When Michael Hsu became acting U.S. Comptroller of the Currency earlier this month, banking industry experts predicted a shift away from the aggressive innovation pushed by fintech-friendly Brian Brooks, who resigned as the Biden administration prepared to take the reins. But nobody knew how quickly that shift would occur. The answer? Fast—very fast. We explain below some of the legal implications for the fintech and DeFi markets.
There are significant changes coming to the Office of the Comptroller of the Currency (OCC), and that creates new challenges for fintechs, cryptocurrency regulation and decentralized finance (or DeFi).
Acting Comptroller Brooks stepped down on January 14, 2021. Before departing, Brooks strongly promoted the OCC’s proposed special-purpose fintech charter (an idea generated under President Obama) and allowed banks and thrifts to provide custody services for crypto assets, among other moves to innovate and modernize the OCC in response to rapid changes in financial services.
But all that is about to change. Pending the naming of a formal replacement, Treasury Secretary Janet Yellen recently named as acting comptroller Michael Hsu, a career banking official who stepped into the role earlier this month. Of greater significance, Hsu has now signaled an impending reversal of the innovations Brooks sought to achieve.
On May 19, 2021, the recently installed Hsu testified before the House Committee on Financial Services. In his written testimony, Hsu identified four priorities, two of which were (1) “guarding against complacency by banks” and (2) “adapting to digitalization.” (The two others related to inequality and climate change.)
As to the first, Hsu expressed concern that some banks, “because of market demand and/or a fear of losing client share, … have set aside their initial risk management concerns and engaged with more risk imprudently.” Further, with compressed margins, “banks of all sizes may be tempted to reach for yield, operate beyond their risk appetites, or compromise their sound risk management.”
As to the digitalization concerns, Hsu identified three related trends that were quickly changing the business of banking: “(1) the mass adoption of digital technology, (2) the rise of payments, and (3) technological innovations developed outside of the banking system.”
Without expressly referencing DeFi,1 Hsu described these changes as a repeat of the “disintermediation” crisis that led to the Great Recession in 2007–08. Broader than DeFi, disintermediation refers to the reduced use of intermediaries between producers and consumers. (In the automotive context, Tesla is a great example in that it sells its cars directly, without car dealers.) But DeFi is today’s banking equivalent. Just read how Hsu addresses the supposed disintermediation problem today:
For me, it is hard not to feel some déjà vu. In the 1990s and 2000s, “disintermediation” was the watchword. Securities firms and capital markets were disintermediating bank lending and the innovation was focused on financial engineering (credit default swaps, collateralized debt obligations, etc.). While this led to greater efficiency in the allocation of credit from savers to borrowers, it also gave rise to a large and less regulated shadow banking system, which eventually collapsed and contributed to the Great Recession.
Today, banks are again being disintermediated but in a different way. Instead of securities firms and capital markets, it is fintechs and technology platforms. Instead of lending, it is payments processing. Instead of financial engineering, it is application programming interfaces, machine learning, and distributed ledgers.
Rather than embracing the DeFi revolution, Hsu expresses concern that regulators have taken a fragmented approach in response to these changes. Hsu writes: “Where should we set the regulatory perimeter? To my knowledge, there is not a shared understanding of the answer to that question and no overarching strategy to achieve it.”
As far as the OCC is concerned, Hsu then telegraphs (and we use that word with all its irony intact) that Brian Brooks’ innovative moves at the agency will shortly be supplanted:
At the OCC, the focus has been on encouraging responsible innovation. For instance, we created an Office of Innovation, updated the framework for chartering national banks and trust companies, and interpreted crypto custody services as part of the business of banking. I have asked staff to review these actions.
So, what does this mean for the special-purpose fintech charter? The message is far from clear. Hsu’s comments suggest that he sees the benefits of avoiding a largely unregulated “shadow banking system” but needs to be persuaded that fintechs will gain the benefits of a bank charter “without its responsibilities”:
Denying a charter will not make the problem go away, just as granting a charter will not automatically make a fintech safe, sound, and fair. I will expect any fintechs that the OCC charters to address the financial needs of consumers and businesses in a fair and equitable manner and support the important goal of promoting the availability of credit. Recognizing the OCC’s unique authority to grant charters, we must find a way to consider how fintechs and payments platforms fit into the banking system, and we must do it in coordination with the FDIC, Federal Reserve, and the states.
In addition to these stated priorities, Hsu likewise advised that he had ordered various reviews, including of “guidance regarding cryptocurrencies and digital assets, and pending licensing decisions.” In other words, the industry should expect to see material changes in how banks deal with crypto, and in decisions regarding which entities are worthy of that coveted national bank charter.
Why It Matters
Given Hsu’s comments, there are new substantial legal and financial risks for fintechs and others that operate within the DeFi space. Will the OCC use its considerable influence to promote anticompetitive policies that stifle innovation? Or will the changes provide greater protections without sacrificing that innovation? And what role should federal regulators play in these new markets?
DeFi is here to stay, but Hsu is signaling he wants to hit the brakes on the fast pace set by Brooks.2 With over $80 billion in value locked into DeFi as of earlier this month, the sector will continue to build off cryptocurrency projects that developed after the release of Bitcoin and Ethereum. With the OCC as a leading component of the huge network of federal and state financial regulators, financial regulators and the entities they supervise have long assumed the presence of intermediaries, and these agencies regulate their supervised entities comprehensively. Hsu does not answer how financial regulators fit into this mix. Rather, he wants the agencies to collaborate (and not compete) to achieve a favorable result.
It is important to put Hsu’s remarks in the context of the overall crypto debate in Washington and among state financial regulators across the country. As the public begins to appreciate the world beyond Bitcoin, competing agencies are emerging to regulate the space. In addition, the global Financial Action Task Force has promulgated recommendations regarding anti-money laundering and know-your-customer rules. We generally advise blockchain clients to be cautious and assume the most adverse plausible outcome with respect to securities, banking, and finance licensing and lending. Blockchain regulations are bound to evolve, and the free ride of the first few years might be coming to an end. Companies need to prepare to invest capital in compliance if they are to become part of the legitimate financial services ecosystem.
Charters are a different issue, and we’ve written extensively on the topic since the OCC announced it would accept applications for special-purpose fintech bank charters in 2018. Whether they seek that option or to become fully licensed banks unto themselves, fintechs will need to ensure that their risk management profile and policies are extraordinarily robust and responsive to regulatory concerns. In addition, these entities will need to anticipate that the chartering process will involve a significant amount of time and monetary investment above and beyond what predecessors may have experienced. No shortcuts; thoughtful and experienced management; and significant capital buffers will all need to be part of any application process. We also expect increased examination focus on bank partnerships and whether chartered banks are adequately protecting themselves (and the financial system) through those relationships.
Of course, whomever President Biden ultimately nominates for comptroller will materially impact this analysis. Two long-rumored options, Manny Alvarez and Mehrsa Baradaran, offer potentially competing visions for banking. Alvarez, despite his current credentials as commissioner of the California Department of Financial Protection and Innovation, was formerly the general counsel at Affirm, a fintech innovator. On the other hand, Baradaran (a law professor at UC Irvine) is a known cryptocurrency skeptic.
Manatt is presently advising clients on the implications of Hsu’s actions and how best to address the anticipated changes from a legal perspective.
1 DeFi, or decentralized finance, is the practice of traditional asset-based finance and investment through nonbank issuers and intermediaries using blockchain technology. DeFi has been criticized because, in some respects, it is unregulated.
2 Since leaving the OCC, Brooks has accepted a position as CEO of DeFi and cryptocurrency trading firm Binance.US.