Custodia Bank’s Fight for a Fed Master Account Explained

From Crypto To Banking

Crypto firms are evolving and converging closer to traditional financial institutions like banks and credit unions. They are also getting into more friendly terms with the regulators, as recently illustrated by the approval for Gemini (GEMI -8.75%) from the U.S to operate as a Designated Contract Market (DCM) and enter the prediction market.

Other crypto companies are moving even further, notably with Custodia Bank looking to acquire a Fed master account, which would give it the same privileges (and responsibilities) as a “real” bank.

This is part of a general tendency of many crypto companies filing to become a bank, or at least something similar to a bank.

However, the path to achieving this goal is not so smooth for Custodia, which has been denied the creation of a Fed master account. The company is now officially asking the full Tenth Circuit Court of Appeals to review the US Fed’s decision, with the legal decision potentially having wide ramifications not just for crypto, but the US banking system as a whole.

What Is a Federal Reserve Master Account and Why It Matters

The Federal Reserve’s master accounts have been in existence ever since the Fed was created more than a century ago and began maintaining deposit accounts for member banks.

A Fed master account is a bank’s deposit account at the Reserve Bank, which gives that bank direct access to the central bank’s payment systems, like Fedwire and FedNow.

The account is possessed by all federally chartered banks, and the services offered to a master account are similar to what customers get from their banks.

So, this account is used by a financial institution to hold funds and make electronic transfers of money between banks, as the accounts are interconnected to facilitate payments between different institutions. Access to payment systems also allows the holder to clear and settle transactions electronically.

For now, many crypto-focused financial institutions operate under limited regulatory frameworks such as state trust charters, money services business (MSB) registrations, or Wyoming’s Special Purpose Depository Institution (SPDI) charter. While these structures allow certain banking-like activities such as custody and fiduciary services, they do not grant full banking powers such as lending or automatic access to Federal Reserve master accounts.

This limited charter allows these firms to perform some banking tasks, like custody of digital assets, fiduciary services, etc. But they do not allow for lending, for example, and a traditional bank charter also grants FDIC Insurance for its deposits.
Swipe to scroll →

Custodia Bank’s Legal Appeal Against the Federal Reserve

Background

For now, Custodia Bank is a Wyoming-chartered special purpose depository institution that is not a member of the Federal Reserve.

Previously, Custodia Bank argued that it should be granted automatic master account access because it holds a state banking charter. A request that was denied by the Kansas City Fed regulator.

This came as a surprise to the company, as it initially had received encouraging feedback.

“On October 29, 2020, Custodia applied for a master account. The Federal Reserve Bank of Kansas City told Custodia that it “was legally eligible” for the account and that “there were ‘no showstoppers’ with its application.”

In internal memorandums, its staff deemed Custodia’s capital “adequate” and its liquidity risk “low,” while praising its “strong” risk management and “impressive” executive team.

The argument for denying the request was that Custodia’s crypto-focused business model introduced undue risk into the Fed’s payment systems and services.

States Vs Feds

In its appeal, Custodia argues that the panel has misread the Monetary Control Act, which it asserts entitles any eligible bank to a master account.

It also argues that this decision undermines state banking authority.

“When the Fed denies a master account to a state-chartered financial institution, it effectively vetoes a bank charter that State regulators have approved.”

This indeed could be the most important part of the argument, as it goes beyond Custodia Bank or even crypto in general.

The USA is organized in a federal structure, and the rights of individual states should not, at least in theory, be submitted to arbitrary decisions by the federal government.

Of course, in practice, legal experts will debate what is and what is not an infringement on states’ rights.

Arbitrary Decisions Versus Rule Of Law

Another criticism of Custodia Bank about this decision is that it gives excessive power to administrative personnel like mid-level Fed officials (regional bank presidents) who are not appointed as either principal or inferior officers under Article II of the Constitution.

According to Custodia, the decision also represents a departure from the application of the law so far.

