At the end of last week, the Federal Reserve Board (“FRB”) issued its semi-annual Financial Stability Report.

In a statement issued with the report, FRB Vice Chair Lael Brainard stated that over the past six months, “household and business indebtedness has remained generally stable, and on aggregate households and businesses have maintained the ability to cover debt servicing, despite rising interest rates.” She also noted that “[t]oday’s environment of rapid synchronous global monetary policy tightening, elevated inflation, and high uncertainty associated with the pandemic and the war raises the risk that a shock could lead to the amplification of vulnerabilities, for instance due to strained liquidity in core financial markets or hidden leverage.”

The Report notes that the FRB’s monitoring framework “distinguishes between shocks to, and vulnerabilities of, the financial system,” and “focuses primarily on assessing vulnerabilities, with an emphasis on four broad categories and how those categories might interact to amplify stress in the financial system.” The four categories of vulnerabilities are (1) valuation pressures, (2) borrowing by businesses and households, (3) leverage within the financial sector, and (4) funding risks. The overview of the Report notes that since the May report was released, “the economic outlook has weakened and uncertainty about the outlook has remained elevated, noting that “[i]nflation remains unacceptably high in the United States and is also elevated in many other countries.”

Related to the funding risk vulnerability (and perhaps showing some prescience to our lead story on FTX this week), the Report noted that stable coins remained vulnerable to runs. The Report included a highlighted discussion of digital assets and financial stability noting trouble and volatility in the crypto market in the spring of this year. That discussion noted that the “[t]he turmoil in the digital asset ecosystem did not have notable effects on the traditional financial system because the digital assets ecosystem does not provide significant financial services and its interconnections with the broader financial system are limited.” However, the report noted that as digital assets grow, so too will the risks to financial stability, and cited the October FSOC Report on Digital Asset Financial Stability Risks and Regulation in addressing those risks and regulatory gaps.

The Report identified several near-term risks that “could be amplified” through the four financial vulnerabilities, including high inflation, geopolitical risks (noting Russia’s invasion of Ukraine), market fragilities, and possible shocks caused by a cyber event.

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The Federal Reserve Board (the “FRB”) issued Supervision and Regulation Letter 22-6 (“SR 22-6”), providing guidance for FRB-supervised banking organizations (referred to collectively herein as “FRB banks”) seeking to engage in activities related to cryptocurrency and other digital assets.  The letter states that prior to engaging in crypto-asset-related activities, such FRB banks must ensure that their activities are “legally permissible” and determine whether any regulatory filings are required.  SR 22-6 further states that FRB banks should notify the FRB prior to engaging in crypto-asset-related activities.  Any FRB bank that is already engaged in crypto-asset-related activities should notify the FRB promptly regarding the engagement in such activities, if it has not already done so.  The FRB also encourages state member banks to contact state regulators before engaging in any crypto-asset-related activity.

These requirements send a clear message to FRB banks and in fact to all banks that their crypto-asset related activities are considered to be risky and not to be entered into lightly.

Indeed, the FRB noted that crypto-asset-related activities may pose risks related to safety and soundness, consumer protection, and financial stability, and thus a FRB bank should have in place adequate systems, risk management, and controls to conduct such activities in a safe and sound manner and consistent with all applicable laws.

SR 22-6 is similar to guidance previously issued by the OCC and FDIC; in all cases, the agencies require banks to notify regulators before engaging in any kind of digital asset activity, including custody activities. The three agencies also released a joint statement last November in which they pledged to provide greater guidance on the issue in 2022.  Further, in an August 17, 2022 speech, FRB Governor Bowman stated that the FRB staff is working to articulate supervisory expectations for banks on a variety of digital asset-related activities, including:

• custody of crypto-assets
• facilitation of customer purchases and sales of crypto-assets
• loans collateralized by crypto-assets, and
• issuance and distribution of stablecoins by banking organizations

Interestingly, SR 22-6 comes a few days after a group of Democratic senators sent a letter to the OCC requesting that the OCC withdraw its interpretive letters permitting national banks to engage in cryptocurrency activities and a day after Senator Toomey sent a letter to the FDIC questioning whether it is deterring banks from offering cryptocurrency services.

