Restoring Order in Crypto’s Wild West

Last week marked another milestone in the evolution of cryptocurrency. Visa announced they would let USD Coin, a stablecoin pegged to the U.S. dollar, settle on its payment network, and PayPal launched “Checkout with Crypto,” a service that allows customers to pay with cryptocurrency at checkout. These moves represent the latest brick to be removed from the wall that had previously separated the crypto-asset sector from the mainstream financial industry.

Despite these recent advances, many banks remain wary of cryptocurrency and crypto-related businesses. Such wariness is understandable considering the novelty of the technology, cryptocurrency’s uncertain legal and regulatory status, and the dramatic volatility displayed by bitcoin and other prominent cryptocurrencies. As a result, many crypto-asset firms have found it difficult, if not impossible, to obtain a banking relationship. But one unlikely state has been trying to change this — Wyoming.

Wyoming Embraces Crypto

Between 2018 and 2019, Wyoming passed 13 blockchain-related bills designed to, in the words of one prominent supporter, make it “the only US state to provide a comprehensive, welcoming legal framework that enables Blockchain technology to flourish, both for individuals and companies.” According to supporters, becoming the “Delaware of digital asset law” will “bring capital, jobs and revenue into Wyoming.”

Wyoming may seem like an odd choice to lead the crypto charge, but, as they say, everything happens for a reason. The state was targeted by native daughter Caitlin Long, a Harvard Law grad and 22 year Wall Street veteran. Long moved back to Wyoming several years ago to co-found the Wyoming Blockchain Coalition in 2017 and to serve as a gubernatorial appointee at the Wyoming Blockchain Task Force (she left the taskforce in 2019). Accordant to Forbes, her work “inspired the legislature to enact 18 laws to facilitate crypto financing.”

But some argue that Long co-opted the legislative process to pass bills favorable to her financial interests. This view is bolstered by the fact that the Wyoming legislative session lasts just 40 days in odd numbered years and 20 days in even numbered years; that’s not a lot of time for part-time legislators to understand the nuances of blockchain technology and the legal status of various crypto-assets. According to the non-profit public-interest news outlet WyoFile, as a member of the Blockchain Task Force, Long “had a vote on which bills passed out of the task force and into the full Legislature” even though she was not a lawmaker. According to Robert Jennings, one of the founders of the Wyoming Blockchain Coalition who has since soured on the effort, “the few people actually writing these laws and pushing them through have a personal financial interest in getting them passed.” Jennings went on to warn that efforts to promote blockchain and related businesses in the state are “dangerous because the Wyoming legislators are being sold on economic diversification and they are passing these very specific laws without fully understanding them or the long-term implications.”

One bill that Long successfully lobbied for created a new state banking charter — known as the Special Purpose Depository Institution (SPDI) charter — that was designed to assist “blockchain innovators” in accessing “secure and reliable banking services.” Long went on to become the beneficiary of her lobbying when she founded Avanti Bank in 2020, which became the second recipient of the SPDI charter. However, a recent proposal by the Wyoming Division of Banking to amend the rules governing SPDIs indicate that Long’s run of luck in the state may be coming to an end.

SPDI Overview

In 2019, the Wyoming legislature passed HB 74 which authorized the chartering of new special purpose depository institutions that are permitted to engage in digital asset activities. SPDIs are permitted to accept deposits from legal entities other than natural persons, but these deposits must be fully backed by unencumbered liquid assets. SPDIs are also “prohibited from making loans with customer deposits of fiat currency and therefore are not required to obtain insurance from the Federal Deposit Insurance Corporation — though they may do so.” The Wyoming Division of Banking began accepting applications for SPDI charters in October 2019.

In September 2020, the cryptocurrency exchange Kraken became the first company to obtain an SPDI charter for its newly created subsidiary, Kraken Bank. In a blog post announcing their approval, David Kinitsky, CEO of Kraken Bank, said:

“We’re thrilled to work in a state so aligned with our philosophy and values. Wyoming is a rare and shining example of how thoughtful regulation can drive innovation for FinTech companies.”

In the same blog post, Kraken Bank indicated that their goal was to “provide clients with everything they expect from a seamless banking gateway between digital assets and national currencies.” Initially, Kraken Bank will allow clients to deposit USD and custody digital assets, and the company plans on expanding their services to include digital asset staking, trust accounts, and a crypto debit card.

