The Fed won the master account war. But can it win the peace?

Bloomberg News

Last Friday, a federal judge issued a much-anticipated ruling in a lawsuit challenging whether the Federal Reserve was wrong in denying Custodia — a Wyoming-chartered neobank with ambitions to be the bank of choice for the cryptocurrency market — a Federal Reserve master account. Custodia, for its part, believes that as a state-chartered bank it is entitled to a master account; the Fed, by contrast, says the central bank alone gets to make the call on who gets an account and who doesn't. 

It's worth taking a moment to understand what a master account is and why someone would want one. A master account — to quote the judge's ruling — is "a bank account for banks." That account allows banks to deposit funds with the Fed — earning interest at the federal funds rate, which is a little bit higher than the overnight reverse repurchase, or ON RRP, rate that nonbanks can access. It also allows banks access to currency and coin from regional Fed banks, settlement and wire services and access to the Fed's discount window. A master account, then, is not absolutely essential for a bank to do business in the United States, but it makes things infinitely simpler and less expensive.

Spoiler alert: The judge sided with the Fed. The journey of how exactly the judge sided with the Fed involves spelunking deep into the recesses of the Federal Reserve Act and its myriad amendments, but the gist of it is this: The Fed holds the cards. If it wants to take your deposits and offer you services, it has to offer them the same for everybody in the club. But the Fed is the bouncer in front of the velvet rope, and it can let you in or not.

At least that's how it stands for now. The ruling relies on a reasonable interpretation of the relevant statutes, which suggest — but don't explicitly state — that master account access is granted at the discretion of Federal Reserve banks. That is based in part on language in the FRA that says the Fed "may" take deposits from eligible banks (as opposed to "shall") and a 2023 amendment offered by then-Sen. Patrick Toomey requiring the Fed to publish a database of banks that have master accounts (or access to one), those who have applied for an account, those who have been denied an account and those whose applications have been withdrawn. In other words, the statute is more supportive of a discretionary rather than compulsory framework, but it's fuzzy either way.

If — but, let's be real, when — the ruling is appealed, it will join a handful of other lawsuits asking a lot of the same questions. The Narrow Bank — the OG master account litigant, having taken the Fed to court in 2019 — recently had its application for a master account denied on grounds including concerns about financial stability, impact on the Fed's conduct of monetary policy and runnability. The Puerto Rico-based Banco de San Juan is also suing the Fed over its decision to terminate the bank's master account on anti-money-laundering grounds. That sounds like an opportunity for different venues to reach different conclusions about how much discretion the Fed has, which in turn sounds like a matter that the Supreme Court will eventually weigh in on in the years to come.

In order to preserve its discretion, then, it would be incumbent on the Fed to articulate exactly what criteria it is using to decide whether an applicant can be granted access. The Fed has to replace the velvet rope with a fence. 

Politics and policy

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There are good reasons why the Fed has been reluctant to do that. For one, if you build a fence, applicants can build a ladder — by articulating what an applicant has to do, applicants can find some way to satisfy those minimum requirements while preserving their goals of banking crypto or undermining banks' favorable interest rates or whatever other disruption they seek in the banking world. Keeping those requirements vague or case-by-case keeps the cards in the Fed's hands.

It also makes those case-by-case decisions somewhat arbitrary, and that's something that both the judicial and legislative branches don't look upon kindly. To be sure, the Fed has articulated a kind of proto-fence in its master account application guidance, but that just says that traditional plain vanilla banks are likely to get an account and more exotic business models will be scrutinized more heavily. What is needed is a clear explanation of what bad things the Fed is trying to prevent by denying an applicant a master account. 

So if the Fed's objection to Custodia is that crypto is volatile and dangerous, then it should say so — and apply that logic to other account holders as well. If it thinks banks should be paid an advantageous interest rate on its reserves relative to nonbanks for monetary policy reasons, it should say so. If it thinks that inadequate AML risk controls are grounds for terminating a bank's master account, then it should say so — and terminate the master accounts of all banks lacking such controls.

Drawing those lines will be difficult and would likely require an articulation of policy that goes beyond the Fed's specific remit — if we're barring crypto from banking, it may mean rethinking bitcoin ETFs, for example. But the velvet rope approach is not one that is built to last, and if the Fed doesn't draw bright lines around master account access, then Congress or the courts will.