Although past guidance already required banks to notify regulators of crypto activity, this guidance likely could discourage additional banks from entering into crypto-related activities in the future or from adding additional crypto services. In the end, it could have the unfortunate effect of making it more difficult for cryptocurrency companies to obtain banking services.

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On Jan. 20, 2022, the Board of Governors of the Federal Reserve System (Fed) issued the Money and Payments: The U.S. Dollar in the Age of Digital Transformation paper (Paper) to discuss how a potential U.S. central bank digital currency (CBDC) could improve the U.S. domestic payments system. The Paper covers: (1) the existing forms of money in the United States; (2) the current state of the U.S. payment system and its relative strengths and challenges; (3) the various digital assets that have emerged in recent years, including stablecoins and other cryptocurrencies; and (4) the pros and cons of a U.S. CBDC. This GT Alert summarizes each of these items.

The Fed is welcoming comments in response to the Paper by issuing 20 questions covering the subject. Answers to such questions must be provided by May 20, 2022, on the Fed’s CBDC Feedback Form. It is not a requirement that all questions be answered.

The Existing Forms of Money in the United States

As a means of payment, store of value, or unit of account, money takes multiple forms in the United States:

• Central Bank Money: A liability of the central bank that serves as the foundation of the financial system and the overall economy. In the United States, central bank money comes in the form of physical currency issued by the Fed and digital balances held by commercial banks at the Fed.
• Commercial Bank Money: The digital form of money most commonly used by the public. Commercial bank money is held in accounts at commercial banks.
• Nonbank Money: Digital money held as balances at nonbank financial service providers (e.g., financial technology firms). These firms typically conduct balance transfers on their own books using a range of technologies, including mobile apps.

In the Paper, the Fed explains the downsides of Commercial Bank Money, which has little credit or liquidity risk due to (i) federal deposit insurance, (ii) the supervision and regulation of commercial banks, and (iii) commercial banks’ access to central bank liquidity, and of nonbank money, which lacks the full range of protections of commercial bank money and therefore generally carries more credit and liquidity risk. Conversely, the Fed explains, central bank money carries neither credit nor liquidity risk of the other two forms of money and is therefore considered by the Fed the safest form of money.

Recent Improvements to the U.S. Payment System

The U.S. payment system connects a broad range of financial institutions, households, and businesses. Most payments in the United States rely on interbank payment services—such as the ACH network or wire-transfer systems—to move money from a sender’s account at one bank to a recipient’s account at another bank. Interbank payment systems may initially settle in commercial bank money, or in central bank money, depending on their design. However, because central bank money has no credit or liquidity risk, central bank payment systems tend to underpin interbank payments and serve as the backbone of the broader payment system.

Recent improvements to the U.S. payment system have focused on making payments faster, cheaper, more convenient, and more accessible. A host of consumer-focused services accessible through mobile devices have made digital payments faster and more convenient. However, some of these new payment services, the Fed explains, could pose financial stability, payment system integrity, and other risks. For example, if the growth of nonbank payment services were to cause a large-scale shift of money from commercial banks to nonbanks, it could introduce run risk or other instabilities to the financial system resulting from the lack of equivalent protections that come with commercial bank money.

The Innovations of Digital Assets

Following the recent improvements to the U.S. payment system summarized above, the Fed recognizes that technological innovation has ushered in a wave of digital assets with money-like characteristics (i.e., cryptocurrencies). Cryptocurrencies arose from a combination of cryptographic and distributed ledger technologies, which together provide a foundation for decentralized, peer-to-peer payments. As a more recent incarnation of cryptocurrencies, stablecoins (digital assets backed by other assets such as fiat currency) are emerging as the favored method used today to facilitate trading of other digital assets, and many firms are exploring ways to promote stablecoins as a widespread means of payment.

The Fed, along with other U.S. banking regulators, has expressed concerns and called for regulatory action with respect to cryptocurrencies, particularly stablecoins, in the President’s Working Group on Financial Markets Report, covered in this November 2021 GT Alert.

Central Bank Digital Currency (CBDC)

In reacting to the rapidly changing landscape of digital assets in the United States, the Fed is considering how a CBDC might fit into the U.S. money and payments landscape.

