Federal Reserve is an exclusive club

The Federal Reserve Board argued that Custodia Bank’s proposed business model was “inconsistent” with approval in an order explaining its denial of the Wyoming-based crypto bank’s application for membership in the Federal Reserve System.
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Friday’s 86-page release, however, is the first time the central bank has expanded on its reasoning for the denial. The Federal Reserve Board argued that Custodia had insufficient risk management and controls, “particularly with respect to overall risk management; compliance with the Bank Secrecy Act and U.S. sanctions … financial projections, and liquidity risk management practices.”

The board also argued that Custodia’s revenue model, which “relies almost solely upon the existence of an active and vibrant market for crypto assets” makes it vulnerable to market volatility, even though the board admitted that “Custodia appears to have sufficient capital and resources to sustain initial operations.”
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pmbug said:

Kraken wants in. ...

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Cryptocurrency exchange Kraken has unveiled a qualified custody service for institutional clients in crypto-friendly Wyoming through the firm’s long-standing state-chartered banking license in the region.

Kraken Institutional, announced on Wednesday, operates under the special purpose depository institution (SPDI) charter snagged by the exchange back in 2020. All deposits will be held in segregated accounts remote from the exchange itself and on a full-reserve basis.
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"Kraken made history as the first cryptocurrency exchange to receive a banking charter in the US in 2020," a spokesman for the exchange said in an email. "It’s taken us the best part of three years since this important milestone to work through all the various legal and compliance checks required to launch a bank and bring Kraken Financial to market."
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The investigations carried out during the court cases exposed major modifications in the assessment reports, which were prepared by the Kansas City Fed and then changed by the main Fed in DC.

Preliminary findings revealed that Custodia had met all major regulatory criteria like capital adequacy, risk management, and liquidity. Nevertheless, the last ones were edited to emphasize the claimed drawbacks, thus venting doubts about the objectivity and justice of the review.

These changes spanned the areas of capital requirement and risk management to liquidity and management experience, leaving Custodia in a very unfavorable picture in the end report. Critics claim that the changes signify a larger distrust and regulatory conservatism with respect to the digital asset service providers, which could, in turn, hamper the growth and innovation of the area.

The lawsuit has received substantial publicity and backing from different sides, including the Blockchain Association and the Attorney General of Wyoming, who submitted amicus briefs in support of Custodia. This assistance emphasizes the perceived wider implications of the case, going beyond the specific interests of Custodia to include fundamental issues of regulatory clarity, financial innovation, and the incorporation of digital assets into the mainstream financial system.
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The United States District Court for the District of Wyoming has ruled against granting Custodia Bank a U.S. Federal Reserve master account and dismissed the digital asset bank’s plea for a declaratory judgment. However, Custodia claims it is not backing down and is exploring all possible avenues.

“We are reviewing the court’s decision and all of our options, including appeal,” a spokesperson for Custodia Bank told Cointelegraph.
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chieftain said:

The question to me is:

- To whom is it risky?

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"The court concludes the statutory language is clear and unambiguous, and the Federal Reserve Act does not support Custodia's position for several reasons," Skavdahl wrote.

One of the reasons cited in the decision was an amendment to the National Defense Authorization Act for Fiscal Year 2023, which required the Fed to begin publishing a list of master account holders and to disclose which applications were "approved, rejected, pending, or withdrawn." Skavdahl said the inclusion of "rejected" solidified Congress' stance that reserve banks could deny applicants.

This interpretation of the amendment drew swift rebuke from some in Washington, including the provision's author, former Sen. Pat Toomey, who called the judge's interpretation "illogical," during an interview with American Banker on Monday.

"Knowing that they did, in fact, approve some, deny others, sometimes reverse themselves as they did in the case of an applicant from Colorado, I simply wanted them to be required to disclose this," Toomey said. "For someone to come along and say the disclosure means you approve of and condone the practice is so illogical. It is a willful refusal to read the English language as it's written."
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"It's nothing less than baffling," Toomey said. "The judge does a complete and absolute 180-degree reversal on his own interpretation of this language with no explanation. How does that happen?"

Last year, former Toomey staffers told American Banker they were misled by Fed staffers when crafting the NDAA amendment. Before being added to the package, the provision had to get approval from the heads of both parties on the Senate Banking Committee and the House Financial Services Committee. During that process, the Fed was consulted about the legislation to ensure its language did not have unintended consequences.

