Mahi Sall, Advisor, Fintech-Bank Partnerships, Payments and Financial Inclusivity
January 25th, 2023
Mahi Sall is the CEO & Founder of FinXpair, a Berlin-based strategic advisory boutique firm focu[...]
The Federal Reserve Issues State Member Bank Guidance for ‘Dollar Tokens’ (Dollar-pegged Stablecoins)
Regulation | Aug 10, 2023
The Federal Reserve's recent announcement regarding the supervisory nonobjection process for state member banks has been a topic of keen interest.
This process pertains to banks looking to engage in activities involving tokens denominated in national currencies, commonly known as "dollar tokens" (aka dollar-pegged stablecoins).
Overview
- The Fed aims to monitor the transaction validation process, including the "timing and finality of settlement of transactions, potential irreversibility of transactions, and the central authority of transaction records." Blacklisting addresses and reversible transactions are common among major stablecoin issuers like Tether and Circle. PayPal's recent stablecoin entry indicates that they might implement similar features.
- The Fed plans to introduce know-your-client (KYC) measures and ensure that nationally-chartered banks have appropriate risk-mitigation strategies. This includes ensuring issuers have enough liquidity to meet redemptions (avoid any sort of run on the banks), referencing significant bank runs in the past, such as Terra’s UST stablecoin and the FTX disaster.
- The U.S. central bank also plans to enhance its program to oversee the "novel activities" of all banks in its jurisdiction that are involved with crypto, crypto companies, or blockchain technology.
See: House Committee Introduces Digital Asset Legislation: The Financial Innovation and Technology for the 21st Century Act
The Role of the Federal Reserve Act
- The Federal Reserve Act serves as a cornerstone for the U.S. banking system, guiding the operations of banks and other financial institutions. The recent clarification by the Board emphasized its general presumption regarding state member banks and their subsidiaries.
- The Board's stance is clear: these entities should limit themselves to activities that national banks are allowed to undertake, unless there's a specific federal statute or regulation that permits otherwise.
- On January 27, 2023, the Board of Governors of the Federal Reserve System took a decisive step to clarify its position on a pivotal section of the Federal Reserve Act, specifically section 9(13). This move was not just a standalone decision but a part of the broader regulatory landscape that has been evolving in response to the rapid advancements in financial technologies.
The OCC's Recognition
- The Office of the Comptroller of the Currency (OCC), another significant regulatory body, has played a crucial role in shaping the discourse around dollar-pegged stablecoins. The OCC has explicitly recognized the potential and authority of national banks to harness distributed ledger technology (DLT) or similar technologies for payment-related activities. This acknowledgment encompasses a range of activities, from issuing to transacting in dollar tokens.
- However, the OCC's recognition comes with a caveat. For a national bank to engage in these activities, it must demonstrate that it has robust controls in place. This is to ensure that the activities are conducted in a manner that upholds the principles of safety and soundness, which are paramount in the banking sector.
Robust Controls for State Member Banks
The Federal Reserve's note emphasizes the importance of robust controls for state member banks engaging in activities involving dollar tokens. Here's a summary of the controls and requirements highlighted in the Federal Reserve's note:
See: A New Era: Financial Stability Board Releases Final Recommendations for Cryptoasset Activities and Markets
- Operational Risks: Banks should have controls to address risks associated with:
- Governance and oversight of the network.
- Clarity of roles, responsibilities, and liabilities of all involved parties.
- The transaction validation process, including the timing and finality of settlement of transactions, potential irreversibility of transactions, and the central authority of transaction records.
- Cybersecurity Risks: Controls should be in place to manage:
- Risks associated with the network on which the dollar token operates.
- The use of smart contracts.
- Any engagement with open-source code.
- Liquidity Risks: Banks need to address:
- The potential for dollar tokens to witness substantial redemptions in a short timeframe, which could lead to rapid deposit outflows.
- Illicit Finance Risks: Controls should ensure:
- Compliance with the Bank Secrecy Act.
- Adherence to the Office of Foreign Asset Control requirements. This includes verifying the identity of a customer, performing due diligence to understand the nature and purpose of the customer relationship, and ongoing monitoring to identify and report suspicious activity.
- Consumer Compliance Risks: Banks should have measures to:
- Identify and ensure compliance with any consumer protection statutes and regulations that apply to the specific dollar token activity.
See: Decoding Judge Rakoff’s Opinion: What It Means for Future Crypto Regulations
Additionally, before engaging in dollar token activities, state member banks should receive a written notification of supervisory nonobjection from the Federal Reserve. This requires banks to demonstrate that they have established appropriate risk management practices, including systems to identify, measure, monitor, and control the risks of their activities on an ongoing basis.
Cautious but Forward Looking Approach
The Federal Reserve's announcement, when viewed in the backdrop of the broader regulatory environment and the OCC's stance, underscores a cautious yet forward-looking approach to integrating emerging financial technologies into the banking system. As the world of digital currencies continues to expand, such clarifications provide a roadmap for banks and financial institutions, ensuring that they navigate this new terrain with clarity and confidence.
The National Crowdfunding & Fintech Association (NCFA Canada) is a financial innovation ecosystem that provides education, market intelligence, industry stewardship, networking and funding opportunities and services to thousands of community members and works closely with industry, government, partners and affiliates to create a vibrant and innovative fintech and funding industry in Canada. Decentralized and distributed, NCFA is engaged with global stakeholders and helps incubate projects and investment in fintech, alternative finance, crowdfunding, peer-to-peer finance, payments, digital assets and tokens, blockchain, cryptocurrency, regtech, and insurtech sectors. Join Canada's Fintech & Funding Community today FREE! Or become a contributing member and get perks. For more information, please visit: www.ncfacanada.org
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