Custodia Comments On The Fed's 86-Page Order: New Fed Policies And Procedural Abnormalities

There are leadership lessons in the Fed's 86-page Custodia order, released Friday, that may help the law-abiding digital asset industry forge a path forward. Custodia is continuing its work to break through, because digital assets are not going away and the U.S. banking system – which is experiencing disruption – is in the crosshairs. The purpose of this post is (1) to frame the context for the Fed’s new policy statements and (2) point out the Fed’s procedural abnormalities and what other banks might learn from them.

Note this post does not discuss Custodia’s application for a Fed master account, which is different from Custodia’s membership application and which is the subject of an ongoing lawsuit brought by Custodia against both the Fed’s Board of Governors and the Kansas City Reserve Bank. As a reminder, Custodia was approved for initial launch by both its primary bank regulator and an independent compliance consultant last Fall.

New Fed Policies Outlined in the Custodia Order

The Fed outlined at least five new policies in the Custodia order. Banking and digital asset policy experts have begun to discuss them all, both in blog posts and at a Wharton RegTech conference on Friday (which was subject to Chatham House Rules and in which Custodia participated). More discussions are forthcoming, but here are the new policies identified so far:

  1. The order may cast doubt on whether, in the Fed’s view, any issuer of a stablecoin on an “open, public and/or decentralized network,” such as Bitcoin or Ethereum, can comply with anti-money laundering/combating financing of terror laws due to the existence of unhosted wallets (see, e.g., pp. 29-34).

  2. The order may cast doubt on whether any “financial institution” is permitted to pay blockchain transaction processing fees to unknown validators, including mining or gas fees (see, e.g., pp. 33-34).

  3. The order may cast doubt on whether the Glass-Steagall Act prohibits a bank from both taking deposits and issuing a stablecoin (see, e.g., p. 68). On this topic the Fed appears to have made a significant break from the President’s Working Group, which recommended that no entity other than an insured depository institution can issue stablecoins. So, the Fed may have outlined for the first time a “catch 22” that blocks both banks and non-banks from issuing U.S. dollar stablecoins. Note that incumbent banks are already doing this with the Fed’s blessing, though, including JPMorgan with JPMCoin and the dozen community banks that issue the USDF stablecoin.

    Some have speculated that the Fed’s newly-articulated policy in the Custodia order could also relate to the Fed’s own project to explore issuing a central bank digital currency (CBDC), since the 12 regional federal reserve banks are privately owned and are likely subject to patents – and Custodia holds the U.S. patent on the tokenization of bank deposits (U.S. patent number 11392906, granted in July 2022). This is an important distinction because the actual issuers of U.S. dollars at the Fed have always been the 12 regional reserve banks, not the Board of Governors in Washington, D.C. – so a patent that applies to the 12 reserve banks might pose a roadblock to a Fed-issued CBDC.

  4. The Fed’s decision not to admit uninsured state-chartered banks as Fed member banks opens a new chapter in the history of the dual banking system in the U.S., in which both States and the OCC have equal power to charter banks and States can choose to defer to federal bank regulators but are not required to do so. The Fed’s new policy means it believes that States must defer to federal bank regulators – something with which States may take issue. Multiple states already have uninsured bank charter laws (including Connecticut, Wyoming and Nebraska, with others under consideration). In the Custodia order, the Fed’s Board in Washington, D.C. appears to have overruled the Kansas City Reserve Bank, which held more than 100 meetings with the State of Wyoming from 2019-21 and provided comments on the creation and implementation of Wyoming’s new bank charter (for which FDIC insurance is not required).

  5. In the Custodia order the Fed de facto established a new requirement that state banks be FDIC-insured in order to become Fed member banks because, in its words, FDIC insurance is “a critical tool in preventing bank runs.” (That is interesting in light of the bank runs at FDIC-insured banks that unfolded just weeks after the Fed wrote the January 27 Custodia order.) In the Custodia order, the Fed four times said: “Custodia is not seeking deposit insurance from the FDIC” without once acknowledging that Custodia did seek deposit insurance. That material omission painted Custodia as a bank trying to avoid federal regulation, when in fact the opposite is true.

Custodia can add a new fact to the policy discussion: Following the Fed’s initial January 27 denial of Custodia’s membership application, Custodia re-submitted its business plan to exclude all activities newly deemed impermissible by the Fed as of January 27. Custodia’s narrowed business plan includes only those activities that are already permissible for banks – Fedwire/ACH for a broader group of tech-forward customers, and custody for Bitcoin and Ethereum (which the Fed is allowing BNY Mellon to do, for example). The Fed still denied Custodia’s narrowed proposal on February 23, 2023.

