The Federal Reserve has long faced pushback over its process for granting access to its master accounts, and the agency may soon have to publicly divulge the details of that process.

After its application for master account access was pending for nearly two years, Cheyenne, Wyo.-based Custodia Bank Inc. filed a lawsuit against the Federal Reserve Bank of Kansas City and the Federal Reserve Board in June, claiming the agencies were delaying consideration of its master account application. A Wyoming judge has since allowed the case to go through despite the Fed's efforts to have it dismissed. If it goes to trial, it would be the first master account case to make it that far.

Having a master account gives a fintech without a bank charter some legitimacy by allowing it to access the Fed's payment rails without relying on a partnership with a bank. Most traditional banks with charters and deposit insurance have master accounts.

The agency has long faced criticism over the lack of public information regarding how it evaluates master account applications and which companies have master accounts. And despite a recent update to its guidelines for master account access, the agency is still receiving criticism.

To mitigate those concerns, the agency on Nov. 4 proposed publicizing which companies have master accounts. The agency asked for public comment by Jan. 17, 2023, but that timeline could be sped up, and the Fed may have to disclose more information than planned.

A must-pass spending bill making its way through Congress includes a provision that would require the Fed to maintain a public database of which institutions have master accounts. However, the provision takes what the Fed proposed a step further by also requiring the agency to maintain a public list of companies that have applied for master accounts and the status of those applications.

That provision and the pending Custodia lawsuit could force the Fed to disclose information it has long kept private, according to industry experts.

"The Fed is in a tough spot on this because, in general, it may want to be more transparent, but having the whole world know who's applying for master accounts and who's getting them could be a political headache and produce a lot of second-guessing," Ian Katz, managing director at Capital Alpha Partners, said in an email.

Custodia lawsuit turns up the heat

After a judge allowed the Custodia lawsuit to go through, the Fed, at the beginning of December, asked to forgo the discovery process and instead provide an administrative record for the court to review, likely to avoid making its process for evaluating master account applications public, industry experts said.

"Having to reveal any of that in discovery is likely something they want to avoid," Clifford Stanford, partner at Alston & Bird LLP, said in an interview.

In an attempt to avoid the discovery process and trial, the Fed could approve Custodia's master account application or grant Custodia's application to become a member bank, which would mean it would be a tier 2 institution instead of tier 3 for its master account application. Tier 3 applicants face the most stringent review compared to tier 1 and tier 2 institutions.

"The more discovery the judge allows in the lawsuit, the more likely it is that the Fed will decide to open Custodia's account," said Julie Hill, a professor at the University of Alabama School of Law. "I suspect the Kansas City Fed would want Custodia to withdraw its lawsuit as a condition of issuing the account."

In a statement, Nathan Miller, a spokesperson for Custodia Bank, said the "Federal Reserve is applying a staggering double-standard that favors incumbent banks over startup banks, and in doing so, it has created financial system risk."

Fed proposal to publicize accountholder list

The Fed in November proposed a rule to publicize who has a master account. However, industry experts believe that recent events might have prompted the proposal, as the agency faces broader scrutiny due to the Custodia lawsuit.

"It might be that the Federal Reserve, knowing that some information is going to come out anyway, has decided just to be magnanimous and appear transparent about it now, rather than fight it tooth and nail," Hill said in an interview.

The Fed could have also been prompted by legislative pressure to propose the rule. A provision to publicize information related to master accounts was included in the proposed National Defense Authorization Act that the House passed Dec. 8. The Senate has not yet voted on the legislation.

That provision, proposed by Sen. Patrick Toomey, R-Pa., the ranking member of the Senate Banking Committee, would require the Fed to maintain a searchable database online, updated quarterly, of institutions with master accounts and those that requested access and the status of their pending applications.

"Perhaps the Fed was aware that members of Congress were considering legislation and decided to circulate their own disclosure proposals," Hill wrote in an email.

If the act passes with the master account provision, it would be notable. While the Fed asked in its request for comment if it should publicize which institutions have applied for master accounts, the proposed rule itself only mentioned disclosing what companies already have accounts.

"The provision is significant because there's a presumption that the Fed wouldn't have gone that far. Having it done through Congress is significant if it goes deeper than what the Fed would have done on its own," Katz said.

Fed likely to remain skeptical

However, even while facing this public backlash, the Fed may still be reluctant to grant master account access to nonbank companies given the recent situation regarding the bankruptcy of FTX Trading Ltd. and the fallout for other companies. That fallout has created broad skepticism that could trickle down to master accounts, as regulators, Congress and the public have become more risk-sensitive, said Chip MacDonald, managing director of MacDonald & Partners LLP.

"In order to get a master account, people are going to have to demonstrate, consistent with the Fed's rule, that they can manage the risk of a master account and not pose risk to the payment system or financial stability generally," MacDonald said in an interview. "That demonstration is going to be more carefully scrutinized and questioned and looked at very carefully by the regulators, by the Fed in particular, and I think it was an uphill battle to begin with."