Today, Fed notes (i.e., physical currency) are the only type of central bank money available to the general public, but a U.S. CBDC would enable the general public to make digital payments without requiring mechanisms to maintain public confidence like deposit insurance, and it would not depend on backing by an underlying asset pool to maintain its value. According to the Fed, a CBDC would be the safest digital asset available to the general public, with no associated credit or liquidity risk.

In the Paper, the Fed states that a U.S. CBDC, if one were created, would best serve the needs of the United States by being:

• Privacy-protected: Any CBDC would need to strike an appropriate balance between safeguarding the privacy rights of consumers and affording the transparency necessary to deter criminal activity.
• Intermediated: Under an intermediated model, the private sector would offer accounts or digital wallets to facilitate the management of CBDC holdings and payments. Potential intermediaries could include commercial banks and regulated nonbank financial service providers and would operate in an open market for CBDC services. Although commercial banks and nonbanks would offer services to individuals to manage their CBDC holdings and payments, the CBDC itself would be a liability of the Fed. An intermediated model would facilitate the use of the private sector’s existing privacy and identity-management frameworks; leverage the private sector’s ability to innovate; and reduce the prospects for destabilizing disruptions to the well-functioning U.S. financial system.
• Transferable: For a CBDC to serve as a widely accessible means of payment, it would need to be readily transferable between customers of different intermediaries.
• Identity-verified: Financial institutions in the United States are subject to robust rules designed to combat money laundering and the financing of terrorism. A CBDC would need to be designed to comply with these rules. In practice, this would mean that a CBDC intermediary would need to verify the identity of a person accessing CBDC, just as banks and other financial institutions currently verify the identities of their customers.

The Fed intends a potential U.S. CBDC to be used in transactions that would be final and completed in real time, allowing users to make payments to one another using a risk-free asset. Moreover it is intended that individuals, businesses, and governments would potentially use a U.S. CBDC to make basic purchases of goods and services or pay bills, and the U.S. government could use a CBDC to collect taxes or make benefit payments directly to citizens.

Potential Benefits of a U.S. CBDC

As highlighted by the Fed, the potential benefits of a U.S. CBDC are:

• Meeting future needs and demands for payment services: According to the Fed, a U.S. CBDC would safely meet future needs and demands for payment services by offering the general public broad access to digital money free from credit risk and liquidity risk.
• Improvements to cross-border payments: In the Paper, the Fed explains that a U.S. CBDC would improve cross-border payments by using new technologies, introducing simplified distribution channels, and creating additional opportunities for cross-jurisdictional collaboration and interoperability. However, realizing these potential improvements would require significant international coordination to address issues such as common standards and infrastructure, legal frameworks, preventing illicit transactions, and the cost and timing of implementation.
• The dollar’s international role: The Fed expects that a U.S. CBDC would support the U.S. dollar’s international role because, in a world where foreign countries and currency unions may have introduced their own CBDCs, which could lead to a decrease in the use of the U.S. dollar, a U.S. CBDC might help preserve the international role of the dollar.
• Financial inclusion: Promoting financial inclusion—particularly for economically vulnerable households and communities— by, among other benefits: (i) providing access to digital payments; (ii) enabling rapid and cost-effective payment of taxes; and (iii) enabling rapid and cost-effective delivery of wages, tax refunds, and other federal payments.

Potential Risks and Policy Considerations for a U.S. CBDC

Conversely, the potential risks and policies considerations of a U.S. CBDC are:

