April 10 (Reuters) - Crypto giant Kraken's landmark Federal Reserve master account comes with restrictions aimed at mitigating risks, but it - and others likely to follow in its wake - could still create vulnerabilities for the U.S. financial system. 

Founded in 2011, Wyoming-based Kraken is one of the world's largest crypto exchanges, with both retail and institutional clients. Last month, it became the first-ever crypto company to win a Fed master account. The Kansas City Fed granted Kraken a "limited- purpose" account for one year initially, but neither party disclosed details of its restrictions. 

Fed master accounts are often likened to bank accounts for banks, letting accountholders move funds directly via the Fed's payment rails.

The decision has sparked concerns among banks and the top Democrat on the House of Representatives Financial Services Committee, Maxine Waters, over potential financial-system risks. They also say the approval process was opaque and that it flouted Fed protocols. Waters has asked the Kansas City Fed to disclose more details by Friday. 

To be sure, banks stand to lose out as crypto firms expand onto their turf. But some regulatory experts said banks' risk concerns are warranted. 

A spokesperson for Kraken told Reuters that the Fed master account allows its Wyoming banking arm to access the central bank's wholesale payments system, Fedwire, and hold limited balances overnight. That means it can cut out bank intermediaries and move money faster and more cheaply.  

But unlike many accountholders, Kraken cannot earn interest on reserve balances it holds at the Fed, or access emergency Fed lending or the central bank's other FedNow and ACH payment systems, the spokesperson said. They declined to say whether Kraken will have access to Fed credit. 

The account details have not previously been reported. Kraken will initially use it to serve wholesale clients. It hopes to eventually add new features, said Jonathan Jachym, Kraken's global head of policy. 

"We look at this as a great testament to regulatory rigor and cooperation. It promotes principles of both safety and soundness, and innovation," said Jachym.

A Kansas City Fed spokesperson said it was reviewing Waters' letter. The spokesperson declined to comment further. 

CRYPTO SYSTEM INROADS

Granted more than five years after Kraken first applied, the account marks another victory for the digital asset industry under President Donald Trump's crypto-friendly administration, which is giving the sector more access to the mainstream financial system, sparking alarm among banks. 

Crypto firms Ripple, Anchorage Digital and fintech money transfer company Wise also hope to win master accounts, according to public information. 

Regional Fed banks manage those accounts, but the Fed board provides guidelines. It has signaled it will open its payment rails to more crypto and fintech firms. In December, it sought feedback on a potential new type of payment account with restrictions similar to those imposed on Kraken's. The proposed account would also not provide access to Fed credit. 

The Fed has said those limits would mitigate liquidity shocks, credit risk to the central bank, and would protect its ability to manage reserves. 

Still, even with safeguards, giving crypto firms direct access to Fedwire - which underpins the global dollar clearing system - creates money-laundering and operational risks, and could suck liquidity out of the banking system, lenders have warned. 

Under Fed rules, only depository institutions can have master accounts. Kraken and Anchorage have depository charters but are not federally insured. Wise and Ripple are seeking similar charters, along with several other crypto companies.     

While the Fed closely scrutinizes applications by uninsured depository institutions, such entities are subject to less rigorous ongoing oversight than insured banks. 

"The concern is by introducing institutions that may have less of a track record, less rigorous compliance and operations, even if they have limited models, that it could create a degree of systemic risk," said Richard Levin, chair of the fintech practice at Taft Stettinius & Hollister. 

OPERATIONAL AND MONEY-LAUNDERING RISKS

Regulators have long flagged that the fintech and crypto sectors sometimes have patchy internal controls and cyber security. A core worry is that such firms, if granted accounts, could become a point of operational weakness. A hack, outage or liquidity misstep could cause settlement failure, rippling through the system and forcing the Fed to backstop the payment. 

"They don't have the experience," said Yesha Yadav, an associate dean at Vanderbilt University Law School. 

The crypto industry also has heightened exposure to money-laundering risk, an issue Fed Governor Michael Barr flagged in December when opposing the Fed's request for information on the potential new payment account.

The Kraken spokesperson said its bank reserves are fully backed and that the company complies with all bank-grade AML and know-your-customer requirements and that it has never been hacked. 

Rachel Anderika, Anchorage's chief operating officer, said everyone was subject to the same AML rules. "The AML risks with crypto are unique, but they are entirely manageable."

London-based money-transfer firm Wise declined to comment. A Ripple spokesperson pointed to a social media post by CEO Brad Garlinghouse in December that said the industry was "prioritizing compliance."

More broadly, by cutting out bank intermediaries and potentially allowing more crypto and fintech firms to park funds directly at the Fed, deposits could eventually be siphoned out of the banking system, others say.  

"Banks play a critical role as a keystone in the resilience of the broader financial system," said Kathryn Judge, a professor at Columbia Law School. "We need to be thoughtful, particularly when we are allowing access to a valuable federal resource."

The Fed's regulatory chief, Michelle Bowman, said last month that Kraken's account would not necessarily open the floodgates, but she also acknowledged that it was uncharted territory.

"It's a bit of an experiment," she said.