Custodia Bank Case Highlights Federal Reserve Hypocrisy Against Crypto

The rise of cryptocurrencies has caused a stir in the financial world, and the Federal Reserve is struggling to come up with a coherent response. The latest example of Fed incoherence involves Wyoming-based Custodia Bank, whose application to join the Federal Reserve System was denied earlier this year by the Kansas City Fed. The rejection highlights how the central bank may not be acting in good faith when it comes to its dealings with cryptocurrency issuers and their affiliated financial institutions.

To begin, consider the case of stablecoins. Stablecoins are cryptocurrencies that are designed to maintain their value by tying their price to a real value, such as the US dollar, gold or another cryptocurrency. In recent years, the Fed has expressed concern about the risks associated with stablecoins, since issuers are sometimes collateralized or otherwise invested in assets other than those pledged for convertibility purposes. This practice exposes them to the possibility of bank runs, since all their customers could theoretically rush to convert their stablecoins at the same time.

In contrast, Custodia Bank is an example of a bank that accepts deposits and is willing to back up these demand deposits more than one-to-one with reserves. This means that if there was ever a run on the bank, Custodia would be able to satisfy all of its customers’ requests. You’d think this would please the Fed, but when the bank applied to join the Federal Reserve System, the application was rejected.

The official reason given by the Fed is that it has concerns over the company’s short history and what the Fed considers to be a problematic business model – one based primarily on fees, for example, for storing crypto-tokens, rather than on investments, by lending customer deposits.

The Fed published an 86-page order explaining its decision in March, arguing that Custodia Bank’s business model is simply too risky because, among other things, it lacks FDIC deposit insurance, which is used to make depositors whole in the event of a bank failure. Custodia also accepts cryptoassets as deposits, including bitcoin and ether, which the Fed apparently rejects due to what it calls the “speculative and volatile nature of the cryptoasset ecosystem.”

However, the Fed’s concerns about safety and soundness are hollow, because one of Custodia’s main missions is to back up more than 100 percent of its demanded deposits with reserves. Traditional banks typically lend out most of their deposits – something called fractional reserve banking – which opens them up to the risk of bank runs. Like Jimmy Stewart in “It’s a Wonderful Life”, if every customer asks for their money back at once, the bank will not have everything available because most of it is invested in the community.

Monetary economist George Selgin has called the Fed’s order denying Custodia’s membership application “a nasty document,” due to the Fed’s two-pronged nature. On the one hand, the Fed chastises stablecoins for being too risky, because in some cases they are not backed 100% by the underlying asset. On the other hand, the Fed chastises Custodia for not having a viable business model, because in this case the bank holds too many funds in reserves, which allegedly put profitability at risk.

The hypocrisy does not end there. Custodia got its name because it seeks to be a reliable manager of its clients’ wealth. To the extent that client assets are held in US dollars, one of the safest places a bank can store dollars is in an account with the US Federal Reserve. Even as the Fed argues that Custodia’s business model is too risky, the central bank blocks Custodia from mitigating risk by holding reserves in a form backed by the full faith and credit of the US government.

The rejection of Custodia Bank’s membership application also highlights the risk that even banks with 100% reserves face. The Fed is satisfied with its ability to maintain control over the existing players in the banking system. Allowing smaller, more innovative competitors into its inner circle disrupts current arrangements, complicates matters for central banks and forces a reassessment of regulatory priorities.

Custodia is now taking the case to court, but it remains to be seen what kind of solution will be reached. The hostility that crypto issuers and crypto banks face from the Fed creates significant uncertainty for this new industry. Even when these industry players do exactly what the Fed says it wants, the central bank still actively works to suppress them.

Only by working together will the crypto industry and regulators develop a coherent framework that ensures that the benefits of cryptocurrencies can be realized while the risks are controlled. But this will not happen until the Federal Reserve recognizes that cryptocurrencies and cryptobanks are legitimate parts of the financial system. They deserve to be treated as such.

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