The unlikely crypto companies using the Trump-era ‘hot money’ rule

WASHINGTON — Some crypto-related companies are using a loophole passed in the waning days of the Trump administration to more freely place deposits at banks. 

The loophole demonstrates the way that crypto firms have crept further into the traditional banking system, and how those companies can place deposits at banks with far less restriction than an ordinary deposit broker. And combined with the recent high-profile bankruptcies in the crypto industry, the use of the loophole also revives fears about brokered deposits — sometimes known as “hot money” — leaving the banking system en masse. 

Chair of the Federal Deposit Insurance Corp., Martin Gruenberg and acting Comptroller of the Currency have both voiced concern about the ways that fintech companies and crypto firms have grown increasingly complicated and expansive relationships with banks.

Coinbase and Paxos are the largest crypto companies listed in the Federal Deposit Insurance Corp.’s 12-page long document of firms using what’s called the “primary purpose exception,” which allows them to escape roadblocks applied to brokered deposits. 

“The 12-page long list of entities claiming the loophole illustrates its dangerousness, which is also highlighted by crypto firms like Coinbase and Paxos claiming the exception,” said Dennis Kelleher, president and CEO of Better Markets. “Like water seeping into the cracks of a foundation, crypto companies have been relentless in attempting to penetrate the core of the banking business for years and this appears to be one of the cracks.” 

Other big names in the crypto world also appear on the list, even if they don’t exclusively deal in the industry. Those include MetaBank, NA (recently rebranded as Pathward N.A.), whose precipitous drop in brokered deposits around mid-2021 reflects the dramatic decline in what could be considered “brokered” after the Trump-era change, as well as fintechs that dabble in crypto such as PayPal and Chime.

The other PPE

At issue is a 2020 rulemaking at the Federal Deposit Insurance Corp., which finalized a new framework for classifying brokered deposits. 

Brokered deposits refer to deposits collected by a third-party and deposited into a bank as a single block.  Critics sometimes refer to these deposits as “hot money,” because investors might pull the money in search of better interest rates elsewhere. 

That’s precisely what happened in the run-up to the savings and loan crisis, leaving many small institutions to fail. In response, regulators began putting up roadblocks for brokered deposits, such as prohibiting undercapitalized banks from accessing them, or demanding that those institutions hold more liquidity to offset their risk. Brokered deposits also tend to garner more regulatory attention and can demand higher deposit insurance premiums. 

So the incentive to avoid deposits being considered “brokered” is high. 

“It makes [traditional] deposits more attractive to the banks,” said Paul Clark, senior counsel at Seward & Kissel LLP. “It’s really got to do with the stigma that the FDIC has attached to the notion that a deposit is brokered.”

The 2020 rule laid out and expanded a number of criteria for a broader set of companies to bypass these restrictions. The primary purpose exception does so by giving a pass to potential deposit brokers when their main relationship or business line with a bank isn’t the placement of deposits. 

Those include cases when less than 25% of a broker’s assets are placed at depository institutions, as well as when “all customer deposits placed at depository institutions are placed into transaction accounts and no fees, interest or remuneration are being paid to the depositor.”

Critics, including now-FDIC Chairman Martin Gruenberg said at the time that the rule dangerously loosened the definition of what is considered brokered, and left the financial system open to risk. 

“This regulatory change opens up great risk to the banking system,” he said in a 2020 statement. “Under this change, a bank could rely for one hundred percent of its deposits on a sophisticated, unaffiliated third party without any of those deposits considered brokered. The bank could fall below well capitalized and still rely on those third party placed deposits for one hundred percent of its funding without any of those deposits considered brokered, effectively an end-run around the statutory prohibition on less than well capitalized banks receiving brokered deposits.” 

Getting around the brokered label

So by claiming the primary purpose exception, Coinbase and Paxos are able to place the deposits that consumers give them into partner banks, without the limitations applied to an ordinary deposit broker. 

“When you liquidate your crypto, say you have $10,000 U.S. fiat currency, the crypto company is putting it in the bank and holding it for you until you want to buy more or take it back,” Clark said. “The moment a third party like that shows up and says I want to put money into your bank and the money doesn’t belong to me, the bank is going to demand a demonstration that they’re not brokered. One way to do that is to have made this filing with the FDIC and show up on that list.” 

That means those crypto companies can place deposits less expensively at a bank, regardless of that bank’s capital levels or stability, or without that bank having to pay more for their deposit insurance or take the regulatory scrutiny that comes along with holding brokered deposits. 

“Firms are using the bank account as an on-and-off ramp to facilitate their primary purpose, which is to run a crypto company or exchange,” said Lawrence Kaplan, chair of the bank regulatory group in the global banking and payments systems practice at Paul Hastings. 

The Coinbase entry lists “enabling transactions” as the reason the primary purpose exception was claimed, and the business line is “cryptocurrency exchange.” 

The Paxos Trust Company LLC entry claims the exception under the 25% threshold. The business line is “exchanges, facilitates, settles, and acts as custodian for stablecoin digital assets.” 

