The New York Department of Financial Services was told by a federal court in New York that it could proceed with its lawsuit challenging plans of the Office of the Comptroller of the Currency to accept and consider applications for special-purpose national bank charters from financial technology companies that have no intent to accept deposits. Separately, companies associated with an international cryptocurrency exchange and its affiliated issuer of a well-renowned stablecoin obtained a show cause order from a New York court, demanding that the New York Attorney General explain why they should comply with an extensive document request by the NY AG obtained through an ex parte process two weeks ago. As a result, the following matters are covered in this week’s edition of Bridging the Week:

• Federal Court Opens Spigot Permitting NY DFS Lawsuit to Proceed Against Federal Bank Regulator for Planning to Issue Fintech Charters (includes My View); 

• Cryptoasset Exchange and Related Stablecoin Companies Tell Court NY AG Lawsuit “Riddled With Factual and Legal Errors” (includes Memory Lane); and more.

Briefly:

• Federal Court Opens Spigot Permitting NY DFS Lawsuit to Proceed Against Federal Bank Regulator for Planning to Issue Fintech Charters: A US federal court in New York ruled that it had jurisdiction to consider a challenge by the NY Department of Financial Services to the authority of the Office of the Comptroller of the Currency to issue special-purpose national bank (“SPNB”) charters to financial technology companies. DFS claimed that OCC’s plan to grant so-called “fintech charters” violated the federal banking regulator’s statutory authority to license national banks in the business of banking because OCC contemplated issuing SPNB charters to entities that did not accept deposits. DFS also claimed that OCC’s action violated the US Constitution, constituting a preemption of state law that was not authorized by Congress.

​OCC contemplated that, by applying its "...uniform supervision over national banks, including fintech companies, [it would] help promote consistency in the application of law and regulation across the country and ensure that consumers [we]re treated fairly." (Click here to access OCC's December 2016 publication "Exploring Special Purpose National Bank Charters for Fintech Companies.) Fintech companies, including those facilitating cryptocurrency trading and custody, had hoped that obtaining an SPNB charter might have obviated the necessity of applying state-by-state for money transmitter and equivalent licenses in order to lawfully conduct their business.

DFS filed its lawsuit against OCC in September 2018 and OCC moved to dismiss DFS’s complaint a few months afterward, claiming that the court had no jurisdiction over the matter because it was not ripe for adjudication. (Click here for background in the article “NY DFS Sues OCC Over FinTech License; Other State Financial Regulators Say Their Legal Challenge Is Right Behind” in the September 16, 2018 edition of Bridging the Week.)

In December 2017, a different judge in the same federal court granted a motion to dismiss an analogous, earlier challenge by NY DFS against OCC also claiming that DFS’s complaint was not then ripe for determination. At the time, however, OCC was solely considering the possibility of potentially processing fintech charters and had not finalized its plans. (Click here for further background in the article “Challenge to NY BitLicense and Potential OCC Fintech Charter Quashed” in the January 7, 2018 edition of Bridging the Week.) 

Subsequently, OCC finalized its SPNB charter program for fintech companies and announced it would accept qualifying applications beginning July 2018. (Click here for background in the article “OCC and Fintech Charters” in the August 5, 2018 edition of Bridging the Week.) As a result, the court in the current matter held that DFS satisfactorily demonstrated that there is now “substantial risk that harm will occur” if SPNB charters were granted, mainly that state oversight of non-depository money transmitters could be eliminated and DFS could lose substantial revenue if current DFS-regulated entities give up their NY licenses for OCC licenses.

The United States operates a dual system of banking organizations, some regulated by federal authorities and some regulated by the states. Traditionally, OCC has mostly approved as banks deposit-taking institutions. Contrariwise, DFS frequently authorizes financial institutions that do not take deposits, such as money transmitters. DFS has also approved a number of entities as special-purpose trust companies that are expressly authorized to facilitate transactions in virtual currencies; as part of their approval, such companies must comply with obligations required by entities obtaining a NY Bitlicense. (Click here for background in the article “Money Service Businesses for Second Largest Virtual Currency Fined for AML Deficiencies; Bitcoin Exchange Gets First NY License as Trust Company” in the May 10, 2015 edition of Bridging the Week.) 

Notwithstanding the general victory by DFS, the court granted OCC’s motion to dismiss the part of DFS’s complaint based on constitutional grounds. The court stated that, for constitutional purposes, it was not relevant whether Congress specifically authorized OCC’s action but whether the national government could authorize such action at all. DFS, concluded the court, did not allege that OCC’s proposed SPNB charter program exceeded an enumerated authority of the national government and thus its constitutional challenge could not stand.

Another lawsuit against OCC challenging its authority to grant fintech charters is pending in a federal court in the District of Columbia. The second action was filed by The Conference of State Bank Supervisors in October 2018 (click here to access the relevant complaint).

Separately, OCC proposed a new program to support innovation in the US federal banking system – the OCC Innovation Pilot Program. Among other objectives, the goal of the program is to promote the “development and delivery of more effective and efficient activities to benefit consumers, businesses, financial institutions and communities.” Eligible entities would receive regulatory input early in their development of innovative programs and would help fashion the development of “appropriate controls.” Comments to OCC’s proposed pilot program will be accepted through June 14, 2019.

