic crisis, if a bank went bankrupt, there wouldn’t be as many ripple effects on the economy.”
Now the Fed faces increased pressure to act. On June 7, the same day that Lummis and Gillibrand introduced their bill, Custodia sued the Federal Reserve and its regional Kansas City bank in federal district court in Wyoming, accusing it of unlawfully delaying the action on its request 19 months after its filing. (The timing was coincidental, an aide to Lummis said.)
The company, founded by Morgan Stanley veteran Caitlin Long, moved to Wyoming in 2020 to take advantage of special rules the state passed the previous year to attract companies looking to mix traditional banking with crypto transactions. Shortly after getting its state charter, it applied for a Fed lead account. In the months that followed, “what resulted was an irresponsible Kafkaesque process that inflicted and continues to inflict serious and irreparable harm on Custodia,” the firm said. said in his suit.
The company presented itself as a David taking on the Goliaths of Wall Street. “If federal regulators continue to rein in innovators like Custodia, they’re just letting the big banks catch up and gobble up the market,” Custodia spokesman Nathan Miller said. “It leaves consumers with fewer choices and higher bank fees at a time when American families grapple with inflation and economic insecurity.”
The Federal Reserve and the Kansas City Fed declined to comment.
Kraken, for its part, is primarily known as a crypto exchange, operating the second largest such trading platform in the United States. But a subsidiary known as Kraken Bank in 2020 was awarded the first charter under Wyoming’s separation for crypto-banks, pledging to provide customers with “a seamless banking gateway” between digital assets and digital assets. traditional currencies.
When Kraken Bank applied to the Fed for its own main account soon after, a united front of banking lobbies pushed back. In a letter At the Fed, the coalition warned that Kraken’s business model posed “new risks,” pointing to the company’s lack of federal oversight as it hosts leveraged trading of volatile digital assets. Amid a sharp downturn in the crypto industry that prompted several of its rivals to cut staff, Kraken, which is a private company, said this month that it plans to add 500 employees. The company declined to comment.
The Fed is in the process of developing standards for granting major accounts, a process whose obscurity has drawn criticism from Republicans in Congress.
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The case took center stage earlier this year in a partisan fight over the nomination of Sarah Bloom Raskin as the Fed’s chief financial regulator. Raskin served on the board of Reserve Trust, a Colorado payments company, when it was granted a primary account in 2018 after being denied one a year earlier. Lummis and other Republicans on the Senate Banking Committee asked Raskin if she was using her influence as a former Fed official to help the company. Raskin denied any impropriety.
But the episode helped sink his nomination. In its wake, the Kansas City Fed revoked the main Reserve Trust account. Sen. Patrick J. Toomey (R-Pa.), the top Republican on the Senate Banking Panel, wrote to the bank in June to ask for details of the decision. The Kansas City Fed rejected his request, citing the need to protect the confidentiality of a private company and the bank’s own process.
Republicans insist on a bigger point: As fintech start-ups seek to compete with traditional banks, the Fed needs to explain its standards for access to its payment rails. Lummis told Powell during a hearing in June that the process remained a “black hole” and said his frustration was “at a boiling point.”
The Fed is considering adopting a system this would subject businesses that are not federally insured or regulated to greater scrutiny. Dennis Kelleher, president of the nonprofit Better Markets, which advocates tougher financial regulation, said the details would be important but the approach “would probably be the worst of all worlds”, granting companies crypto access to the Fed’s payment infrastructure “without imposed regulations”. on banks. The result would be the appearance of protection for taxpayers and the financial system, but not the reality.