The former Toomey staffers, who were granted anonymity because they still work on Capitol Hill and interact with the Fed, said staffers from the central bank insisted on certain language that was later cited by Fed lawyers in a motion to dismiss the Custodia case.

"They certainly know what our intent was. They know what we were trying to accomplish. They were consulted extensively and had very strong feelings about what the language should say, and then they turn around and go to court and argue that it means something wildly different from what they know, it actually was intended to mean," Toomey said. "You can draw your own conclusions, but that's the fact pattern."
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If — but, let's be real, when — the ruling is appealed, it will join a handful of other lawsuits asking a lot of the same questions. The Narrow Bank — the OG master account litigant, having taken the Fed to court in 2019 — recently had its application for a master account denied on grounds including concerns about financial stability, impact on the Fed's conduct of monetary policy and runnability. The Puerto Rico-based Banco de San Juan is also suing the Fed over its decision to terminate the bank's master account on anti-money-laundering grounds. That sounds like an opportunity for different venues to reach different conclusions about how much discretion the Fed has, which in turn sounds like a matter that the Supreme Court will eventually weigh in on in the years to come.

In order to preserve its discretion, then, it would be incumbent on the Fed to articulate exactly what criteria it is using to decide whether an applicant can be granted access. The Fed has to replace the velvet rope with a fence.

There are good reasons why the Fed has been reluctant to do that. For one, if you build a fence, applicants can build a ladder — by articulating what an applicant has to do, applicants can find some way to satisfy those minimum requirements while preserving their goals of banking crypto or undermining banks' favorable interest rates or whatever other disruption they seek in the banking world. Keeping those requirements vague or case-by-case keeps the cards in the Fed's hands.

It also makes those case-by-case decisions somewhat arbitrary, and that's something that both the judicial and legislative branches don't look upon kindly. To be sure, the Fed has articulated a kind of proto-fence in its master account application guidance, but that just says that traditional plain vanilla banks are likely to get an account and more exotic business models will be scrutinized more heavily. What is needed is a clear explanation of what bad things the Fed is trying to prevent by denying an applicant a master account.

So if the Fed's objection to Custodia is that crypto is volatile and dangerous, then it should say so — and apply that logic to other account holders as well. If it thinks banks should be paid an advantageous interest rate on its reserves relative to nonbanks for monetary policy reasons, it should say so. If it thinks that inadequate AML risk controls are grounds for terminating a bank's master account, then it should say so — and terminate the master accounts of all banks lacking such controls.

Drawing those lines will be difficult and would likely require an articulation of policy that goes beyond the Fed's specific remit — if we're barring crypto from banking, it may mean rethinking bitcoin ETFs, for example. But the velvet rope approach is not one that is built to last, and if the Fed doesn't draw bright lines around master account access, then Congress or the courts will.

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... if you build a fence, applicants can build a ladder ...

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The two most recent court rulings on master accounts are the U.S. District Court in Wyoming's decision in Custodia v. the Federal Reserve Bank of Kansas City and the Federal Reserve Board, and the U.S. District Court in Idaho's dismissal of a suit brought by PayServices Bank against the Federal Reserve Bank of San Francisco.

In both cases, the two neobanks were suing their regional reserve banks over master account denials. The decisions were issued within one day of each other, with the ruling against Custodia being cited as a reason for dismissing the PayServices suit.

While different in many ways, the two claims argued that, as state-chartered banks, Custodia and PayServices were both entitled to master accounts. This stance is based on a provision of the Monetary Control Act of 1980, which granted access to the Fed's financial services to depository institutions that were not members of the Federal Reserve System.

The debate centers on whether the law's assertion that the Fed "shall" make master accounts available to nonmember banks meant the central bank must do so or if it had the option to do so.

Judge Scott Skavdahl, the Wyoming judge overseeing the Custodia case, wrote in his decision that for the argument to be true, Congress would have been violating a long-held statutory construction principle that it not "hide elephants in mouseholes" — a legal interpretation that lawmakers cannot hide sweeping changes to regulatory frameworks in "vague terms or ancillary provisions." Therefore, he wrote, the act in question stands as proof that Congress wanted the Fed to have discretion over which banks can have master accounts.

But Conti-Brown — who was retained by Custodia as an expert witness for the case and provided written testimony — said Skavdahl's reading of the law would amount to using a vague statute to grant the Fed a significant authority.