• Financial-sector market structure: A U.S. CBDC could fundamentally change the structure of the U.S. financial system, altering the roles and responsibilities of the private sector and the central bank. For example, a widely available U.S. CBDC would serve as a close substitute for commercial bank money. This substitution effect could reduce the aggregate amount of deposits in the banking system and potentially reduce credit availability or raise credit costs for households and businesses. Similarly, an interest-bearing CBDC could result in a shift away from other low-risk assets, such as shares in money market mutual funds, Treasury bills, and other short-term instruments. A shift away from these other low-risk assets could reduce credit availability or raise credit costs for businesses and governments.
• Safety and stability of the financial system: The safety and stability of the financial system could be affected by a U.S. CBDC because the ability to quickly convert other forms of money—including deposits at commercial banks—into CBDC could make runs on financial firms more likely or more severe. Traditional measures such as prudential supervision, government deposit insurance, and access to central bank liquidity may be insufficient to stave off large outflows of commercial bank deposits into CBDC in the event of financial panic.
• Consumer privacy: A general-purpose CBDC would generate data about users’ financial transactions in the same ways that commercial bank and nonbank money generates such data today. In the intermediated CBDC model that the Fed would consider, intermediaries would address privacy concerns by leveraging their existing tools.
• Prevention of financial crimes: Financial institutions must comply with a robust set of rules designed to combat money laundering and the financing of terrorism, including customer due diligence, recordkeeping, and reporting requirements. Any U.S. CBDC would need to be designed in a manner that facilitates compliance with these rules by involving private-sector partners with established programs to help ensure compliance with these rules.
• Operational resilience and cybersecurity: Threats to existing payment services—including operational disruptions and cybersecurity risks— would apply to a U.S. CBDC as well. Any dedicated infrastructure for a U.S. CBDC would need to be resilient to such threats, and the operators of the U.S. CBDC infrastructure would need to remain vigilant as bad actors employ ever more sophisticated methods and tactics. Many digital payments today cannot be executed during natural disasters or other large disruptions, and affected areas must rely on in-person cash transactions and central banks are currently researching whether offline CBDC payment options would be feasible.
• Efficacy of monetary policy implementation: Under the current “ample reserves” monetary policy regime, the Fed exercises control over the level of the federal funds rate and other short-term interest rates primarily through the setting of the Fed’s administered rates. In this framework, the introduction of a U.S. CBDC could affect monetary policy implementation and interest rate control by altering the supply of reserves in the banking system. In the case of a noninterest-bearing U.S. CBDC, the level and volatility of the public’s demand for U.S. CBDC might be comparable to other factors that currently affect the quantity of reserves in the banking system, such as changes in physical currency or overnight repurchase agreements. In this case, a decline in U.S. CBDC that resulted in a corresponding increase in reserves likely would only make reserves more ample and have little effect on the federal funds rate.

Conclusion

While the Paper examines the potential benefits and risks of a U.S. CBDC, it is not intended to advance any specific policy outcome, nor is it intended to signal that the Fed will make any imminent decisions about the appropriateness of issuing a U.S. CBDC. However, the Paper undoubtedly is the Fed’s first step toward central bank digital currencies via a public discussion with its stakeholders.

As previously indicated, the FED is accepting comments in response to the Paper until May 20, 2022, through the FED’s CBDC Feedback Form.

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On November 18, 2021, the Federal Reserve, Federal Deposit Insurance Corporation, and Office of the Comptroller of the Currency issued a new rule regarding cyber incident reporting obligations for U.S. banks and service providers.

The final rule requires a banking organization to notify its primary federal regulator “as soon as possible and no later than 36 hours after the banking organization determines that a notification incident has occurred.” The rule defines a “notification incident” as a “computer-security incident that has materially disrupted or degraded, or is reasonably likely to materially disrupt or degrade, a banking organization’s—

1. Ability to carry out banking operations, activities, or processes, or deliver banking products and services to a material portion of its customer base, in the ordinary course of business;
2. Business line(s), including associated operations, services, functions, and support, that upon failure would result in a material loss of revenue, profit, or franchise value; or
3. Operations, including associated services, functions and support, as applicable, the failure or discontinuance of which would pose a threat to the financial stability of the United States.”

Under the rule, a “computer-security incident” is “an occurrence that results in actual harm to the confidentiality, integrity, or availability of an information system or the information that the system processes, stores, or transmits.”

Separately, the rule requires a bank service provider to notify each affected banking organization “as soon as possible when the bank service provider determines it has experienced a computer-security incident that has materially disrupted or degraded or is reasonably likely to materially disrupt or degrade, covered services provided to such banking organization for four or more hours.” For purposes of the rule, a bank service provider is one that performs “covered services” (i.e., services subject to the Bank Service Company Act (12 U.S.C. 1861–1867)).

In response to comments received on the agencies’ December 2020 proposed rule, the new rule reflects changes to key definitions and notification provisions applicable to both banks and bank service providers. These changes include, among others, narrowing the definition of a “computer security incident,” replacing the “good faith belief” notification standard for banks with a determination standard, and adding a definition of “covered services” to the bank service provider provisions. With these revisions, the agencies intend to resolve some of the ambiguities in the proposed rule and address commenters’ concerns that the rule would create an undue regulatory burden.

