Analysis of the Common Issues of Cannabis Banking

Problems with Cannabis Financial Processes

Cannabis-related Businesses (CRBs) have become a major domestic retail market in the United States, and will continue to drive tax revenue growth for state economies in the future. The University of Pennsylvania Wharton School of Policy states that although CRBs, “have thrived in the localities that have legalized marijuana as a consumer product, the industry has suffered from crippling uncertainty, in the form of limited access to the banking system.” This is due to the often confusing direction on cannabis legislation from almost every level of government in the US. Exploring the legislative structure of the cannabis economy in the US is the starting point to identify potential business solutions for this young industry.

Put simply, the legal landscape for cannabis in the US is a literal tug of war. This exposes the immense confusion surrounding the legality of CRB processes and activities. Because of the regulatory uncertainty, “the cannabis industry thus has been forced to operate in a cash-intensive ‘gray market’ which is a huge problem. An entire industry conducting all of its business in cash cannot be fairly taxed or regulated and, historically, has been associated with lawlessness—everything from security concerns, transportation and currency problems, money laundering, and cash hoarding.” With State and Federal entities directly countering each others arguments with dueling legislation, added friction has slowed the growth of the entire industry in large state economies like California, Colorado and Washington.

There are several policy options for addressing the inconsistency between federal and state regulation. The potential solutions range from Congress doing nothing, and maintaining the current policy, to complete federal legalization of marijuana. Regardless of how policy changes, solutions to effectively interact with federal and banking institutions with the utmost transparency and security must be explored.

A Brief History of United States Cannabis Regulation

  • 1970: President Richard Nixon signs into law the Comprehensive Drug Abuse and Prevention and Control Act. Title II of the law is known as the Controlled Substances Act.[6] Under this statute, the federal government classifies each drug under one of five Schedules that are based on a drug’s established medical value and its potential for abuse.” Marijuana was established as a schedule 1 drug.

  • 1970: The Bank Secrecy Act of 1970 (BSA), also known as the Currency and Foreign Transactions Reporting Act, is a U.S. law requiring financial institutions in the United States to assist U.S. government agencies in detecting and preventing money laundering.

  • 1996: Proposition 215, or the Compassionate Use Act of 1996,[1] is a California law allowing the use of medical cannabis despite marijuana's lack of the normal Food and Drug Administration testing for safety and efficacy. It was enacted, on November 5, 1996, by means of the initiative process, and passed with 5,382,915 (55.6%) votes in favor and 4,301,960 (44.4%) against.

  • 2011: The Financial Crimes Enforcement Network (FinCEN) today announced that Money Services Businesses are now able to register with FinCEN using the Bank Secrecy Act (BSA) E-Filing System. BSA E-Filing is a free, web-based electronic filing system that allows MSBs to submit their Registration of Money Services Business form (RMSB or FinCEN Form 107) and other BSA reports through a secure network. Compared with the traditional paper filing process, MSBs will find BSA E-Filing a faster and more convenient, secure, and cost-effective method of submitting their registrations as well as for receiving confirmation of their registration's acceptance. The greater use of the BSA E-Filing system also assists FinCEN in providing important information relating to money laundering and terrorist financing to law enforcement in the quickest manner possible.

  • 2012: On December 6, 2012, Washington became the first U.S. state to legalize recreational use of marijuana.[b] The state had previously legalized medical marijuana in 1998. Under state law, cannabis is legal for medical purposes and for any purpose by adults over 21.

  • 2013: In response to this spate of legalizations, the Department of Justice issued a memorandum—written by Deputy Attorney General James Cole—explaining the DOJ’s enforcement priorities for the use, recreational or otherwise, of marijuana. Known as the Cole Memorandum,[8] the document was not a binding regulation of the Department of Justice but a “guidance” that individuals, private-sector institutions, and governments should follow with respect to marijuana enforcement.”

  • 2014: Financial Crimes Enforcement Network (FinCEN) issued additional guidance governing the enforcement of anti-money laundering laws as relevant to the funding and distribution of marijuana by participants in the financial system. It attempted to facilitate a safe operating space for financial institutions to service the marijuana industry.[10] In the same year, the independent financial regulatory agencies—the Board of Governors of the Federal Reserve System, the Federal Deposit Insurance Corporation, the National Credit Union Administration, and the Office of the Comptroller of the Currency—indicated a willingness—but not a commitment—to use the same guidances in their supervisory examinations.

