FRB Issues Guidance to Banks Undertaking Novel Activities
Commentary by Sebastian Souchet
The Federal Reserve Board ("FRB") provided guidance to banking organizations on (i) supervision over "novel activities" and (ii) the process for state member banks to follow before engaging with dollar token or stablecoin activity.
Novel Activities Supervision Program
In one letter, the FRB Division of Supervision and Regulation notified banking organizations of the recent establishment of the Novel Activities Supervision Program which was designed to focus on novel activities, including crypto-assets, distributed ledger technology and "technology-driven partnerships with nonbanks." According to the FRB, the program will be risk-focused so that its level of supervision is in accordance with the "level of engagement in novel activities by each supervised banking organization." The FRB said it intends for the program to complement existing supervisory processes.
Non-Objection Process for State Member Banks
In a joint letter, the FRB Division of Supervision and Regulation and the FRB Division of Consumer and Community Affairs advised that in order to obtain a written notification of supervisory nonobjection regarding the engagement in dollar token-related activities, state member banks should first demonstrate "appropriate risk management practices." These include:
- operational risks associated with the (i) "governance and oversight of the [decentralized] network," (ii) defined roles and responsibilities of parties involved and (iii) the transaction validation process;
- cybersecurity risks associated with (i) the decentralized network on which the dollar token is transacted, (ii) smart contracts and (iii) open source code;
- liquidity risks of the dollar token if it experiences "substantial redemptions in a short period of time" which could lead to rapid outflows of deposits;
- illicit finance risks regarding compliance with the Bank Secrecy Act and OFAC requirements; and
- consumer compliance risks applicable to the specific dollar token activity.
Commentary
The supervisory letters are another action by the federal banking agencies to bring digital assets and FinTech within the regulatory perimeter. As alluded to in both letters, the letters should be read in light of (i) the January 2023 Joint Statement on Crypto-Asset Risks to Banking Organizations; (ii) the February 2023 Joint Statement on Liquidity Risks to Banking Organizations resulting from Crypto-Asset Market Vulnerabilities; and (iii) the FRB's January 2023 policy statement on Section 9(13) of the Federal Reserve Act.
Some additional details on the supervisory letters below:
- Novel Activities Supervision Program. The Novel Activities Supervision Program will focus on: (i) partnerships with non-banks where the non-bank serves as a provider of banking products and services to customers "usually involving technologies like application programming interfaces...that provide automated access to the bank's infrastructure"; (ii) crypto-asset-related activities (e.g., custody, collateralized lending, trading, stablecoin issuance/distribution); (iii) use of distributed ledger technology in connection with, among other things, issuance of stablecoins and "tokenization of securities or other assets"; and (iv) banks emphasizing the provision of "traditional banking activities...to crypto-asset related entities and fintechs" (p. 2).
- Nonobjection Process for Dollar-Token"Activities. Footnote 7 of the supervisory letter concerning the nonobjection process states that a state member bank that is already engaged in dollar token activities as principal prior to the letter (i) must "notify its lead supervisory point of contact at the Federal Reserve of such pre-existing dollar token activities within 30 calendar days" of the issuance of the letter (i.e., by September 7, 2023) ; and (ii) may continue engaging in the existing activities "or any planned expansion of such activities" while the FRB considers issuing a supervisory nonobjection for such activities (p. 2).