Fed, Custodia clash over discovery requirements in master account lawsuit

The Federal Reserve Board of Governors and Custodia Bank are at odds over discovery in their ongoing legal battle about access to the central bank's payment system.

In a court filing last week, the Fed said rather than going  through discovery — a legal process in which parties can request and must disclose information pertinent to the case — it would simply prepare an administrative record for the court to review.

In response to the filing, Custodia, a Cheyenne, Wyoming-based digital bank that is suing to get access to a so-called master account with the Federal Reserve Bank of Kansas City, accused the Fed of attempting to game the legal system as part of its "pattern of obfuscation and delay." 

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"Further delay and gamesmanship only exacerbate the harm that is the basis for Custodia's claim," the firm's filing states. "As an agency of the federal government, the Board must play by the same rules as other litigants."

Custodia is urging the court to compel the Fed board to comply with its discovery requests in short order or issue a default judgment in Custodia' favor.

Custodia brought suit against the Fed Board of Governors and the Kansas City Fed in June, accusing them of slow-walking the depository's application for a so-called master account, which would grant it access to the Fed's various services, including the settlement of payments. Custodia submitted its application in October 2020. 

Whether or not the Fed Board of Governors must go through discovery could have significant ramifications on both the lawsuit as well its broader implications. Aside from the direct matter of its master account application, Custodia raised questions about the nature of the Fed's 12 regional reserve banks, their relationship with the Board of Governors and the board's involvement in the master account process writ large.

The Fed board has long maintained that reserve banks are separate entities that it oversees, rather than an extension of it, a classification that exempts the reserve banks from disclosure requirements under the Administrative Procedure Act and freedom-of- information laws. This distinction has frustrated both banks and scholars who have sought to understand where the board's jurisdiction stops and the reserve banks' jurisdiction begins. 

Judge Scott Skavdahl, the judge overseeing the lawsuit in the U.S. District Court of Wyoming, acknowledged the murkiness of this arrangement after hearing the Fed's argument to have the lawsuit dismissed in October. "Where does the buck stop?" Skavdahl said at the time.

In a filing in October, Fed warned that examining the issues through a wide scope — one that could be used in an exhaustive discovery process — could have "potential ramifications for the careful balance Congress has created with the Federal Reserve System — including potential consequences far beyond this case." 

The board is a Washington-based entity composed of presidentially appointed and congressionally approved governors. It oversees the Federal Reserve System as a whole. The 12 reserve banks are independently chartered and led by presidents selected by member banks. They enact the Fed's monetary and supervisory policies in their respective districts. The Kansas City Fed oversees the 10th District, which includes Wyoming.

In its filing last week, the Fed argued that, because the lawsuit is about its adherence to the APA, it only needs to provide an administrative report, which documents its decision making process. It said it was in the process of compiling such an account and would submit it to the court by Feb. 9, 2023.

Key issues intact in Custodia-Fed lawsuit over master accounts

Custodia pushed back against the Fed's interpretation of case law. It argues that agencies can be forced to go through discovery to address questions about "bad faith or improper behavior," which Custodia has alleged in its suit. The bank also pointed to the court's statement that some level of discovery would be necessary to determine what role the board has played in the Kansas City Fed's decision-making process on the Custodia application.

Reserve banks are supposed to have the final say on which banks in their districts are granted master accounts, but in its lawsuit, Custodia has accused the Board of interjecting in the Kansas City Fed's review of its application and halting it. Skavdahl deemed this conclusion to be plausible and said more information was necessary to say definitively. 

The Fed board has said it has not weighed in on Custodia's application directly, it has only provided guidelines for how all reserve banks should assess master account applications. But Custodia argues this position is contradicted by the board's assertion of APA rights.

"There is no 'administrative record' to compile because the Board disclaims responsibility for making the decision," the filing states. "Thus, the Board is obligated to answer the complaint, provide initial disclosures, and engage in discovery. The Board cannot have its cake and eat it too."

The Fed board declined to comment on Custodia's accusations or delve into the specifics of its latest request on Monday.

Questions about which entities are entitled to master accounts and on what grounds have come to the fore in recent years, coinciding with the rise in nontraditional banks and novel state charters. Wyoming has one such charter for so-called special-purpose depository institutions, which are allowed to do some business with digital assets but are prohibited from providing loans. Custodia holds one of these charters.

In its latest filing, Custodia also accused the Fed of applying a double standard to existing master account holders and novel applicants. The firm cited the ability of the Bank of New York Mellon to begin providing crypto custodying services and the recent revelation that Moonstone Bank — a Farmington, Washington, bank formerly known as Farmington State Bank — had sold around 10% of its equity to the now-failed crypto exchange FTX as evidence that the Fed's aversion to crypto exposure is one-sided.

"The Federal Reserve is applying a staggering double-standard that favors incumbent banks over startup banks, and in doing so, it has created financial system risk by allowing crypto companies through the back door to take control positions of incumbent Fed member banks and enter the crypto business," said Nathan Miller, a spokesperson for Custodia Bank. "As a nonleveraged bank that plans to hold 108% of customer deposits in cash at the Federal Reserve itself in its first three years, Custodia would be the far safer alternative — yet it is the one bank whose Fed applications continue to languish as others with risky business models are waved through."