  • 2016: President Trump installs Republican Senator Jeff Sessions,  a staunch critic of the legalization movement, as Attorney General. Although marijuana policy was not the most pressing priority for the new DOJ, eventually Sessions announced an about face in his approach to prosecuting federal law as it relates to marijuana.”

  • 2018: January 4, 2018, Sessions reinforced the prosecutorial authority of the federal government when he instructed U.S. attorneys “to use previously established prosecutorial principles” regarding federal marijuana enforcement, nullifying the Cole Memorandum.”

  • 2018: November 7, 2018, Session resigns from AG Position. Intereum attorney general is assigned but not yet confirmed by Congress.

  • 2019:  E-File is now Required for BSA-SARs. “FinCEN is extending its January 1, 2019 deadline to February 1, 2019, for FinCEN’s system to continue accepting the FinCEN SAR discrete form (v1.0-1.1) as well as the existing ASCII-based batch format. On February 1, 2019, FinCEN will ONLY accept the new FinCEN SAR discrete form (v1.2) and the new XML-based batch format. On February 1, 2019, the system will REJECT the FinCEN SAR discrete form (v1.0-1.1) and ASCII-based batch format filings. Rejected files may put an institution at risk of a BSA violation for failure to timely file.”

Use Case: Fourth Corner Credit Union

In order to explore the current process of the servicing cannabis business, Fourth Corner Credit Union has been chosen as a case study in order to evaluate their journey in seeking validation to act as a Money Servicing Business (MSB) for CRBs. Fourth Corner was chartered in Colorado with the full support of the state’s governor in late 2014. Colorado established thorough procedures for complying with the Cole Memo, and Fourth Corner followed every rule the state imposed upon it in seeking its charter[15]. Fourth Corner was established to, “service the unique financial needs of the cannabis and hemp industries and their supporters”[16].

In November 2014, Fourth Corner applied for a “master account” from the U.S. Federal Reserve System, as administered by the Federal Reserve Bank of Kansas City which oversees the payment system in the state of Colorado. A master account allows, among other things, a financial institution to engage in electronic credit and debit transactions with other financial institutions. Without it, a financial institution cannot function legally in the united states and maintain good faith with the businesses it services.

Fourth Corner spent over eight months answering intensive questions from the Kansas City Fed in response to their filing for a master account. According to the credit union, normally master accounts are typically approved within one week. In July 2015, the Kansas City Fed finally informed Fourth Corner that it had not approved the credit union’s master account—essentially delivering a death sentence to Fourth Corner.

The Fed based its decision largely on Fourth Corner’s inability to acquire deposit insurance from the National Credit Union Administration (NCUA). For its part, the NCUA did not believe Fourth Corner would be able to manage the risk of working within a single industry that had no track record and that remained illegal nationally[18].

The Fed clearly had a problem with marijuana and was not going to let states move forward independently. According to the Fed, Fourth Corner did not have the operational right to inject state marijuana money into the federal banking system, given the illegality of cannabis at the federal level.

In response, Fourth Corner immediately filed a lawsuit against the Fed, claiming that the Fed’s own rules do not give it discretion in deciding which institutions should be disqualified from master account access, nor do they explicitly allow for decisions to be based on those of other agencies, like the NCUA[20]. A federal district court later dismissed the lawsuit from Fourth Corner. The Fed, along with many private financial institutions, argued that those FinCEN guidelines provided no binding protection from prosecution.

Quick to counter, Fourth Corner subsequently appealed the district court decision. In June 2017, the Tenth Circuit Court of Appeals issued its decision in the case of Fourth Corner Credit Union v. Federal Reserve Bank of Kansas City[22]. The court’s opinion is dizzying, and illustrates well the rank confusion that the state-federal mismatch sows in this area of law.

The three-judge panel could not agree on the disposition of the case. The only reasonable outcome for this kind of division was to settle on the least-common denominator: it was ruled that Fourth Corner could amend its complaint and seek again a master account, subject to a commitment to follow the law. While Fourth Corner could declare a partial victory, this ruling effectively prohibited it from servicing the only clientele for whom it was originally formed: Cannabis-related Business.

The experience of Fourth Corner Credit Union demonstrates a few key points about the fragility of marijuana banking. First, the Federal Reserve’s control over access to its payment systems gives it significant regulatory and supervisory control to which courts will defer[23]. Second, the CSA remains dominant in any debate over sovereignty on the marijuana issue, generally. And third, states will not be able to circumvent federal statutes in order to solve the problem of marijuana banking simply by chartering and endorsing special financial institutions[24].