In October 2020, Avanti Bank became the second recipient of the SPDI charter. Avanti’s initial plan is to provide crypto-asset custodial services to institutional investors like hedge funds and family offices. In addition, Avanti plans on issuing tokenized U.S. dollars called Avits. According to Long, Avits are “electronic bank notes analogous to any bank note or check that is an obligation of the bank.” Avits will be issued on either the bitcoin or Ethereum blockchain and can be used in software applications “where the settlement of the payment and the asset happens at the same time.”

The ultimate success of Kraken Bank and Avanti depends on their ability to obtain a master account at the Federal Reserve (the Fed). A master account is basically a bank account at a regional Federal Reserve Bank that enables access to the Federal Reserve Payments System — and this access is essential if Avanti and Kraken Bank want to serve as a gateway between crypto-assets and U.S. dollars. On their website, Avanti notes that they have applied to become a U.S. dollar clearing bank at the Federal Reserve, which would allow them to “directly clear payments for their customers at the Federal Reserve, without the cost, delays, reconciliation headaches and counterparty risk of relying on various intermediaries traditionally used.” This means that the fate of Kraken Bank and Avanti rests in the hands of the Federal Reserve Bank of Kansas City, who is currently reviewing their applications. While the Fed has been silent on the topic, several prominent banking industry groups have raised concerns about the SPDI charter and have cautioned against granting master accounts to SPDIs.

SPDI Critiques

Banking industry groups have been critical of Wyoming SPDIs and similar attempts by the OCC to charter crypto banks. Rob Nichols, CEO of the American Bankers Association, wrote that: “The lack of FDIC insurance and loan offerings suggests that the SPDIs would not meet the definition of ‘bank’ under the Bank Holding Company Act.” As a result, SPDIs are not subject to consolidated supervision by the Federal Reserve, giving them a competitive advantage over traditional banks. To make this point concrete, Kraken Bank (the Wyoming SPDI) is supervised by the Wyoming Division of Banking, while Kraken (its parent company, which includes its primary cryptocurrency exchange business), is not subject to consolidated Federal Reserve supervision or any other kind of federal supervision. As mentioned, Wyoming SPDIs are also permitted to apply for a Federal Reserve master account, which would allow them to access Federal Reserve payment systems like the Fedwire Funds Service and the automated clearinghouse  network. Nichols believes that the main premise of the SPDI charter is to grant cryptocurrency banks “access to the nation’s payments system with a lower level of oversight,” and he argues that the Federal Reserve should delay granting “non-traditional entities” access to master accounts “until a uniform policy can be adopted.”

The Bank Policy Institute (BPI), a lobbying and advocacy organization representing the largest banks in the U.S., called out the SPDI business model as “inherently unstable under stress” due to the requirement that all deposits be fully reserved by liquid assets. The problem, according to BPI, is that the Wyoming Banking Division defined “liquid assets” to also include investment-grade corporate debt as well as investment-grade state and municipal securities. Therefore, when interest rates go up, the bonds held by SPDIs as reserves will decline in value, and the value of deposits may exceed the assets held in reserve. Depositors would then “run” on the bank to make sure they withdraw their deposits while the SPDI still has enough liquid reserves to pay them. A sufficient capital base can help prevent, or stem, deposit outflows — but because SPDIs are not FDIC-insured banks, they need only comply with Wyoming’s Division of Banking capital requirements. Importantly, the Division of Banking maintains significant discretion in establishing SPDI capital requirements, and noted that “required initial capital will vary from institution to institution.” The Division stated that prospective SPDIs can expect an initial minimum capital requirement of “1.25–1.75% of proposed assets under management/assets under custody (off-balance sheet assets) or $10,000,000 — whichever is greater.” As BPI noted, it is not “clear what level of capital requirements these amounts translate to as a percentage of assets” but it most certainly falls short of the basic minimum capital requirement of 7% of common equity tier 1 ratio for a bank supervised by a federal banking agency.[i] The capital discrepancy is even more startling when you consider that SPDIs do not have access to Federal Reserve lender of last resort facilities and may not have deposit insurance.