The final rule becomes effective April 1, 2022, and compliance is required by May 1, 2022. The regulators hope this new rule will “help promote early awareness of emerging threats to banking organizations and the broader financial system,” as well as “help the agencies react to these threats before they become systemic.”

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The FSOC’s members are the top regulators of the financial system in the United States, including the heads of the Federal Reserve, the Securities and Exchange Commission (SEC), and the Consumer Financial Protection Bureau. Their charge is to identify risks facing the country’s financial system and respond to them. This new Report supports steps being taken by various financial regulators in the U.S.

The Report suggests four steps necessary to facilitate an orderly transition to a net-zero economy.

1. Regulators must develop and use better tools to help policymakers. “Council members recognize that the need for better data and tools cannot justify inaction, as climate-related financial risks will become more acute if not addressed promptly.” The FSOC Report highlights the tool of scenario analysis, “a forward-looking projection of risk outcomes that provides a structured approach for considering potential future risks associated with climate change.” The FSOC recommends the use of sector- and economy-wide scenario analysis as particularly important because of the interrelated and unpredictable development of climate impacts and technologies necessary to address them. Each of these technologies may have an unexpected impact on a part of the economy.
2. Climate-related financial risk data and methodologies for filling gaps must be addressed.  The FSOC Report noted that its members lacked the ability to effectively access and use data that may be present in the financial system. The FSOC Report also noted potential risks to lenders, insurers, infrastructure, and fund managers caused by physical and transitional risks of climate change and the need to develop tools to better understand those risks.
3. As has been highlighted by the environmental, social, and governance (ESG) movement, disclosure by companies of their climate-related risks is a key piece of data not only for investors but also for regulators and policymakers. Disclosure regimes that promote comparable, consistent, or decision-useful data and impacts of climate change are necessary, according to the Report, and also regimes that cover both public and private entities. The Report highlights various ongoing discussions on this topic, including possible regulations by the SEC.
4. To assess and mitigate climate-related risks on the financial system, methods of analyzing the interrelated aspects of climate change are necessary. The Report details the developing thoughts around scenario analysis as a tool to help predict the many aspects of climate change on the financial system but notes that clearly defined objectives and planning are essential for decision-useful analysis.

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The Federal Reserve has created a number of programs to provide loans and other credit facilities to support the economy in response to COVID-19.  Several of these programs provide for new extensions of credit for small, medium and large businesses, including the Main Street Lending Program and the Primary Market Corporate Credit Facility.  The Main Street Lending Program creates three separate facilities (“MSLFs”):  (1) the Main Street New Loan Facility, (2) the Main Street Expanded Loan Facility and (3) the Main Street Priority Loan Facility.  Each of these facilities contemplates banks and other financial institutions making “new money” loans to eligible borrowers, and in turn selling participation interests in the loans to a Fed / Treasury special purpose vehicle.  The Primary Market Corporate Credit Facility (“PMCCF”) i contemplates a Fed / Treasury special purpose vehicle that will make new money extensions of credit to eligible borrowers by directly purchasing bonds issued by them, or by making loans to such eligible borrowers, whether as a direct lender or by purchasing loans to such borrowers under syndicated loan facilities.

The Federal Reserve released and then updated term sheets for the MSLFs and PMCCF in March and April 2020 and circulated an FAQ for the MSLFs in April 2020, and the Federal Reserve Bank of New York released and circulated FAQs for the PMCCF in April and May 2020.  The term sheets and FAQs provide a number of material terms and conditions for the facilities, but many questions and issues remain in terms of structuring and implementing these facilities generally and for agents, lenders, trustees, borrowers, issuers and other parties satisfying eligibility requirements for and participating in transactions under these facilities.

The MSLFs and PMCCF, which collectively represent hundreds of billions of dollars of new money financing for borrowers and issuers, are expected to launch by the end of May 2020.

A comprehensive summary of the MSLFs and PMCCF based on the term sheets and FAQs issued to date, market reconnaissance and strategic planning and considerations around these facilities can be accessed here.  We will periodically update and supplement the MSLF/PMCCF summary and separately provide additional alerts and guidance regarding these facilities generally and the parties qualifying for and participating in transactions under these facilities.

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