Federal Reserve Says Custodia’s Plans Would Endanger Itself and the Crypto Industry

The Federal Reserve Board hammered more nails into the coffin of Custodia Bank's failed push for membership on Friday, condemning the proposal's shortcomings in every single category the Fed assesses, saying each of those misfires would have justified its own rejection.

Custodia’s membership application, as well as its application for a master account, was denied in January, 18 months after the applications were initially filed. Custodia, formerly known as Avanti Bank, sued the Federal Reserve in June 2022, alleging that the central bank was unlawfully delaying its decision, and filed an amended complaint earlier this year alleging a Fed conspiracy to block it. This epic response from the Fed is the first detailed effort at explanation.

In Friday’s 86-page release, the Fed’s famously measured language was about as harsh as it gets as the central bank detailed "fundamental concerns" with Custodia's approach. The banking supervisor noted "significant deficiencies in Custodia’s ability to manage the risks of its day-one activities," and doubted its ability to handle basic safety measures and to comply with banking laws regarding money laundering.

The Fed's response also potentially signaled its deeper thinking about other key crypto banking issues, such as its worries about banks handling stablecoins. It could give the industry more to think about once it moves past the tremors from the recent bank failures.

“The Custodia order is 14 times longer than the next-longest Fed denial order in history, and 41 percent longer than the longest Fed order of any type, which speaks volumes about the messages the Fed intended to send to both banks and crypto companies in this order,” said Nathan Miller, a Custodia spokesperson.

The board’s explanation for the January rejection comes just two weeks after the collapse of Silicon Valley Bank, which was shut down on March 10 after a bank run. Shortly after, the Federal Deposit Insurance Corporation took over SVB. The failure of SVB – a $200 billion bank – is the biggest U.S. bank failure since the 2008 collapse of Washington Mutual.

In the wake of SVB’s collapse, state regulators in New York shut down another lender, Signature Bank, claiming that there had been a “crisis of confidence” in the bank’s leadership. Both Signature and SVB were known for being crypto-friendly institutions. Their closures have added fuel to the fire of conspiracy theories that U.S. regulators are making a coordinated effort to cut crypto off from the wider banking system.

Custodia has pushed back on the Fed’s rejection, both through its ongoing lawsuit and in a further statement Friday which called the order “the result of numerous procedural abnormalities, factual inaccuracies that the Fed refused to correct, and general bias against digital assets.”

“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,” the Custodia statement said. “Perhaps more attention to areas of real risk would have prevented the bank closures that Custodia was created to avoid. It is a shame that Custodia must turn to the courts to vindicate its rights and compel the Fed to comply with the law.”

Outside of the crypto sphere, the global banking system has continued to show increasing signs of instability post-SVB. Credit Suisse, after years of being plagued by controversy, was forced to merge with UBS. And San Francisco-based First Republic Bank required an injection of $70 billion in liquidity from the Federal Reserve and J.P. Morgan to ensure its ability to meet withdrawal requirements.

Rationale for Custodia’s denial

The Fed’s eviscerating explanation for its denial of Custodia cites the crypto bank’s decision not to insure its deposits – instead, the bank proposed to be fully capitalized, holding $1.08 in cash for every dollar deposited by customers – which the FRB said could increase Custodia’s risk of runs and contagion.

The Board 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.”

The Fed explained that it has several factors it uses to evaluate an application, from managerial ability to financial strengths, and it argued that the results in each were “so adverse as to present sufficient grounds on their own for warranting denial of the application.”

One of the most biting observations from the regulator was in its assessment that Custodia’s business plan may not only be a danger to itself, but also to the crypto customers it’s seeking to serve.

“The current record indicates Custodia could in fact pose significant risk to its community,” the document said.

The membership was denied without prejudice, meaning that Custodia would, in theory, be able to apply again in the future.

Stablecoin concerns

The central bank’s criticism of Custodia seemed to go well beyond its own business. Crypto industry observers will be paying close attention to the Fed’s language on stablecoins – those tokens, generally tied to stable assets such as the dollar, that are the lifeblood of cryptocurrency trading.

In contrast to what federal regulators had once agreed was the safest course for stablecoins – that they be issued by regulated banks or financial firms that are under similar strict rules – the Fed had a lot to say Friday about how dangerous a Custodia-issued stablecoin could be. More in line with statements the U.S. banking regulators had issued at the start of the year, the central bank outlined worries about what would happen with Custodia’s token Avit if the business were granted a Fed master account.

The regulator said that Custodia piling its Avit reserves into the Fed account could give a sense to the market that the token had “a form of implicit backing” from the central bank.

“This could enable such a product to scale quickly and globally; it could plausibly become a tool for persons around the world to access the stability of the U.S. dollar instantly and anonymously,“ the Fed argued. That could create “a new, meaningful, and volatile source of demand for Federal Reserve liabilities.”

The Fed's position suggests “the virtual impossibility – if not actual impossibility – of banks engaging with stablecoins issued on open, public blockchains,“ said Miller, the Custodia spokesperson. “This is terrible policy for the United States, because the rest of the world has figured out solutions to this problem.”

UPDATE (March 24, 2023, 21:06 UTC): Adds details of the Fed's views on the Custodia application.