Fed: management, poor business model contributed to Custodia rejection

The Federal Reserve disclosed more details on its decision to deny Custodia Bank’s application for membership.


The Federal Reserve said Custodia Bank has insufficient management experience, a non-viable business model and an over-reliance on the “speculation and sentiment”-driven crypto sector, and those factors contributed to its decision to deny the digital asset bank’s application to join the Fed system.

The Fed released the full 86-page order — albeit with some redactions — on Friday afternoon, explaining why the Cheyenne, Wyo.-based depository presented a safety and soundness risk too great to be permitted into the traditional banking system. It first announced the rejection nearly two months ago.

Among the litany of concerns outlined in the rejection summary were Custodia’s lack of federal deposit insurance, its liquidity risk management practices and its failure — in the eyes of the Fed — to meet necessary standards for implementing anti-money laundering and Bank Secrecy Act requirements. 

The Fed expressed skepticism that the resolution requirements under Wyoming’s Special Purpose Depository Institutions were as robust as what is required by the Federal Deposit Insurance Corp. Wyoming is the first — and, so far, only — state with a licensing regime for digital asset banks.

The Fed’s order also detailed its many concerns with the digital asset sector, which it described as being not only volatile and highly interconnected, but also a hotbed for fraud, theft, money laundering and illicit finance. It described cryptocurrencies as being “not anchored to a clear economic use case.”

In a response statement issued on Friday afternoon, Custodia spokesman Nathan Miller pushed back against many of the facts cited in the Fed’s decision. He also suggested that, had Custodia been permitted to serve as a regulated bridge between the crypto space and traditional financial markets, recent turmoil in the banking sector could have been avoided.

“The recently released Fed order is the result of numerous procedural abnormalities, factual inaccuracies that the Fed refused to correct, and general bias against digital assets,” Miller said. “Rather than choosing to work with a bank utilizing a low-risk, fully-reserved business model, the Fed instead demonstrated its shortsightedness and inability to adapt to changing markets. Perhaps more attention to areas of real risk would have prevented the bank closures that Custodia was created to avoid.”

Miller said the bank engaged with its primary regulator, the Wyoming Division of Banking, as well as an independent compliance consultant last fall, both of which gave its risk management practices and controls a clean bill of health. 

He also said Custodia would not need deposit insurance because it planned to hold more than a dollar in liquidity for every dollar deposited by a customer. He argued that doing so served as a better protection against deposit runs than insurance.

“Historic bank runs in the last two weeks underscore the dire need for fully solvent banks that are equipped to serve fast-changing industries in an era of rapidly improving technology,” Miller said. “That is the exact model proposed by Custodia Bank – to hold $1.08 in cash to back every dollar deposited by customers.”

One of the stipulations of the Wyoming SPDI charter is that banks cannot make loans using customer deposits. Typically, banks create loans for far greater amounts than they bring in through deposits, a concept known as fractional-reserve banking. Rather than profit off interest charged on loans or returns from investments, Custodia intended for its revenue to be entirely fee-based.

Yet, the Fed took issue with this business model. In its denial, it argued that such a reliance on fees would inextricably link Custodia to the broader health of the crypto ecosystem, which has proven to be volatile and unpredictable.

“The institutional clients and individual customers that Custodia is targeting will only need the bank’s services if crypto-assets are perceived as an attractive investment,” the Fed’s order notes. “Moreover, given the importance of fee income from planned crypto-asset-related activities to Custodia’s overall business plan and the concentration and interconnectedness of the crypto-asset industry, potential run-related risks with respect to assets under custody could impact the viability of Custodia via a significant and sudden reduction in fee-based revenue. For that reason, Custodia’s fortunes are tied directly to those of the crypto-asset markets.”

Custodia’s proposed business model includes providing custody, core banking and payment services to businesses and, eventually, wealthy individuals who use digital assets. In 2020, it sought to become the first bank of its kind to gain access to the Fed’s payments system by applying for a master account with the Federal Reserve Bank of Kansas City.

It later applied to become a state-chartered member bank, which would have made the Fed its primary regulator. Based on guidelines established last year, being federally supervised streamlines the application process for uninsured depositories to obtain master accounts.

Custodia’s bids for a master account and Fed membership were shot down on Jan. 27

Custodia is suing both the Fed’s Board of Governors in Washington, D.C. and the Kansas City Fed over the decisions. It argues that, as a state-chartered depository, it is entitled to a master account under the Monetary Control Act of 1980.

After its twin rejections in January, Custodia altered its initial lawsuit, which sought to compel the Fed to make a decision about its applications. It has since amended its complaint, arguing that the Board of Governors and the Kansas City Fed coordinated with other government agencies to block it and other digital asset-focused firms from the banking system.

“It is a shame that Custodia must turn to the courts to vindicate its rights and compel the Fed to comply with the law,” Miller said.

Custodia’s claims are poised to be put on trial later this year, a rarity for Fed-related legal challenges.

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