The Federal Reserve sent a shot across the bow of financial institutions engaging in cryptocurrency-related activities when it denied Custodia Bank Inc.'s application to become a member bank in conjunction with a policy statement on banks' involvement with cryptocurrency.
The Federal Reserve Bank of Kansas City on Jan. 27 denied Custodia's master account application, which had been pending for
In addition to the denials, the Fed issued a policy statement saying that all banks regulated by the Fed Board, regardless of deposit insurance status, will be subject to the same limitations when it comes to "novel banking activities." The statement specifically named crypto-asset-related activities as an example.
Industry experts said those three actions sent a sharp message that the agency is not open to financial technology companies seeking master accounts nor banks under its supervision engaging in cryptocurrency activities.
These developments "may portend an even less-receptive approach to new business models at the Fed," said Dan Awrey, a professor specializing in corporate law and financial regulation at Cornell Law School, in an email.
The Fed sends a message
On its website, Custodia describes itself as a company "formed to be a compliant bridge between digital assets and the U.S. dollar payments system, and a custodian of digital assets that can meet the strictest level of institutional custody standards."
Although the Fed has not yet released its order denying Custodia's member bank application, the agency said in a statement that the company's "novel business model and proposed focus on crypto-assets presented significant safety and soundness risks" and mentioned the company's proposal to issue a crypto-asset on public, open or decentralized networks.
According to Julie Hill, a professor at the University of Alabama School of Law, the Fed's recent actions sent a clear message to banks: "We're not keen about any of them doing crypto," she said.
Announcing the denial in conjunction with the policy statement was likely intended to support its decision on Custodia's application and "provide a consistent position," according to Chip MacDonald, managing director of MacDonald & Partners LLP.
Further, the denials of Custodia's master account and member bank applications point to even more headwinds ahead for fintechs seeking master accounts. 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.
Fintechs have increasingly sought more guidance on how they can gain access to master accounts, but following the Custodia decision, the odds of gaining access to those payment rails are diminishing.
"The path is narrowing for a lot of these crypto startups to be able to gain access through the Fed to this very protected banking system," Derek Tang, economist at Monetary Policy Analytics, said in an interview.
Next steps for Custodia
In a press release following the Fed's decisions, Custodia CEO Caitlin Long said the Fed advised the company 72 hours prior to the denial to either withdraw its application or receive a denial. Custodia plans to appeal the decision, Long said in a statement to S&P Global Market Intelligence.
Tang said Custodia could have withdrawn the application, but getting a record of a denial helps with lawsuits and public relations. The written denial could also be helpful to the Fed as it sets expectations for companies seeking master accounts and becoming Fed member banks.
"All this has been written with a view to the litigation as well but also to create consistency and certainty — more certainty among people who apply for this," MacDonald said.
With its rejection of Custodia's master account application, the Fed also filed a motion to dismiss Custodia's lawsuit seeking an answer to its long-pending request. In a statement, Custodia's Long said the bank plans to oppose the Fed's attempt to dismiss the suit.
Experts believe Custodia will likely file an amended complaint or new suit.
"The courts are not the only place where this is going to play out," Tang said. "This is going to play out in Congress. This is going to play out through public opinion as well."
Another critical wrinkle in Custodia's battle for master account access going forward is who will be at the helm of the Kansas City Fed. Former President and CEO Esther George retired Jan. 31 because of mandatory age limits, and it is unknown who will be leading the organization if Custodia reapplies or other financial institutions in the area apply for master accounts.
"Wyoming has been trying to position itself as a crypto industry state," Tang said. "The Kansas City Fed has to take a lot of the flak when it rejects these Wyoming players."
White House "roadmap"
On Jan. 27, the same day as the Fed's Custodia decisions and policy statement, the White House National Economic Council, or NEC, published a "roadmap to mitigate cryptocurrencies' risks." It referenced guidance issued by the banking agencies earlier in January about separating digital assets from the banking system.
"We encourage regulators to continue these efforts, including those designed to address and limit financial institutions' exposure to the risks of digital assets," the NEC statement read.
Regarding the Fed's statement from the same day, a White House official told S&P Global Market Intelligence that "the timing was just coincidental."
MacDonald noted the NEC statement addresses a wider variety of crypto issues and was likely a response to the fallout of FTX Trading Ltd. and crypto "collapses, losses and uncertainties," he wrote in an email.
Tang said the combination of the White House's focus on the topic, the coordinating nature of the Financial Stability Oversight Council and the potential for Fed Vice Chair Lael Brainard to lead the NEC "suggests the Fed will be working closely with Treasury and other authorities on crypto regulation in the future."