Solutions to Cannabis Financial Processes

Based on these findings, three active pathways have been identified to build out business solutions which may be leveraged to limit friction between financial institutions and CRBs and mitigate the fragility of marijuana banking. Building financial technology that satisfies the complex needs of the cannabis market requires that three conditions must be met:

  1. Controlled and partitioned access to the system based upon authorization and authentication credentials.  

  2. Private, transparent, and secure data storage within the system.

  3. Ensuring costs of these services remain the same or decrease in cost while not introducing any new risk to the business processes.

Put simply, CRBs must be as compliant with both state and federal regulation as possible. The path to stable cannabis financial services begins with complete and transparent compliance to allow interaction with the Federal Reserve and CSA. However, before technological solutions can be designed or analyzed for this issue, the problem has to be explicitly defined.

Defining Compliance

Cole Memorandum

  1. Preventing the distribution of marijuana to minors.

  2. Preventing revenue from the sale of marijuana from going to criminal enterprises, gangs, and cartels.

  3. Preventing the diversion of marijuana from states where it is legal under state law in some form to other states.

  4. Preventing state-authorized marijuana activity from being used as a cover or pretext for the trafficking of other illegal drugs or other illegal activity

  5. Preventing violence and the use of firearms in the cultivation and distribution of marijuana.

  6. Preventing drugged driving and the exacerbation of other adverse public health consequences associated with marijuana use.

  7. Preventing the growing of marijuana on public lands and the attendant public safety and environmental dangers posed by marijuana production on public lands.

  8. Preventing marijuana possession or use on federal property.

FinCEN Guidance

  1. Verifying with the appropriate state authorities whether the business is duly licensed and registered.

  2. Reviewing the license application (and related documentation) submitted by the business for obtaining a state license to operate its marijuana-related business.

  3. Requesting from state licensing and enforcement authorities available information about the business and related parties.

  4. Developing an understanding of the normal and expected activity for the business, including the types of products to be sold and the type of customers to be served (e.g., medical versus recreational customers).

  5. Ongoing monitoring of publicly available sources for adverse information about the business and related parties.

  6. Ongoing monitoring for suspicious activity, including for any of the red flags described in this guidance.

  7. Refreshing information obtained as part of customer due diligence on a periodic basis and commensurate with the risk.

Analysis of the Cole Memo Priorities and the FinCEN Guidance Priorities identify the most important aspects of CRB compliance when interacting with state and federal regulations. This definition allows for business process analysis and technical architecture design to be performed in order to develop the optimal solution for this problem.

Redesigning Cannabis Banking

The current cannabis banking infrastructure involves a complex network of entities that have varying degrees of influence and functionality in the value-chain of CRBs to financial services. Some of the current entities influencing the interaction between CRBs and financial institutions are the Financial Crimes Enforcement Network (FinCEN), Credit Support Annex (CSA), the Federal Reserve, individual state judicial branches, the and the Federal Judicial Branch.

As politics and lobbying will decide future legislation regarding cannabis banking,  software solutions can be implemented in the current state of the industry to be as compliant with all of the influencing entities. This has the ability to significantly reduce friction for financial institutions to offer cannabis banking services.  However, due to the legislative, organizational, and infrastructure complexities of the current systems, standard software solutions such as centralized systems will not sufficiently implement the business process solutions outline above.

For example, an administrative entity would need to be in control of the centralized data storage needed to track the information necessary to be in compliance with the current regulations. With so many entities involved, it would be extremely difficult to delineate control without creating inequality within the network. This could lead to could lead to conflicts of interest, not sharing proper information, or filing inaccurate or misleading financial statements. The problems with cannabis banking is that there is an extra degree of calculus to the complexities that pose significant issues for classic software solutions. A secure, completely transparent system with distributed storage of information and interaction within a network is needed to address the complexities regarding the cannabis banking problem.

Private blockchain technology solves many of the inherent functional problems facing centralized systems regarding the distribution of information and interaction, transparency, and security of that data throughout a system that solves the cannabis banking problem. Decentralized storage, giving entities access to their own data, without anyone else's in the system increases security and addresses the issue of a single entity controlling all the information of the system while mitigating the conflicting opinions of the different entities involved. Furthermore, the logic of the system can be transparent to all interacting parties to ensure that correct functionality is being carried out by the smart contracts of the system ensuring compliance is maintained throughout the ecosystem as a whole.