Custodia ruling leaves Fed with no good options

Custodia Bank’s lawsuit against the Federal Reserve is not going away anytime soon, and the case will likely have major implications for the reach of the Fed’s authority.

The Fed’s effort to have the suit dismissed from the U.S. District Court of Wyoming fell flat on Friday as Chief Judge Scott Skavdahl said it was appropriate for the court to consider why the Wyoming-based digital asset bank has had to wait two years for a decision on its application for a master account.

The Fed now has two options: grant Custodia an account or let the case go to trial. Both routes would establish new precedents and expectations for master accounts — and potentially other matters — according to legal and institutional experts.

Should the Fed allow the case to go to trial, it would not only risk being forced into a decision on Custodia’s application, it would also have to release a host of previously non-disclosed information during the discovery process. 

Brainard Powell
Jerome Powell, chairman of the Federal Reserve, right, and Lael Brainard, vice chair of the Federal Reserve, during a public listening event in September. A federal judge in Wyoming last week allowed a suit against the central bank to proceed, a development that could have major implications for the Fed’s authority regardless of the outcome.

Bloomberg News

Julie Hill, a University of Alabama law professor whose research focuses on Fed master accounts, said the Fed would almost certainly have to divulge information about master accounts that it keeps closely guarded.

“Almost everything we know about the master account process … has come through litigation. They don’t just let this information out. We know about these things, because of the Fourth Corner [Credit Union] case, because of the Custodia case and because of The [Narrow Bank] case,” Hill said, referring to previous master account challenges. “Those are the reasons we know anything about what’s happening in the master account realm, so I expect if you actually had a case that went to trial, you would learn all sorts of interesting stuff.”

The cases involving Fourth Corner, a Colorado-based institution that sought to serve the state’s legal cannabis industry, and The Narrow Bank, a Connecticut-based bank that wanted to hold all of its customers’ deposits in risk-free reserves at the Fed, were both dismissed before going to trial. The Fed provided some explanation about the master account process in pre-trial court filings, but there was never a discovery process.

Custodia says it has built on the rulings from the previous proceedings by ensuring it has a state charter that is in compliance with various federal requirements related to the Bank Secrecy Act, anti-money laundering requirements and host of other considerations. Custodia argues that the Kansas City Fed’s delay in issuing a ruling is having crippling effects on its business.

In response to an interview request, a Custodia spokesperson said the bank was grateful to have its day in court and was awaiting a final ruling from Skavdahl. 

The Fed, meanwhile, maintains that Custodia’s business model, which includes providing custody services for digital assets and, eventually, issuing its own stablecoin, pose novel risks to the banking system that must be considered carefully. Representatives from the board and the Kansas City Fed declined to comment.

Among the most critical questions to be answered during discovery, Hill said, is what role the board of governors plays in the review process. 

“It’s not really clear, because the whole process is pretty opaque, what role the board is actually performing. Nobody really knows how many of the levers they’re pulling,” Hill said. “As the Custodia case goes forward, we should expect to see an answer.”

By law, the Federal Reserve System’s 12 reserve banks each handle accounts for banks in their respective regions. Earlier this year, Fed Chair Jerome Powell said the reserve banks have the final say over master account access, albeit with guidance from the board. 

In August, the board updated the guidelines for evaluating master account application by establishing a three-tiered review system, with Tier 1 banks getting the least scrutiny and Tier 3 banks getting the most. The change was made specifically to address new types of charters, such as Custodia, which operates as a “special purpose depository,” a relatively new type of charter under Wyoming law specifically for institutions dealing with digital assets.

Whether the board or the reserve bank ultimately controls the master account process speaks to another core issue raised by the Custodia suit: whether the process should be governed under the Administrative Procedure Act, which would limit the review process to 12 months. 

The APA applies to the board as a government agency, but not to the reserve banks, the Fed has long maintained, arguing that they are not arms of the government but rather private entities composed of member commercial banks. 

This distinction has long been the topic of debate among Fed scholars and policy makers and has rarely been tested in court, Kaleb Nygaard, a research fellow at the University of Pennsylvania focused on Fed history, said.

“The Fed rarely is forced into court over large policy issues like this,” Nygaard said. “When they are, they normally come out on top. Yet when they do lose, as they did with certain disclosure rules following the [mortgage crisis], I expect them to make the appropriate adjustments quickly to come into line.”

Because of the sweeping structural questions posed by the Custodia suit, the Fed has already petitioned the court to take a limited view of the questions at hand, warning that failing to do so could have “potential ramifications for the careful balance Congress has created with the Federal Reserve System.”

While the case is poised to advance, some of the broader questions raised by Custodia could be stripped away, Skavdahl said.

“Here’s what I want to tell both sides: the tree is going to be trimmed but the tree is not going to be cut down and this matter will survive in some form,” he said, adding that he will render his final decision “as quickly as possible.”

Should the structure of the Federal Reserve System be challenged as a result of the proceedings, Nygaard said he would expect any resulting changes to follow the long-running trend toward consolidation of power within the board.

“This will put more and more pressure on the Federal Reserve Board in Washington to insert itself more forcefully in an area in which it has traditionally taken a hands-off approach,” he said. “The last thing the Fed wants is to be forced into policy decisions that will apply to the whole system by a single court in Wyoming.”

Should the Fed opt not to continue fighting Custodia in court and instead grant its request, that would also likely set a precedent for the many other non-traditional institutions that want master accounts of their own, Gabriel Rosenberg, a lawyer with the law firm Davis Polk who specializes in cryptocurrencies and financial regulation, said. 

At this point, the Custodia suit has risen to such prominence, Rosenberg said, that its resolution is likely to draw the attention of lawmakers, some of whom are already keenly focused on the master account issue and others who have broader grievances with the Fed

“Depending on the outcome, it is the kind of thing that could lead to legislative change,” he said.  “There are really fundamental issues here about how [the Federal Reserve System] operates. The court is going to have to come to some view on that one way or the other.”

Read More: Custodia ruling leaves Fed with no good options

2022-10-31 17:58:00

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