Key issues intact in Custodia-Fed lawsuit over master accounts

Some of the most consequential questions raised by Custodia Bank's master account lawsuit against the Federal Reserve are poised to have their day in court.

Key issues in the Custodia case concerning the nature of regional reserve banks, the structure of the Federal Reserve System and the process for obtaining access to the Fed's payment systems are all fit for trial, U.S. District Court of Wyoming Judge Scott Skavdahl ruled Friday.

Skavdahl's order came in response to an August motion by the Fed Board of Governors and the Federal Reserve Bank of Kansas City to dismiss the various complaints raised by Custodia. 

federal-reserve
A federal judge left several assertions by Wyoming-chartered bank Custodia intact as he allowed the company's lawsuit against the Federal Reserve to proceed Friday, including whether the Fed regional banks are Federal agencies and whether the Fed Board of Governors is involved in granting master account access.
Bloomberg News

The digital-asset bank filed suit in June hoping to compel the Fed make a decision on its application for an account with the Kansas City Fed. Its application has been pending since October 2020, a delay Custodia claims has led to significant losses by forcing it to partner with an intermediary bank for its services.

Chartered as a Wyoming special-purpose depository institution, Custodia is authorized to hold deposits of U.S. dollars and custody digital assets, including crypto currencies. It is not permitted to make loans. The firm aims to act as a payment provider, bridging the gap between digital and traditional finance. It also aspires to mint its own stablecoin eventually, although it has not yet developed that capability.

"It is unfortunate that the company must seek our rights in court, when a fair administrative process would have led the Federal Reserve to grant Custodia a master account long ago," Custodia spokesman Nathan Miller said in a written statement. "Custodia's conservative business model complies with the same requirements applicable to all Fed member banks. We look forward to shining a light on the Federal Reserve's black-box process for doling out master accounts." 

The Fed has argued that Custodia's business model — which is the first of its kind, by the company's own assertions — presents a novel risk to the financial system, one that requires additional time to evaluate. 

In August, the Fed finalized a three-tier process for evaluating master account applications, with top-tier institutions, those that are well established and federally regulated, facing the least scrutiny and new charters, such as Custodia, facing the most. That same month, the Fed asked the court to dismiss the Custodia suit, arguing the depository's claims had no standing.

The Fed also argued that the Board of Governors should not be party to the suit, noting that the reserve banks have full discretion over which banks are granted accounts. Skavdahl rejected this argument, noting there were several reasons that made it reasonable to infer that the board intervened in the matter, including initial indications from the Kansas City Fed that Custodia met all the criteria to be eligible for a master account.

Skavdahl heard arguments from both sides during a hearing on Oct. 28, after which he said the matter was likely to live on "in some form," albeit with some changes. 

In his Friday ruling, the judge threw out several components of the lawsuit, including ones claiming the Fed violated the separation of powers doctrine, due process and the Appointments Clause of the Constitution. 

Unless the matter is settled outside of court, the Fed will have to defend its assertions that the reserve banks are not agencies and therefore not subject to the Administrative Procedure Act, but still have complete discretion over granting access to the Fed's payment system. The Fed would  also have to prove its claim that the Board of Governors played no role in slowing Custodia's application. 

The Fed declined to comment on the ruling or its next steps in the litigation process.

Brainard Powell
Custodia ruling leaves Fed with no good options

Meanwhile, Custodia will have a chance to make its case that not only should the Fed have issued a decision by now, but that the company is entitled to an account. Friday's order left open the possibility that the court could force the Fed to grant Custodia an account, if it does not elect to do so on its own.

Skavdahl's ruling does not determine whether either side is correct in their assertions, only that there is a plausible cause of action for the surviving arguments made by Custodia.

Custodia's primary assertion was that the Fed should have issued a decision on its application within one year, in accordance with APA requirements. Skavdahl noted that the one-year deadline likely did not apply, but a set timeframe is not necessary for establishing an excessive delay. The Fed's master account application form notes that most decisions are rendered in five to seven days.

Lawsuits against the Fed are rare and few actually go to trial. There have been two other challenges to the Fed's master account practices — one involving The Narrow Bank in Norwalk, Connecticut, which sought to hold all of its customers' deposits in risk-free assets at the Fed, and the other related to Fourth Corner Credit Union, a cannabis bank based in Denver — but both were dismissed. 

Skavdahl noted that the question of whether reserve banks constituted federal agencies was unsettled, with a handful of prior cases reaching different conclusions. Should the court rule that they are, in fact, arms of the government and not private entities composed of member banks — as the Fed has long maintained — the consequences could be wide-reaching.

In its motion to dismiss, the Fed acknowledged the potential ramifications of wading into questions about the structure of the Federal Reserve System. It cautioned the court against "ruling on complex issues with potential ramifications for the careful balance Congress has created with the Federal Reserve System — including potential consequences far beyond this case." 

With those most sweeping challenges still intact, a potential trial between Custodia and the Fed could set important precedents beyond the master account issue. 

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