Tightening the SPDI Rules

The Wyoming Division of Banking apparently recognised that HB 74 had gaps that could potentially undermine the safety and soundness of SPDIs, because in February 2021, they recommended several amendments and additions to the rules governing SPDIs. Of particular note, the Division recommended eliminating investment-grade corporate debt from the definition of liquid assets. In addition, the Division recommended “[p]rohibiting non-financial (commercial) firms from obtaining an SPDI” charter, which would mirror the prohibition on the mixing of banking and commerce that has historically been reflected in federal banking law. And perhaps most significantly, the Division wants the legal authority to “conduct an examination of a legal entity with a controlling interest in a special purpose depository institution” and “[r]equire a person with a controlling interest in a special purpose depository institution to divest or sever their relationship with the institution, if necessary to maintain safety and soundness.” These changes would partially align Wyoming banking law with the Bank Holding Company Act.

The proposed amendments and additions reflect prudent regulatory practice and are in keeping with the safety and soundness mandate of state banking regulators. However, if implemented, these recommendations would transform the SPDI charter in a way that would make it far less attractive to existing SPDIs and potential applicants.

The comment period for the proposed amendments and additions ended on March 26, 2021, and the Division of Banking received just one comment letter from, you guessed it, Avanti Financial Group (their letter was co-signed by Caitlin Long). Avanti’s comments reflect the company’s closely held nature. In response to the proposal that a “person with a controlling interest in a special purpose depository institution shall…(i) Submit annual audited financial statements, and as otherwise reasonably required by the Commissioner”, Avanti notes that under Wyoming law, a “person” includes an individual and that it is “impossible” for an individual to obtain audited financial statements. Avanti suggests that either individuals should be exempt from this provision, or that individual controlling shareholders should simply submit an annual “attestation of solvency.”

Avanti also takes issue with the proposed rule that would “require a person with a controlling interest in a special purpose depository institution to divest or sever their relationship with the institution, if necessary to maintain safety and soundness.” Avanti is concerned about a lack of standards for judging “safety and soundness” and the potential for the Banking Commissioner to “arbitrarily” require “the controlling shareholder to divest within an unreasonably short period of time (e.g., 24 hours).”

Avanti’s first two comments on the proposed SPDI rule changes are clearly an attempt to protect the personal interests of Caitlin Long as Avanti’s founder and controlling shareholder. Their third comment relates to the proposal that SPDIs “conduct appropriate market surveillance to prevent, detect and combat manipulative or illegal trading practices in traditional and digital asset markets.” Such surveillance capabilities were imposed by the Commodity Futures Trading Commission on exchanges that list cryptocurrency futures contracts and are clearly designed to counteract the rampant fraud and manipulation in the cryptocurrency market. Avanti believes that market surveillance requirements should not apply to SPDIs that are not engaged in market making or brokerage activities.

Conclusion

The Wyoming legislature put the Division of Banking in a difficult position by requiring them to develop the rules and regulations for an entirely new type of charter that was expressly created to provide banking services to “blockchain innovators.” Not only was the Division of Banking forced to establish guidelines governing the SPDI application process, but now they must determine how they will supervise SPDIs going forward. The crypto-assets created by blockchain technology represent a new asset class with novel and distinct risk characteristics. To that end, the Division of Banking contracted with Promontory Financial Group to help develop the SPDI Examination Manual and Supervisory Handbook, which is yet to be released. Given the limited resources most state banking agencies possess and the absence of any kind of federal standard governing the regulation of crypto-assets in the banking sector, it is understandable why the Division of Banking would request the assistance of a prominent consulting firm.

Last October, Fred Rife, the interim director of the Wyoming Department of Audit, which oversees the Division of Banking, acknowledged that the Division is “out on the leading edge and they’re doing things that nobody else in the country’s been asked to do at this point.” The reality is that a small group of self-interested individuals put the Division in this position. The Division’s recent proposal to amend the rules governing SPDIs is an attempt to restore some law and order to what has become crypto’s wild west. I encourage the Division of Banking to finalize these rules without amendment and without delay.

Lee Reiners is the executive director of the Global Financial Markets Center at Duke Law

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[1] See, e.g., 12 CFR 217.10-11. The 7 percent CET 1 ratio includes a capital conservation buffer of 2.5 percent on top of a 4.5 percent CET 1 minimum.