My View: As I have written before, the case for a single federal regulator of cryptocurrency exchanges is overwhelming. Today, jurisdiction over such entities is practically divided among FinCEN (which generally requires exchangers of virtual currency to be registered as money service businesses), the states (many of which require such entities to register as money transmitters or in an equivalent manner, or in the case of New York, also mandate such entities to obtain a so‑called “BitLicense”) and the Commodity Futures Trading Commission (which exercises anti-fraud and anti-manipulation authority over transactions involving spot virtual currencies but does not functionally regulate such transactions day to day). To me, this hodgepodge approach is a big problem waiting to happen and creates a too-high barrier to entry for legitimate firms that wish to provide innovative cryptoasset trading solutions.

Watching states and federal agencies duke it out in court over who should regulate fintech-type banking entities – which could include non-deposit-taking financial institutions that provide fiduciary services in connection with offering virtual currency trading planforms – does not seem an optimal use of taxpayer funds. Congress must intervene and propose a comprehensive solution.

• Cryptoasset Exchange and Related Stablecoin Companies Tell Court NY AG Lawsuit “Riddled With Factual and Legal Errors”: Companies associated with Bitfinex and Tether obtained an order from a New York court requiring the NY Attorney General to “show cause” during a hearing on May 6 why the firms should not be excused from providing over four years of documents required by an April 24 order of the same court. 

Previously, the NY court required the associated companies to produce a multitude of documents by May 24, 2019, as well as prohibited the companies from accessing, loaning or encumbering in any way US dollar reserves supporting tether stablecoins. The NY AG had applied for such order without giving respondents notice or having an opportunity to object, claiming such emergency action was necessary because of the potential danger of respondents compromising tether’s supporting balances to help fund Bitfinex’s operations. (Click here for background in the article “NY Attorney General Sues Stablecoin Issuer and Related Companies for Purportedly Misusing Tethered Fiat Currency Without Customer Disclosure” in the April 28, 2019 edition of Bridging the Week.)

Last week, the defendants vehemently objected to the NY AG obtaining the order against them on an ex parte basis, claiming that the lawsuit was “riddled with factual and legal errors.” Among other things, defendants claimed they (1) had voluntarily cooperated with the NY AG’s investigation as soon as they learned about it; (2) had no obligation to maintain a 1:1 ratio of fiat currency to the value of each tether stablecoin; and (3) had not committed fraud or failed to disclose a potential conflict of interest. This is because, argued the defendants, Tether had expressly disclosed to customers on its website in February 2019 that tethers could be backed by ”other assets and receivables from loans made by Tether to third parties, which may include affiliated entities.” 

According to the NY AG, Tether extended to Bitfinex a US $900 million line of credit that closed in March 2019. Subsequently, Bitfinex drew down US $625 million of this amount to replenish funds that previously Bitfinex had transferred to Tether in accounts at Crypto Capital, a payment processor, in return for Tether transferring an equivalent sum from Tether’s reserves to Bitfinex at a different financial institution. At the time, said the NY AG, Bitfinex was apparently having difficulty meeting customers' demands to withdraw money because of its inability to access funds maintained at Crypto Capital. Beginning in late December 2018, said the NY AG, the defendants expressed specific concerns about US $850 million of their funds at Crypto Capital that the settlement firm claimed had been “restrained” by governmental authorities in Poland, Portugal and the United Sates.

In papers filed in the NY court, the defendants claimed that the court’s grant of the NY AG’s requested ex parte order denied it due process. Moreover, claimed defendants, nothing is fundamentally wrong with tethers not being backed 1:1 by fiat currency; a “fractional reserve” system underpins commercial banking, said the defendants. Moreover, even after the companies posted their February 2019 disclosure, tethers traded on marketplaces close to their US $1 face value. The companies claim that, currently, all tethers are supported 74 percent by fiat money reserves and 100 percent by fiat money reserves and other assets, including a loan repayment obligation from Bitfinex.

Separately, two individuals were charged by the US Attorney’s Office in New York City with bank fraud and operating an unlicensed money transmitter business in connection with their activities on behalf of the Crypto Companies. The US Attorney’s office claimed that the individuals made false and misleading statements to open accounts at US banks and financial institutions, claiming they were to support real estate businesses, when they were, in fact, to support crypto exchanges’ activities. In the indictment against the two individuals – Reginald Fowler and Ravid Yosef – the government requested forfeiture of certain funds it had seized that had allegedly been obtained by defendants in connection with their alleged offense. The funds currently are frozen at HSBC Bank and HSBC Securities accounts in the US. (Click here for the relevant indictment.)

Memory Lane: In September 2018, the NY AG issued a report claiming that trading platforms for cryptocurrencies often (1) engage in several lines of business that may pose conflicts of interest; (2) have not implemented “serious efforts to impede abusive trading activity”; and (3) have “limited or illusory” protection for customer positions. Moreover, the report alleged that three cryptocurrency platforms may be operating unlawfully in New York and referred these platforms to the NY Department of Financial Services for possible further action. 