“It also departed from 35 years of history: for decades, the Fed did not interpret the MCA as conferring the power to debank financial institutions.

The panel’s holding invaded the States’ core regulatory prerogatives and put the Fed in constitutional quicksand.”

What Happens Next in Custodia’s Fed Master Account Case

The Latest Appeal

What Custodia Bank is asking for is a procedure called a “rehearing en banc”. This is an “extraordinary procedure” only granted in cases of exceptional public importance, or when a ruling directly contradicts another ruling by the same circuit or the Supreme Court.

Statistically, the odds of receiving such a rehearing are extremely low.

However, Custodia insists that it is needed, as the decision erodes states’ rights when it comes to control over banking.

“The panel’s decision permits the Fed to reduce state charters to nothing, all but erasing the States’ historic chartering privileges.

The panel’s holding thus gives the Fed a veto over state charters. If the Fed thinks certain banks—or entire categories of banks—should not be chartered, it can deny those banks a master account.”

It also raises constitutional questions about the authority granted to the mid-level Fed officials.

“Under Article II of the Constitution, presidents of regional Federal Reserve Banks cannot perform duties that would make them “Officers of the United States”.

Only the President may appoint “principal” officers, and “only the President, a court of law, or a head of department” may appoint “inferior” officers.

Presidents of regional Federal Reserve Banks, however, are not selected in any of these ways. ”

So the discussion seems to be extending from crypto banks’ access to master accounts, to a broader discussion of the true reach of the Federal Reserve power, independently from US States or elected officials.

However, this decision seems to go in the opposite direction of the Fed’s Plan for “Skinny” Master Accounts. These would not include overdraft privileges or interest on balances, but still represent a major improvement for crypto companies looking to access the sort of privilege reserved for banks until now.

Consequences

According to Custodia Bank itself, this could spell doom for the company.

“Closing a bank’s master account—or refusing to open one—all but sentences the bank to death.”

The company sees this refusal as part of a larger effort to “debank” it entirely, accusing the Fed officials of aiming for this exact goal.

“On January 27, 2023, the Kansas City Fed denied Custodia’s master account application.

Since then, Fed officials have exerted “regulatory pressure” against Custodia’s banking partners, apparently in an effort to debank Custodia entirely.”

So not only might Custodia Bank not have its own access to a Fed master account, but it could ultimately lose all access if its banking partners follow this direction and refuse to collaborate in the future.

Will Custodia Actually Win a Fed Master Account?

In general, there has been a trend over the past decade of members of the administration and judges to take more and more decisions that would maybe have been handled by other parts of the government in the past, be it the Federal Reserve or the Supreme Court.

So even if you believe Custodia Bank is right in its argumentation, this does not necessarily bode well for its chance at winning its appeal and obtaining a rehearing en banc.

And after all, it has been 5 years that Custodia has been trying to obtain a Fed master account, so far unsuccessfully.

So while crypto enthusiasts might hope otherwise, the prospect of a quick reversal of this decision seems rather unlikely.

On the other hand, by escalating the discussion about the constitutionality of the decision as well as making it about states’ rights versus the Federal Reserve legal reach, the appeal might put the hand of the Wyoming legislators and politicians to apply their own pressure on the Fed and judges, as the state is aiming to become a major “crypto friendly” jurisdiction.

Conclusion

What sounds at first glance like a dry and boring legal debate (and it is also that) could have wide-reaching consequences not only for Custodia Bank, but the crypto sector as a whole.

It could even affect the discussion of how the respective prerogatives of the US states and the Federal Reserve are shared, and who decides when they disagree with each other.

Right now, the chances of Custodia Bank getting a Fed master account seem rather slim.

However, maybe the plans for “skinny” Fed master accounts could allow for a compromise midway: not fully denying Custodia’s request or “sentencing the bank to death”, but also not acknowledging the legal basis of its appeal, as the ramifications of that decision would go way beyond the discussion of giving crypto firms access to the Federal banking payment system.