A faction of Washington, D.C. regulators is apparently considering a move to tighten the vice on digital assets that could – if implemented – perversely incentivize unregulated crypto activity in the U.S. This move by anti-crypto beltway forces seems intended to slow the growth of licensed crypto institutions in the U.S. and would raise many foundational questions. If enacted it would likely bolster the view of the U.S. as woefully slow in developing a cohesive and safe policy on crypto for the world’s largest financial market.

Here’s the move under consideration: D.C. bank regulators are considering adopting the SEC’s staff accounting bulletin for crypto custody in a manner that would apply it to every bank and – potentially – every non-bank crypto intermediary in the U.S. as well. If enacted, this could:

1. significantly increase the capital requirement for U.S. crypto intermediaries, and
2. in the worst-case scenario, render useless the licensing regime currently used by most U.S. crypto intermediaries – money transmitter licenses – because crypto assets are not “permissible investments” under the money transmission laws currently relied upon by most companies in the industry. If that happens, all 50 states could lose the fee revenue they currently collect from the crypto industry in the form of money-transmission licensing fees.

To be clear, nothing is yet certain and I have no first-hand knowledge of the plans. The topic has quietly been the “talk of the town” in Washington D.C. for the past few weeks, with crypto lobbyists and banking lawyers revving up. And, as with all things D.C. during an election year, some political types are privately expressing concern that an anti-crypto push ahead of the November election – one that goes well beyond a push for reasonable regulation – could backfire among millennial voters.

What Regulators Are Considering

The proposal under consideration builds on the SEC’s Staff Accounting Bulletin 121, released on March 31, 2022, which requires SEC-reporting companies to account for crypto held by intermediaries for customer safeguarding as on-balance sheet assets and liabilities, rather than off-balance sheet. It penalizes the accounting for crypto custody relative to the accounting for securities custody. Building on the SEC’s move:

• Federal bank regulators in D.C. are considering adopting a similar requirement for banks, according to the buzz in D.C. If they do so, crypto assets and liabilities under custody would presumably attract a capital requirement. Depending on each bank’s business and capital mix, the capital requirement could be 5% of crypto asset value or higher.
• Next, if the federal bank regulators adopt the proposal, there is a real question whether it would also extend to the FFIEC (Federal Financial Institutions Examination Council). Apparently this is also under consideration – though, again, no one knows details. State financial services regulators follow FFIEC guidance when they regulate all of the financial institutions within their states (banks, trust companies and money transmitters) – which means all state-regulated entities could – again, could – then also be required to start reporting crypto custody as on-balance sheet assets and liabilities too.

Here are some implications:

First, the worst-case scenario, in which the FFIEC adopts the proposal too, could render money transmitter licenses inapplicable to crypto intermediaries. Would the crypto assets held for customers on-balance sheet be considered “investments”? If not, what then are they?? If investments, it may be illegal for money transmitters to hold the crypto assets because state money transmitter statutes generally permit money transmitters to invest only in safe, liquid assets like cash, T-bills and money market funds. This worst-case scenario would raise foundational questions about the licensing regime relied on by nearly all crypto intermediaries in the U.S.

Second, adoption of the proposal could massively increase the capital requirement for the crypto industry as a whole. Looking at U.S. industry in aggregate, crypto intermediaries today have almost no capital requirement – this is not unique, though, as the same is true of the fintech industry. Why? Because most fintechs and crypto intermediaries are licensed as money transmitters, and money transmission laws do not contain a prudential capital requirement; they instead focus on reserve requirements and the type of “permissible investments” for those reserves. A few crypto intermediaries and fintechs are currently licensed as trust companies, and trust companies do have a capital requirement but it is minimal compared to the capital requirement for banks. For example, in one instance, a trust company with roughly $30 billion of crypto assets under custody has only a $7 million minimum capital requirement today. Under the possible new rule, its capital requirement could spike to ~5% of assets under custody, or ~$1.5 billion. From $7 million to $1.5 billion – that would be quite a radical change indeed.

Connecting the dots: if the capital-light money transmitter licensing regime doesn’t work anymore, U.S. crypto intermediaries would need to become licensed as something else (i.e., banks, trust companies, broker/dealers, etc.) – and would become subject to far higher capital requirements. To cover the cost of that capital, they would need to charge customers more.

It’s also far from clear that the door is even open for crypto intermediaries to become licensed as banks, trust companies or broker/dealers, especially at the federal level.

Third, crypto custodians that also provide crypto lending services for custody clients could end up with a double capital charge under the possible new rule: one for the loan and another for the custody asset.

Fourth, U.S. GAAP currently treats crypto as “indefinite intangible assets.” This means the crypto custody assets moved onto the intermediary’s balance sheet will be carried at the lower of cost or market value (subject to impairment testing), while the liabilities will be carried at cost. This accounting mismatch is a recipe for earnings volatility at the crypto intermediary.

What Will Happen?

No one knows for sure, and this may all turn out to be a false alarm. But the SEC’s staff bulletin just appeared without warning – it was done in the form of a staff bulletin, which meant it was not subject to a notice and public comment process. Will federal bank regulators use a similar closed-door process? Again, no one knows.

Last Friday the banking and securities industry associations submitted a joint letter raising serious questions about the SEC’s staff bulletin – questions that should have been addressed before it was adopted, but there was no public comment process to identify these issues. Thankfully, when D.C. bank regulators have changed FFIEC guidance historically, they have normally done so via a notice and public comment process.

If the possible rule is enacted and the worst-case scenario actually happens, U.S. crypto companies would likely enlist their ~40 million U.S. customers to start lighting up Congress again, just as they did en masse in the summer of 2021 when the infrastructure bill included a proposal that was similarly serious.

Oh, and it’s an election year.