2022: The year Custodia took on the Fed

Litigation involving the Federal Reserve is rare, and rarer still is a lawsuit that actually survives to go to trial. This past year saw the former, and every indication is that the latter will arrive in 2023.

Custodia Bank, a Cheyenne, Wyoming-based digital asset bank, sued the Fed claiming the central bank unduly delayed making a decision on its application for an account with Federal Reserve Bank of Kansas City.

Despite the Fed's best efforts to have the case dismissed — as it was able to do with two previous suits involving so-called master accounts — a U.S. District Court judge in Wyoming has found Custodia's claims credible enough to be hashed out in open court.

At face value, the suit deals with the issues of what institutions can access master accounts — which offer holders access to the Fed's payments system and discount window — and on what grounds. Both topics are of great interest to both nontraditional banks that would like master accounts as well as traditional ones, which want to ensure they aren't being placed at a competitive disadvantage to less regulated fintechs.

Beyond those issues, Custodia's suit raises more fundamental questions about the relationship between the Fed Board of Governors and the regional reserve banks, a topic that has vexed financial institutions, politicians and scholars alike.

What follows is a review of the case and the politics surrounding it.

Raskin nomination brings master accounts into focus

Republicans Stall Fed-Nominee Votes Over Raskin Opposition

Bloomberg News

During her confirmation hearing to serve as the Federal Reserve's vice chair for supervision in February, Sen. Cynthia Lummis, R-Wyo., asked Sarah Bloom Raskin — a former Fed governor and Treasury official — about her service on the board of Reserve Trust, a Colorado-based depository firm that had been granted a master account.

Lummis said that Raskin had contacted Esther George, president of the Federal Reserve Bank of Kansas City, shortly before Reserve Trust was granted a master account. In subsequent written answers to lawmakers' questions, Raskin said she could not recall specifics the conversation, but she insisted at the meeting that she has "had the honor to serve in various public capacities, and each time I left, I have been very mindful of the rules regarding departure."

That exchange led to a tense standoff between Senate Banking Committee ranking member Pat Toomey, R-Pa., and the Biden administration over moving toward a committee vote on Raskin's nomination, as well as the nominations of Lisa Cook and Philip Jefferson to serve as Fed governors. Raskin ultimately withdrew her nomination after Sen. Joe Manchin, D-W.Va., said he would not support her nomination over her views regarding fossil fuels.

Banks join the fight with the Fed

Federal Reserve Board Chair Jerome Powell addresses the Senate Banking Committee

Bloomberg News

The controversy around the Fed's master account application process didn't end there. Banking trade groups — including the American Bankers Association, Bank Policy Institute, Consumer Bankers Association and the Independent Community Bankers of America — called on the Fed and its regional banks to provide more clarity about the process in April, saying that accountability remains "paramount to achieve consistent outcomes at the Reserve Banks and equitable access for the institutions they serve."

Toomey also asked for further information regarding Reserve Trust's grant of a master account from the Kansas City Fed, to which President Esther George issued a terse reply claiming that the information Toomey sought was confidential supervisory information and therefore not something the regional Fed bank was free to disclose.

During his semiannual testimony in Congress, Federal Reserve Chair Jerome Powell said that while the Fed board sets rules around granting master accounts, regional Fed banks make determinations about which firms to grant access to, not the board.

"We set rules, but the reserve banks really make the decisions about granting accounts subject to those rules," Powell said.

Custodia files suit

Bloomberg News

Custodia, a Wyoming-based depository, applied for a master account with the Kansas City Fed in October 2020. In June 2022, Custodia sued the Kansas City Fed and the Federal Reserve Board of Governors, arguing that the extended delay in making a decision on its account application was unlawful, and seeking to force a decision one way or the other.

In August, the Fed issued revised final guidance on master account access, which stipulates what level of scrutiny a master account applicant can expect to receive from a regional Fed bank. Under the guidance, FDIC-insured banks with traditional services and enhanced supervision would receive the least scrutiny. Firms without FDIC insurance or a federal regulator would receive the most.

Motions and countermotions

A recent court ruling in Illinois advances a conspiracy case against prominent Wall Street banks.

Later in August, the Fed answered Custodia's suit with a motion to dismiss, arguing that it needed more time to address issues in the suit that it was already tackling internally. The Fed's motion to dismiss is a tactic the central bank had already employed twice to fend off master account-based litigation — first from a Colorado cannabis bank Fourth Corner Credit Union in 2017 and again in 2020 from The Narrow Bank in Connecticut, which sought to hold all of its customers' deposits in risk-free reserves at the Fed.

Several members of Congress — led by Lummis — filed an amicus brief in support of Custodia's suit in September, arguing that the Monetary Control Act of 1980 requires the central bank to provide reserves to all banks, regardless of whether or not they are members. In doing so, the legislators argued, the law also expanded master account access to all banks willing to pay for the service.

The Fed argued in a later court filing that Custodia's own marketing materials purport it to be a "first-of-its-kind digital asset bank," suggesting that the Kansas City Fed was correct in its caution about granting the firm a master account.

Custodia's business model "raises technical, complex, and novel issues that present risk to" the Federal Reserve Bank of Kansas City "and that potentially have implications for the stability of our nation's payment system," the Fed said.

The federal judge overseeing the case ruled in November that, while not all of the issues raised in Custodia's suit would advance to be heard in court, several of the most critical questions would, leaving the Fed in the uncomfortable position of either settling the suit or taking it to court — either of which would send a critical signal to would-be applicants.

Master list of master accounts

Bloomberg News

The Federal Reserve Board in November said that it was seeking comment on a proposal to publish a master list of master account holders and applicants in order to provide more transparency around the master account application process. Comments on the proposal are due by Jan. 15, 2023.

But Toomey got there first, including a provision in the National Defense Authorization Act in December that would require the Fed to publish precisely such a list and update it quarterly.

"Events and information gleaned over the last year have raised significant policy questions about the Fed's approach to awarding master accounts," Toomey said in a written statement following the passage of the NDAA. "Access to the Fed's payment system is a highly valuable public good, and Congress has a responsibility to taxpayers to ensure regulators give out public goods in a fair and consistent manner."

But the Fed also got an important win in December: The same judge that denied the Fed's motion to dismiss the suit upheld its argument that it would not be subject to full discovery, calling Custodia's motion to compel the Fed to open its records fully to the bank "borderline nonsensical."