US Fed Rejects Crypto Bank’s Application After Two-Year Wait

January 31, 2023
The US Federal Reserve Board has denied an application from Custodia Bank, a major digital asset bank, to become a member of the Federal Reserve System, citing “safety and soundness” risks.

The US Federal Reserve Board has denied an application from Custodia Bank, a major digital asset bank, to become a member of the Federal Reserve System, citing “safety and soundness” risks.

Last week, the FRB announced that it has unanimously rejected the application of Custodia Bank, a digital asset bank based in Wyoming, to become a member of the Federal Reserve System.

In a statement, the FRB said it had determined that Custodia’s application, as submitted, was inconsistent with the required criteria under US banking law.

The FRB’s full decision statement has not yet been made public, but will be released following a review of confidential information. In the meantime, the FRB dropped several hints as to why Custodia’s application failed.

“The firm proposed to engage in novel and untested crypto activities that include issuing a crypto-asset on open, public and/or decentralised networks,” said the FRB.

“The Board has previously made clear that such crypto activities are highly likely to be inconsistent with safe and sound banking practices.”

Although not essential to become a Federal Reserve System member, the FRB also noted that Custodia is not covered by the Federal Deposit Insurance Corporation (FDIC) — however, in 2021, Custodia announced its intention to join the FDIC.

Additionally, the FRB was not satisfied that Custodia demonstrated the required controls to mitigate money laundering and terrorist financing risks.

Responding to the FRB’s decision, Custodia CEO Caitlin Long said it was not the outcome that Custodia was expecting.

“Custodia is surprised and disappointed by the Board’s action today,” she said. “The Board’s denial is unfortunate but consistent with the concerns that Custodia has raised about the Federal Reserve’s handling of its applications, an issue we will continue to litigate.”

Separately, the FRB also rejected an earlier application from Custodia to open a master account at Fed.

That decision, which the FRB has not yet announced publicly, was mentioned in court documents seen by VIXIO that were filed last Friday (January 27).

Crypto critics welcome FRB’s decision

Dennis Kelleher, president and CEO of Better Markets, a non-profit that campaigns for financial system reforms, said the FRB’s decision is a “huge win” for financial stability.

“While it has not proved a valid legal use case in 14 years, crypto has proven itself invaluable to financial predators, money launderers, tax avoiders, terrorist financiers, narco-kingpins and others engaged in egregious illegal activities,” he said.

“Ensuring that banks are not involved in and do not facilitate such activities is and must remain a priority for the Fed, which this decision reflects.”

Kelleher went on to say that the collapse of the crypto-asset markets over the past year would have caused more damage to the US economy had crypto been more closely connected to the banking system.

“If the Fed had allowed crypto banks like Custodia to become members of the Fed and de facto legitimized crypto, then crypto activities and related products would likely have been on the balance sheets of Fed regulated banks,” he said.

“If the $2+ trillion in crypto losses had rippled through the banking system, those too-big-to-fail banks would have come under extreme stress and may have failed, requiring the Fed to bail them out as happened in 2008.”

However, in other statements, Custodia has emphasised that it would not put crypto-asset deposits on its balance sheet, and is prohibited from doing so by state and federal banking laws.

“When holding digital assets on behalf of a customer, Custodia will do so in its trust department rather than for its own account,” it said.

“In other words, Custodia does not expose the US banking system to digital asset risk, as Custodia would only handle US dollars on its balance sheet."

As per state and federal banking laws, Custodia has said it must hold a minimum of $1.08 in cash and short-term high-quality liquid assets, such as Treasury bills, to back each $1.00 of customer deposits during its first three years as a Fed member bank.

Gene Grant, CEO of digital asset trading and banking platform LevelField Financial, said the FRB’s decision was not a rejection of cryptocurrency per se, but rather a rejection of Custodia’s plans.

“Given that Custodia Bank’s business plan included the issuance and holding of cryptocurrency as principal, the bank would be deemed to be seeking to operate in a manner that is not consistent with safe and sound banking practices,” Grant told VIXIO.

“Based upon that categorisation alone, the Federal Reserve had no choice but to reject the application.”

Jim Preissler, chief strategy officer at digital asset exchange, said that in the wake of the FTX collapse, extreme caution from regulators towards crypto players within the banking system is to be expected.

“The uncovering of the FTX debacle has been a wake up call for regulators,” he told VIXIO. “Unfortunately, this may put a freeze on some near-term approvals — especially those that might be seen as a new line of business — from regulators that are scrambling to catch up.”

Preissler pointed out that regulators have been spooked by revelations, which emerged last week, that FTX had purchased $11.5m worth of stock in Farmington State Bank, a small rural outfit.

“Further licensing may be tabled until regulators reach a comfort level and receive instructions from the government. And even those applications that are on the right path could get delayed,” he said.

Two tough applications

The FRB’s two decisions bring to an end a long period of waiting for Custodia, which applied for Fed membership in August 2021 and for a master account in October 2020.

Custodia’s application to open a master account, had it been successful, would have allowed it to have direct access to the US payment system without the need for bank intermediaries.

“Our digital asset competitors rely on other clearing banks to facilitate fiat transactions,” said Custodia. “This practice increases both counterparty credit risk and settlement delays.

“As a result, without direct access to US dollar clearing, our competitors cannot execute on a settlement risk-free basis between a digital asset and fiat currency.”

In June last year, Custodia sued the FRB and the Federal Reserve Bank of Kansas City in an effort to secure a default judgment in its favour or a motion to compel a decision on the master account application.

In its complaint, Custodia had argued that the application was “unreasonably delayed” by the FRB under the provisions of the Administrative Procedures Act (APA).

However, last Friday (January 27), a US district court judge in Wyoming dismissed Custodia’s complaint in full, following the FRB’s decision to deny the master account application.

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