The AG’s report followed a voluntary request for information sent to 13 cryptocurrency platforms earlier in 2018. (Click here for background in the article “New York Attorney General Seeks Information From 13 Cryptocurrency Exchanges Even If No State Connection” in the April 22, 2018 edition of Bridging the Week.)

Among specific findings, the NY AG claimed that few trading platforms restrict or even monitor “bots” or algorithmic trading on their systems. Moreover, many venues offer special pricing and other features, including preferential trading access, to professional traders. These circumstances could negatively hurt retail investors, said the NY AG.

The NY AG also raised potential conflict of interest concerns at cryptocurrency trading platforms. The NY AG said it is unclear why trading platforms list certain cryptocurrencies, suggesting that sometimes payments to a platform may drive listings. The NY AG also said that the owners and investors in several trading platforms are large holders of cryptocurrencies trading on their platform, and trading platforms themselves, as well as their employees, are often investors in virtual assets and trade against customers.

(Click here to access the full NY AG Report.)

More Briefly:

• CFTC Chairman Touts Accomplishments and Discusses Final Plans Before Departure In Front of House Ag Subcommittee: Commodity Futures Trading Commission outgoing chairman, J. Christopher Giancarlo, discussed current challenges and certain of his accomplishment during testimony before the House Subcommittee on Agriculture last week. Among other things, Mr. Giancarlo identified the need for the CFTC to become a 21st century regulator and noted the launch of LabCFTC under his watch to help achieve that requirement. However, he bemoaned that LabCFTC lacks the legal authority to “test, demo and generate proof of concepts around these complex emerging technologies and systems.” As a result he said, the CFTC cannot leverage opportunities to help the derivatives markets as well as the CFTC’s own activities. He encouraged Congress to pass legislation to grant the CFTC relevant authority. During his testimony, Mr. Giancarlo also expressed his expectation that the CFTC would propose a revised position limit rule prior to June 30, 2019, and by the time he left the Commission, would authorize a proposal dealing with the registration of non-US clearinghouses clearing swaps for US persons. Mr. Giancarlo also observed that, because of the “explosion in interest in cryptocurrencies,” he anticipated new applications for derivatives clearing organizations. He noted that, for such entities, the “protection of cryptocurrencies will be one of the highest risks.” Mr. Giancarlo is expected to be succeeded by Heath Tarbert, currently Acting Undersecretary for International Affairs, US Department of Treasury.

• CFTC Proposes Comprehensive KISS Rules Cleanup for Clearinghouses: The Commodity Futures Trading Commission proposed a multitude of amendments to rules governing derivatives clearing organizations to codify previously granted staff relief and guidance; enhance processes around the default of a clearing member; conform rules to existing registration practices; modify some financial obligations; and add a reporting requirement for the proposed clearing of new contracts. Comments will be accepted on the rule amendment proposals through 60 days after their publication in the Federal Register. Many of the CFTC’s proposals were made in response to its Project KISS initiative. (Click here for background on Project Kiss in the article “CFTC Chairman Nominee Warns of Tough Love to Come: KISS but Also Aggressive and Assertive Enforcement” in the March 19, 2017 edition of Bridging the Week.)

• UK Functional Regulator Proclaims Project Innovate a Success So Far: The UK Financial Conduct Authority issued a report identifying a number of successes of its innovation program adopted in 2014, including participating firms becoming authorized 40 percent faster than traditional firms; beneficial offerings coming to market; and participating firms obtaining “significant levels of investment.” This program, which includes adoption of a regulatory sandbox in 2016, has supported 686 firms since inception. Among the key objectives of FCA’s innovation program is to provide firms with increased regulatory certainty. FCA believes that by encouraging innovative firms to bring “improved offerings to the market, incumbents are pressured to enhance their offerings.”

• FINRA Proposes Authority to Impose Heightened Financial Requirements on Members With Misconduct History: The Financial Industry Regulatory Authority proposed a new rule to authorize it to impose tailored financial obligations on firms with significant prior regulatory issues, as measured by quantifiable thresholds. Generally, FINRA is requesting authority to require a restricted deposit of cash or qualified securities by members with a high level of disclosure events by itself or its employees. FINRA’s proposed rule sets forth how it will compute the quantifiable thresholds and determine the maximum restricted deposit requirement (i.e., based on the nature of the member’s operations and activities, annual revenues, capital, number of offices and salespersons and the nature of the disclosure events). FINRA appears to propose giving itself the right, but not the obligation, to give a member the right to challenge any proposed requirement; however, the member must overcome a presumption that it should pay the maximum restricted deposit amount. FINRA will accept comments on its proposed new rule through July 1, 2019. Currently, the National Futures Association may impose enhanced supervisory requirements on members that employ a high number of associated persons or principals that previously were associated with member firms that have been formally sanctioned or banned for utilizing misleading or deceptive sales practices or promotional literature. (Click here to access NFA’s Interpretive Notice 9021 regarding Enhanced Supervisory Requirements.)

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