Regulatory arbitrage in the payments system is risky business

By Steve Kenneally
ABA Viewpoint

Innovation happens when creators find efficiencies—shortcuts or backdoors that sidestep obstacles that don’t belong anymore. The Ford Model T assembly line found shortcuts in time that made it possible to mass-produce affordable cars. The credit card allowed merchants to sidestep the process of validating the legitimacy of shoppers’ checks and allowed consumers to skip the process of getting and holding cash.

But not all backdoors are signs of innovation. Some of them are created by regulatory arbitrage—an effort to game the system and capitalize on points of weakness in the rules and laws that are meant to protect us all. And while some efforts at regulatory arbitrage illuminate places where we can modernize regulation, many others point to a place where a well-working regulatory structure needs to be reinforced.

Consider our payment system: it’s worked well with the Federal Reserve Banks and its regulated financial institution participants because all parties are held to the same high standards. However, over the past several years some under-regulated entities have sought access to the Fed’s payment system, and that presents a risk we just can’t accept.

In Wyoming, a new charter type for “special purpose depository institutions,” or SPDIs, was created to attract cryptocurrency businesses to establish state-chartered institutions that would carry out some bank functions—but with no federal supervision or insurance. Instead of FDIC insurance the banks must carry reserves to offset all deposits. Because there is no FDIC insurance, these entities are not subject to the Bank Holding Company Act.

Currently, there are two SPDI applications for access to the payment system pending with the Fed. This regulatory arbitrage play should be rejected. They are seeking access to the payment system without the oversight that the rest of the participants in that same payment system receive. We urge the Federal Reserve to recognize this end-run to avoid financial oversight, while still seeking all the benefits access to the payment system provides.

Consider a SPDI with no federal oversight or insurance getting access to the payment system. Without a federal agency or the FDIC looking over their shoulder, bank customers’ deposits and privacy are at risk. The same state agency that fast-tracked these charters is responsible for protecting the consumer. One of the SPDIs has a parent company that is a large cryptocurrency exchange, and without the BHCA applying there is no oversight of that relationship or the risks it poses.

There is trouble brewing with some trust charters approved by the Office of the Comptroller of the Currency as well. At the end of the prior administration, the OCC issued an interpretative letter that expanded the eligibility criteria for federal trust charters from the OCC, even if they do not plan to provide traditional fiduciary services.

The result is that several state-chartered trust companies that provide merely custodial services for digital assets were granted conditional approval for a national OCC charter and thus on the path to apply for Federal Reserve payment system access. The OCC fundamentally changed the eligibility for trust charter applicants with no public notice or comment period. (Just this week, the OCC entered into a consent order with one of those companies for failing to adopt and implement an anti-money laundering compliance program.) This is a familiar arbitrage play. Chartered institutions focusing on digital assets with no FDIC or BHCA oversight are seeking access to the payment system. This time it was done with an assist by the OCC, although the OCC may no longer be as receptive to these approvals.

The Federal Reserve payment system has long worked well because all of the players were subject to consistent oversight and supervision. If these novel charters are allowed access in their current form, we cannot be sure the system will retain that strength and resilience. Innovation that puts the payment system at greater risk isn’t “disruption.” It’s an unforced error that the Fed can and should easily avoid.

Steve Kenneally is SVP for payments system policy issues at ABA.

ABA Viewpoint is the source for analysis, commentary and perspective from the American Bankers Association on the policy issues shaping banking today and into the future. Click here to view all posts in this series.