The bank regulators are what matters now in the United States
- Future of Finance
- Dec 15, 2023
- 3 min read
The SEC has certainly disturbed the incumbents in the custody industry in the United States by advising public companies to treat client assets in custody as a balance sheet asset and liability (via SAB 121) and by threatening to extend the range of assets for which custodians are responsible while potentially shrinking the number of institutions that are eligible to take responsibility (by the proposed “safeguarding” rule). Yet it is not the attitude of the SEC that is really bothering the leading custodian banks; it is the attitude of the banking regulators, and in particular the Federal Reserve, the OCC and the FDIC, that troubles them most.
Regulated banks are always wary of what their regulators want. In the aftermath of the string of cryptocurrency exchange and lending failures in 2022, and the associated failures of some of the banks that serviced cryptocurrency market participants, regulated banks are more sensitive than ever. While claims that the banking regulators are engaged in a crackdown on digital asset banking in general (the so-called “Operation Choke Point 2.0”) are not credible, it is certainly true to say that American banking regulators are proceeding cautiously.
The refusal of the banking regulators so far to take up the invitation of Gary Gensler to resolve the capital uncertainty over the accounting advice of SAB 121 by addressing “how they treat capital, however they wish to treat capital” is ostentatious. Every quarter since June 2022, the inter-agency body of the bank regulators has confirmed they are still reviewing the effects of SAB 121. They maintain this position despite widespread agreement that its origins are problematic and its validity questionable, forcing all affected parties to comply with the requirements of SAB 121 while the banking regulators deliberate for what will by February 2024 total 24 months.
It also remains unclear how or whether the BIS recommendations on the Prudential treatment of cryptoasset exposures will be implemented in the United States – and that is a major concern for regulated banks because it affects directly the capital treatment of custody. That uncertainty, coupled with uncertainty over SAB 121 and the “safeguarding” rule, is dampening the enthusiasm of the custodian banks to develop cryptocurrency custody services. That is in turn limiting the experience they need to custody more promising types of digital asset, such as security tokens.
The firms that have provided cryptocurrency custody services are not being welcomed by the banking regulators either. The Federal Reserve is moving actively to deny master accounts to banks it considers too risky. Wyoming-based Custodia, holder of a local chartered special purpose depository institution (SPDI) licence, is the most prominent victim. But the central bank is equally hostile to similar licences issued by State regulators in Washington, South Dakota and especially Nevada, where one provider has got into trouble.
Another visible change has occurred at the OCC, where Acting Comptroller of the Currency Michael J. Hsu has reversed the cryptocurrency custody-friendly policy of his predecessor. Under the previous Comptroller, the OCC had licensed or conditionally licensed banks that wanted to offer cryptocurrency custody services. The OCC licence granted to Anchorage Digital Bank N.A. (ADB), allowing it to offer digital asset custody as a “qualified custodian,” was denied to Paxos and Protego even though they were earlier granted conditional licences. In August 2023, blockchain-based Figure Technologies withdrew its application for an OCC licence.
That same month of August 2023 saw institutional cryptocurrency exchange EDX Markets choose Anchorage Digital as its custodian. EDX was reported to be planning to appoint Paxos, whose application for an OCC licence expired in March 2023. So it is clear that an OCC licence matters. What banking regulators think, not just about how cryptocurrency should be custodied but how digital assets in general should be custodied, matters. The behaviour of the banking regulators in the United States is now a major determinant of how digital asset custody develops.
As far as the development of digital asset custody is concerned, the most important banking regulator is Michael J. Hsu, the Acting Comptroller of the Currency. At a conference in early November 2023, he said something that ought to give regulated custodians considerable grounds for hope.
“There seems to be more and more of a divide between crypto on one hand and tokenisation,” he said. While cryptocurrency is “driven by the hope for speculative gain” and “replete with frauds, scams and hacks,” tokenisation “is focused on solving an actual problem, and that problem is settlement. This is boring back-office stuff, but it’s super, super important.” (1) So there is at least one American banking regulator who understands what is at stake in digital asset custody.