Custodia Bank denied Federal Reserve Membership

Details on the rejection and what it means for Frax's bid for a Fed Master Account

Samuel McCulloch
Samuel McCulloch
Feb 2, 2023
Custodia Bank denied Federal Reserve Membership

Custodia Bank, a digital-assets-focused bank based in Wyoming, recently faced a setback in its 27-month effort to become a member of the United States Federal Reserve System. The Fed rejected the bank's application, stating that it was "inconsistent with the required factors under the law" and citing an insufficient management framework. The bank's CEO, Caitlin Long, stated that the bank actively sought federal regulation and went above and beyond all requirements that apply to traditional banks.

The rejection came as a surprise to many in the digital assets industry, as the Fed only issued guidelines for granting master accounts in August of 2022, after it became clear that digital asset banks could have a difficult time receiving one. According to the Fed, institutions that engage in novel activities and for which authorities are still developing appropriate supervisory and regulatory frameworks would undergo a more extensive review.

A master account enables a bank to make international transfers and carry out other important functions. Without a master account, digital-assets-focused banks like Custodia and Circle have to rely on intermediaries that can access the payment rails that let traditional banks transfer money to each other. This puts them in a lower tier of banks and also places on-chain funds at a higher risk level.

The Fed's rejection of Custodia's application is seen as a major blow to the digital assets industry, and it also raises questions about how quickly Frax will be able to attain a Fed Master account. Despite the rejection, the bank's application for a master account remains pending, and the bank has stated that it intends to continue with its lawsuit against the Kansas City Federal Reserve and re-apply for a master account at the right time.

The Federal Reserve's decision is part of a larger trend of federal agencies, regulators, and the White House taking a more cautious approach to allowing crypto into the broader financial system. This shift in posture can be attributed to the recent collapse of FTX, 3AC, and Luna.

Recently the White House published  The Administration’s Roadmap to Mitigate Cryptocurrencies’ Risks, that highlights the risks and potential dangers posed by cryptocurrencies and the need for safeguards to be put in place to protect investors and ensure that financial stability is not undermined. It also highlights the need for agencies to use their authorities to enforce regulations and issue guidance on the separation of risky digital assets from the banking system. The statement calls for Congress to take action to prevent misuses of customers’ assets, strengthen transparency and disclosure requirements, and limit the risks that cryptocurrencies pose to the financial system.

The Federal Reserve, the Office of the Comptroller of the Currency, and the Federal Deposit Insurance Corporation issued a joint statement on January 3, highlighting key risks of crypto. According to Caitlin Long, this statement was likely when everything changed for Custodia and the Fed postponed the bank's mid-January check-in due to scheduling conflicts.

Despite the rejection, the Fed's policy announcement confirmed Custodia as a bank, a status that was unclear for Wyoming-chartered special purpose depository institutions. The Fed also clarified that banks can provide custody services for assets like Bitcoin and Ethereum. Custodia was one of the first banks in decades to actively try and offer retail and institutional bank accounts without FDIC insurance.

The Fed Master account is extremely desirable for the up and coming stablecoin entrants and it would benefit stablecoin issuers like Circle, Paxos, and Frax by providing them with direct access to the payment rails of the Federal Reserve System. This would allow them to transfer money to other traditional banks, improving the efficiency and speed of transactions, as well as provide access to the discount window in case of a “bank run” caused by asset outflows.

While a setback, the fight is far from over. FMA is a dream for every stablecoin issuer, but its not going to manifest without closer ties to federal regulators to ensure the stability and security of the digital assets sector. Despite the recent rejection, Custodia Bank intends to continue with its lawsuit against the Kansas City Federal Reserve and re-apply for a master account at the right time.

Frax DAO should be ready for a long fight potentially to get FMA access. The recent implosions of FTX and Luna only further heightened regulators and lawmakers fears about crypto as a whole. Banking is the key place where crypto and TradFi meet. With the DOJ now investigating Silvergate and Custodia being denied, the mood has soured on digital assets. The blow back to the industry will take time to pass, but it doesn’t mean we should stop.

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