"The idea that Congress gave the Fed untrammeled authority to deny all of these depository institutions access to the payment system based on its own whims is exactly the thing that the MCA was trying to stop," Conti-Brown said. "The argument that Congress tried to do one thing and did the complete opposite does not give me much confidence in this district court judge."
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Meg Tahyar, a regulatory lawyer with the law firm Davis Polk, believes the ultimate decisions reached in the three master account cases will come down to statutory interpretation. But, she said, such a debate is not the ideal forum for addressing the key question of what entities should be able to engage in payments in the 21st century.

"I make a clean break in my mind between the policy question of whether non-traditional banks, fintechs or payment companies should get master accounts — is that a good policy idea — and what the statute actually says," Tahyar said. "We're having this legalistic fight when what we should really be asking ourselves is: Who should have access to a master account?"

An ironclad view on payments system access and the Fed control over it would take an act of Congress, the likes of which is not being discussed broadly — if at all — on Capitol Hill.
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Despite the string of victories by the Fed, Julie Hill, a law professor at the University of Alabama who researches master account policy, said technically it is too soon to say that the Fed's broad authority over master accounts is settled law — but it could be soon.

"At some point, when you have no split of opinion among the circuits, it might as well be settled, but that's not where we're at yet," Hill said. "We still haven't seen any courts of appeals clearly decide this issue, so we still have some legal ambiguity."

For Custodia and PayServices, a successful appeal hinges on finding a panel of judges to interpret the Monetary Control Act as they do, Hill and others said, which is possible, given the polarizing nature of the passage in question.

Still, Hill said she expects the decisions to have a "chilling effect" on other nontraditional banks that might have otherwise sought access to the payments system.
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Custodia Bank will appeal the district court decision handed down last month in its lawsuit against the Federal Reserve.

The Cheyenne-based digital asset bank submitted a notice to the 10th Circuit Court of Appeals on Friday that it would challenge the decision reached by Judge Scott Skavdahl of the U.S. District Court in Wyoming on March 29.
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Custodia also filed a motion with the District Court in Wyoming objecting to the Kansas City Fed's effort to recoup more than $25,000 in costs from the bank related to the lawsuit.

The reserve bank submitted an itemized bill of costs to the court, requesting that Custodia reimburse it for expenses related to deposition transcription.

In its filing, Custodia referred to its case against the Fed as a "David versus Goliath lawsuit," arguing that if the court forces it to cover the reserve bank's costs, it would "risk chilling future legitimate lawsuits challenging the administrative actions of governmental and quasi-governmental entities."

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... This week American Banker Reporter Kyle Campbell interviewed Custodia Bank CEO Caitlin Long. Their topic was her bank's legal tussle with the Federal Reserve Bank over its decision to deny Custodia a master account. ...

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A Connecticut de novo bank focused on banknote distribution is on track to become the first uninsured institution to secure direct access to Federal Reserve financial services since the central bank revamped its approval process two years ago.

Greenwich-based Numisma Bank received conditional approval for a so-called master account and cash services through the Federal Reserve Bank of New York in March, a company spokesman confirmed Thursday.

Once the conditions are met, it would become the first "Tier 3" applicant to secure a master account under the Fed's three-tiered evaluation framework, a development that has frustrated other de novo applicants and drawn questions from others in the industry.

Michele Alt, a partner at the consulting firm Klaros Group, said the public is owed an explanation about how the New York Fed arrived at its decision. She added that Numisma's affiliation with former Fed Vice Chair for Supervision Randal Quarles — whose private equity firm Cynosure Group owns a share of the bank — is further cause for transparency.

"This is a bad look for the Fed," Alt said. "I think there is pressure to share the distinguishing features of the Numisma application and I also think there will be significant pressure on the Fed to approve other Tier 3s that meet whatever criteria the Fed found persuasive about Numisma's applications."

Alt noted that the approval harkens back to 2018, when the Federal Reserve Bank of Kansas City granted a master account to Colorado-based fintech Reserve Trust, which happened shortly after former Fed Gov. Sarah Bloom-Raskin joined the company's board and placed a call to then-Kansas City Fed President Esther George. Reserve Trust's master account was removed after the ordeal became public during Raskin's confirmation hearing to serve as the Fed's vice chair for supervision.

"The market value of Fed former governors has gone way up as a result of all this," Alt said.

The New York Fed declined to comment on the decision to grant Numisma a master account.
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According to a database of master account holders and applicants, the Fed has received 27 applications from Tier 3 institutions since 2017. Three of those have been rejected, eight have been withdrawn and the rest remain pending, leaving many to question whether it was possible, in practice, for a Tier 3 applicant to be granted an account.
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Playing with Fire: Money, Banking, and the Federal Reserve​