On August 8, 2023, the Federal Reserve released new guidance for supervised banking organizations on how they can engage in certain crypto-asset-related activities. With the release of the guidance, the Federal Reserve announced:
- New details as part of its supervisory nonobjection process that state member banks must follow to engage in activities that involve the tokenization and issuance of national currencies through distributed ledger technology (Dollar Tokenization)
If a state member bank wants to engage in Dollar Tokenization activities, it must ensure it has sufficient controls, risk-monitoring systems, and risk-measuring systems in place to satisfy the Federal Reserve's expectations for mitigating the risks associated with these activities. It must also follow a preclearance process before engaging in these activities, even if only in the testing stage.
- The creation of a new "Novel Activities" Supervision Program that will work with the Federal Reserve's existing supervisory processes to apply a risk-based approach to monitoring and examining supervised banking organizations engaged in novel, technology-driven activities
The Federal Reserve's releases coincided with the announcement of a notable stablecoin offering by PayPal and Paxos Trust Company, a New York limited-purpose trust company. The guidance also updates the Federal Reserve's 2022 announcement that aligned its approach with the nonobjection frameworks of the Office of the Comptroller of the Currency (OCC) and Federal Deposit Insurance Corporation (FDIC).
The Federal Reserve's new guidance does not apply to OCC- or FDIC-supervised institutions.
As crypto-assets and distributed ledger technologies develop, federal banking regulators have come to view their use as "novel activities" associated with heightened and unique risks, compared with the risks associated with traditional banking activities. The federal banking regulators have been working in recent years to create a more harmonized approach to regulating applications of these technologies, leading to the Federal Reserve's recent guidance.
Tokenization is the process of converting an asset (or the ownership rights of an asset)—whether tangible (e.g., artwork) or intangible (e.g., shares in a company)—to unique units called "tokens" for use on, for instance, a distributed ledger. In Dollar Tokenization, each token represents one actual dollar held in reserve.
Preclearance: Supervisory Nonobjection Process for Dollar Tokenization
State banks that are members of the Federal Reserve System now appear to have a clearer path forward for integrating Dollar Tokenization into their payment facilitation services. The Federal Reserve has adopted a process for evaluating state member banks' Dollar Tokenization plans that resembles the OCC process for evaluating national banks' plans to do the same.
While national banks seeking to integrate novel activities into their payment facilitation services have been subject to a regulatory approval process for several years now, that framework notably changed recently. In 2020 and 2021, the OCC explained that Dollar Tokenization and related activities fall within the scope of national banks' permissible payments-related activities, provided national banks can demonstrate to OCC supervisors' satisfaction that they have adequate controls to ensure that the activities do not pose risks to the bank's safety and soundness. Before engaging in Dollar Tokenization activities, a national bank must receive a nonobjection letter from its OCC supervisory office.
Last year, the Federal Reserve issued similar guidance on crypto-asset and related activities that also required a preclearance process. In line with the OCC and the FDIC, the Federal Reserve essentially requires supervised entities to give written notice and similarly receive nonobjection letters before engaging in these activities.
Earlier this year, the Federal Reserve further clarified in a policy statement that uninsured and insured banks under Federal Reserve supervision are generally subject to the same limits on certain activities as national banks.
Now, the Federal Reserve's new guidance adds more color to the preclearance process. A state member bank seeking to engage in these activities must first obtain "a written notification of supervisory nonobjection" from the Federal Reserve before engaging in the proposed activities. This step requires the state member bank to notify the Federal Reserve of the bank's intention to engage in the proposed activity, provide a description of the proposed activity, and provide information on the state member bank's framework for controlling the risks presented by the proposed activities.
The Federal Reserve notably expects a notification even for testing new Dollar Tokenization activities.
State member banks will receive the Federal Reserve's nonobjection only if they can demonstrate sufficient controls to mitigate key risks, including:
- Operational risks
- Cybersecurity risks
- Liquidity risks
- Illicit finance risks
- Consumer compliance risks
We note that permissible activities in other areas of federal banking law do not generally require prior notice. Often mere after-the-fact or post-transaction notice suffices. The Federal Reserve, like the OCC, has essentially established a preclearance process for crypto-asset and related activities, and this recent guidance enshrines that approach for Dollar Tokenization.