Coinbase said that the exemption was claimed on the exchange’s behalf by a financial institution that the company works with, and that Coinbase’s “business model does not utilize PPE.” A third party filing on Coinbase’s behalf does not change the fact that the company doesn’t have any restriction on where it places deposits, a spokesman confirmed. 

Paxos did not return a request for comment. 

The fear for some, then, is a mass exodus of capital from a bank if, say, one or both of those crypto firms were to go under, or decide to yank those deposits suddenly. 

That fear of a sudden withdrawal is present with any of the companies on the FDIC’s PPE list, but that fear is far less theoretical in the case of cryptocurrency, which has experienced heightened volatility in recent months. 

And even if a single actor pulled its deposits, the result might not affect broader markets. But if there was a more seismic event, the fragility of those PPE deposits could make a smaller financial crisis far worse. 

Concerns about crypto companies and the brokered deposit rule are, so far, theoretical, and not all experts share them. 

Kaplan said that partnerships between crypto or fintech firms using the primary purpose exception are fundamentally different and less risky than those that troubled regulators in the lead up to the savings and loan crisis. 

“There you had huge amounts of money that could move in a second causing a liquidity crisis, that’s where brokered deposits are so dangerous, that third parties really controlled the liquidity,” he said. “When the primary purpose is to sell crypto, the money goes in and goes out and the bank will know exactly what will go in and out. That’s not the same risk as the traditional hot money, it’s just really cheap and easy money for some banks to hold.”

The big bankruptcies in the crypto industry — FTX, Voyager, Celsius Network, Genesis and BlockFi — don’t appear in the primary purpose exception list, and it seems like brokered deposits weren’t a part of Silvergate’s liquidity crisis following the unwinding of FTX. 

But that statement comes with a few caveats: The relationship between financial companies and crypto firms can be opaque, so it’s still possible that one or all of those crypto companies are placing deposits that would have been considered brokered pre-2020 rulemaking but that aren’t anymore. 

The companies could have also notified the FDIC that they’re claiming the exemption after the last publication of the list in late June, although policy experts thought that was unlikely since the bulk of companies that claimed the exemption did so shortly after they were expected to be fully compliant in 2021. 

The case of MetaBank and The Bancorp Bank

But there is plenty of evidence that Silvergate’s crypto and fintech-focused competitors — MetaBank NA and The Bancorp Bank — do hold a substantial share of deposits that aren’t considered brokered because of the primary purpose exception. 

The banks, which are now both headquartered in crypto-friendly South Dakota, explained that brokered deposits plummeted after they complied with the FDIC’s updated rule, meaning they were able to reclassify brokered deposits as non-brokered. Both also have partnerships with some of the biggest nonbanks on the FDIC’s primary purpose exception list, including Coinbase and PayPal. 

A source with firsthand knowledge of how some crypto and fintech companies came to be on the primary purpose exception list said that MetaBank and The Bancorp are the go-to banks for facilitating these kinds of transactions. 

Of the two banks, MetaBank is the only one on the FDIC’s list. The bank claimed the exemption under “enabling transactions” and said that the business line is “custodial accounts.”

Notably, MetaBank partners with Coinbase in the crypto exchange’s direct deposit program, which allows consumers to have their paycheck directly deposited into their Coinbase account. MetaBank also issues the “Coinbase Card.” 

As a result of the FDIC’s updated brokered deposit rule, the bank’s deposits “that were classified as brokered deposits reduced significantly.” 

While The Bancorp. doesn’t appear on the FDIC’s list, they acknowledge the change the FDIC’s rulemaking had on their business, saying that “the majority” of the bank’s deposits were previously classified as brokered. 

“In December 2020, the FDIC issued a regulation which resulted in the reclassification of the majority of our deposits from brokered to non-brokered,” the bank said. The bank’s assessment rate decreased accordingly. 

The Bancorp Bank’s business is heavily focused on payments and fintech partnerships. The bank provides mobile banking services for Chime Financial Inc., which appears on the FDIC’s list. It also provides banking services such as cards and savings accounts for cardholders at PayPal, which also, according to the FDIC, claims the primary purpose exception. 

The kinds of business relationships between Bancorp Bank and its fintech partners are, in part, why at least one regulator said the rule was amended in the first place. 

“Under the previous status quo, the broad definition of brokered deposits discouraged bank and fintech partnerships by imposing unnecessary burden and costs — specifically, by deeming app-based fintech services that facilitate consumer savings accounts potential deposit-brokering activity,” said then-acting Comptroller of the Currency Brian Books. Brooks was named CEO of crypto exchange Binance US after leaving the OCC and currently serves as CEO of crypto firm Bitfury Group. 

Other regulators, such as Gruenberg or current acting Comptroller Michael Hsu — who has spoken about the risks of bank-fintech partnerships in the past — might take a harsher view on the way the primary purpose exception has opened up deposit-taking activities at crypto companies and fintechs. 

“Whether they had in mind that you would have all these people coming out of the woodwork saying ‘we want that too,’ I don’t know,” Clark said. 

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