Procedural Abnormalities and Precedent-Setting Level of Confidential Supervisory Information Disclosure

Banking law experts have already noticed the precedent-setting length of the Fed’s order. At 86 pages, the Custodia order is 14 times longer than the longest denial order ever issued by the Fed and is 41% longer than the longest-ever order issued by the Fed of any type, based on Custodia’s analysis of public records. One banking law expert speculated that the Fed wrote the order “with the litigation in mind.”

Because the Fed disclosed extensive confidential supervisory information in the order, the Fed itself made the following discussion of the procedural issues possible. Pointing to disclosures made by the Fed in the Custodia order, here are some procedural issues that other banks may find noteworthy:

  • The Fed examined Custodia in September 2022 and delivered an exam findings letter in October (see, e.g., footnote 83). Then, without notice months later, the Fed changed its mind and retroactively pointed to the exam results to justify a “no” (in January 2023).
  • The Fed acknowledged that it did not review any of the extensive updated information submitted by Custodia both during and after the September exam (see, e.g., footnotes 112, 126, 128). This meant the Fed Board’s denial vote was based on outdated information that was more than six months old in many cases (and six months is an eternity for a de novo bank establishing its policies and procedures for the first time). The Fed’s order disclosed that all parties were working toward a follow-up exam for Custodia (see, e.g., page 45; footnotes 112, 126 and 128, and the many references in the Fed’s order to Custodia’s remediation plan from which an inference can be drawn that the parties did not stop working after the first exam). But the Fed, without warning, changed its mind before Custodia could have the follow-up exam, and Custodia’s remediation materials went unreviewed (see, e.g., footnote 126).
  • Because of this, Custodia lost its right to appeal the exam findings via the Fed’s Ombuds program. The window to file an Ombuds complaint had expired months before the Fed changed its mind and voted to deny Custodia.
  • The order cited as a reason for denial a new Fed policy statement that had not yet been enacted or published in the Federal Register, and which was not made available for prior public comment (see footnote 184).
  • On January 27, in a coordinated maneuver orchestrated by the Fed’s Board in consultation with the White House and leaked to reporters by Board officials the day before it occurred, the Kansas City Reserve Bank reported the denial of Custodia’s master account application immediately after the Board denied Custodia’s membership application.
  • The Board and Kansas City Reserve Bank thereby neglected to provide Custodia its 15-day statutory right to request reconsideration of the Board’s membership denial before the Kansas City Reserve Bank denied Custodia’s master account application on the same day.
  • The Fed refused to correct factual inaccuracies in the order (e.g., the Fed’s calculations on page 50 omitted a capital raise completed by Custodia after the exam).

There are many other procedural abnormalities, but the above are likely the ones most relevant to other banks combing the Fed’s precedent-setting order for clues as to how the Fed will approach its future disclosure of confidential supervisory information. This is particularly true as both the regulation and federal supervision of banks are under a microscope. In the race to plug gaps and push out new policies, due process to the banks of course still matters.

Custodia is standing firm on its strategy to construct a regulatory-compliant bridge that can both transact US dollars and custody digital assets. Custodia took a constructive approach to working with the Fed beginning in May 2020, which makes the Fed’s response with its precedent-setting 86-page order discouraging at a minimum. But digital assets are not going away, and neither is Custodia. Already today, the world’s 8 billion people can create and transact U.S. dollars simply by running code on a smartphone – the only question is how fast the change will happen. Custodia will continue to forge ahead at a time when disruption reigns supreme in banking.

Interested parties and potential customers can contact Custodia at [email protected]. Press can contact Custodia at [email protected].

About Custodia: Custodia Bank, Inc. is a Wyoming bank formed to serve as a compliant bridge to the U.S. dollar payments system and a custodian of digital assets that can meet the strictest level of institutional custody standards. Custodia is required to fully comply with all applicable laws and regulations, including the Bank Secrecy Act and federal “know your customer,” anti-money laundering and related laws and regulations. Custodia will also comply with Wyoming’s special purpose depository institution and digital asset laws, which include requirements that fiat deposits be 100% reserved and that Custodia meet the strictest investor protections in the digital asset industry. This press release may contain forward-looking statements, including forward-looking statements within the meaning of the Private Securities Litigation Reform Act of 1995. Forward-looking statements describe future expectations, plans, results, or strategies (including product offerings, regulatory plans and business plans) and may change without notice. You are cautioned that such statements are subject to a multitude of risks and uncertainties that could cause future circumstances, events, or results to differ materially from those projected in the forward-looking statements, including the risks that actual results may differ materially from those projected in the forward-looking statements.

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