Federal Reserve−supervised banking organizations may send questions via the Federal Reserve's public website. The failure to provide a dedicated contact is unusual, but is generally consistent with the slow, piecemeal development of this framework and likely reflects other priorities at the Federal Reserve in the wake of the 2023 bank failures.
Novel Activities Supervision Program
The Federal Reserve has also established a new supervision program that will apply a risk-based approach to supervising banking organizations to the extent they are engaged in so-called novel activities more generally. The Novel Activities Supervision Program "will work within existing supervisory portfolios and alongside existing supervisory teams," primarily to examine supervised entities engaged in:
- Complex, technology-driven partnerships with non-banks to provide banking services
- Distributed ledger technology projects with a potential for significant impact on the broader financial system (e.g., Dollar Tokenization, or tokenization of securities or other assets)
- Concentrated provision of banking services (e.g., deposits, payments, lending) to entities and fintechs focusing on crypto-assets
- Crypto-asset-related activities
Banking organizations engaged in any of these activities will receive notice from the Federal Reserve that they are subject to examination of novel activities through this new program, and the Federal Reserve will periodically update its list of these supervised banking organizations.
The Federal Reserve specifically noted that "crypto-asset-related activities" include crypto-asset custody, crypto-collateralized lending, facilitating crypto-asset trading, and engaging in stablecoin/dollar token issuance or distribution. These activities are generally analogous to traditional banking services, and, based on their inclusion in the guidance, none of these would appear to be impermissible activities.
In addition, the Federal Reserve's inclusion of bank and non-bank partnerships also builds on the this year's finalization of the interagency guidance on third-party risk management, which remains a heightened area of scrutiny. These partnerships notably include arrangements where a non-bank serves as a provider of banking products and services to end customers, usually involving technologies like APIs that provide automated access to a bank's infrastructure.
We note that Section 7(c) of the Bank Services Company Act subjects a service provider's performance of certain services by contract or otherwise to "regulation and examination … to the same extent as if such services were being performed by the depository institution itself," and therefore provides the statutory basis for regulation and supervision of certain third-party service providers, including non-bank partners of banks.
In addition, the Federal Reserve recently issued an enforcement action against Farmington State Bank—ensnared in recent crypto-market turmoil and itself in liquidation—for allegedly improperly changing its business plan without notifying the bank's supervisors and obtaining prior approval for those changes under various commitments and legal authorities.
According to the Federal Reserve, the bank committed to "work with" a third party "to design the necessary IT infrastructure" to facilitate the third party's issuance of stablecoins to the public in exchange for receipt of 50 percent of mint and burn fees on certain stablecoins. The Federal Reserve further alleges that the bank took material steps to implement that commitment without receiving the Federal Reserve's prior approval.
As the recent Dollar Tokenization guidance explains, "some activities involving dollar tokens may represent a change in the general character of a bank's business."
While Farmington State Bank's situation is relatively unique, the specific attention to novel activities in the enforcement order should serve as a warning call to industry participants. Including violations related to stablecoins and business plan changes in enforcement actions is consistent with the Federal Reserve's continued scrutiny in this area and its well-established authorities.
Regulation by Supervision?
The use of a purely supervisory framework rather than regulation means that, for the time being, the Federal Reserve's expectations concerning novel activities will remain shrouded in secrecy. While that secrecy is a fundamental feature of effective bank supervision for an individual banking organization's specific facts and circumstances, exclusive use of the supervisory process, unlike codified regulations, raises the possibility that unknown and differing standards may develop and be applied to banking organizations.
We anticipate that, as industry adoption of Dollar Tokenization and other novel activities continues to grow, and the federal banking agencies learn more through their supervisory approaches, more formal regulations will eventually be developed. Codifications of the federal banking regulators' approaches, determinations of and prudential limits to permissible activities, and other expectations in this area would afford industry participants with more transparency and the benefits of the provisions of the Administrative Procedures Act, such as a robust notice-and-comment process.