Custodia Amps Up Suit Against Fed; Crypto firms say the central bank is breaking the law

Custodia Bank is accusing the Federal Reserve Board of “patently illegal” actions that would prevent the company from providing financial services to the digital-asset industry, part of a broader government crackdown on the cryptocurrency sector that has intensified in recent days.

The bank claims the Fed hijacked a decision by the Federal Reserve Bank of Kansas City that would have given the Wyoming-chartered institution access to custody services necessary for it to compete with entrenched rivals, specifically identifying BNY Mellon.

“Custodia will not be able to operate as designed and may have to cease all banking operations,” as a result of the Fed’s actions, according to an amended complaint filed in the federal district court for Wyoming.

The bank has been suing the Fed since June 7, 2022. It upped the ante Friday with an amended complaint accusing the central bank of “pulling the strings” of the supposedly independent Kansas City institution. The regional Federal Reserve branch denied Custodia’s application for a master account that would have allowed the bank to avoid going through a third-party bank to access wholesale payment systems and related Fed services.

“This case involves the defendant’s manifestly unlawful denial of an application critical to Custodia’s business — a principal account — to which it is unequivocally entitled as a qualified depository institution,” according to the amended suit.

The Kansas City Fed’s decision was revealed on January 27, following the board’s rejection of Custodia’s separate application to join the Federal Reserve System. Membership would have given it recognition as a bank throughout the United States, rather than just the 35 states that recognize the Wyoming Special Purpose Depository Institution (SPDI) charter under which Custodia operates. Wyoming created SPDIs as part of its campaign to attract digital asset companies to the state.

The Kansas City Fed cannot legally deny the application, according to Custodia’s complaint. Indeed, the branch had indicated that it was informed in January 2021 that there were “no showstoppers” Custodia claims that the Federal Reserve Board “asserted control over the decision-making process” in the spring of that year. The Kansas City Fed’s rejection of Custodia’s main account application argued that new banks that have to build their customer base from scratch are not allowed to engage in crypto assets.

This echoed the earlier rejection by the Fed Board which claimed that “crypto activities are highly likely to be inconsistent with safe and sound banking practices” and “Custodia’s risk management framework was inadequate to address concerns regarding the increased risks associated with its proposed crypto activities, including its ability to to reduce the risk of money laundering and terrorist financing.”

“The timing and circumstances of the denial reinforce that the denial was part of a larger effort coordinated by the board (in conjunction with the White House),” according to the lawsuit, that new banks “should not be allowed to engage in crypto assets,”

The rejections roughly coincided with a senior department statement on the risks of cryptoassets on Jan. 27, the complaint noted. Further regulatory measures indicate that the government is cracking down on digital finance.

This month, the Securities and Exchange Commission sued crypto exchange Kraken – which ended a US interest offering known as staking – and Terraform Labs, the provider of the failed terraUSD stablecoin, claiming both had offered unregistered securities and also charged the latter with fraud. The SEC has also told Paxos, which provided a version of the Binance USD stablecoin, that it was under investigation, also for selling what it considered unregistered securities, although it has not yet determined that any crypto products qualify as securities.

Caitlin Long, CEO of Custodia, wrote in a blog post that the government, exasperated by presiding over a wave of crypto disasters, most of which appear to be the result of malpractice, is taking a heavy-handed and politically biased approach to the industry.

“Custodia tried to be federally regulated,” she wrote. But the bank “has been denied and now disparaged for daring to come through the front door.” She added: “Washington’s misguided crackdown will only push risks into the shadows, leaving regulators to play dumb as risks continually pop up in unexpected places.

“If the White House and federal agencies crack down on crypto, at least Custodia has an ally on Capitol Hill. Hometown Sen. Cynthia Lummis (R-Wyo.) strongly disagrees with the Fed’s decision to deny Custodia Bank’s master account application.

“The Fed has not provided the applicant with due process of law,” Lummis said. know whether the Fed is actually free of political influence.”