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By Anushree Dave

Custodia's failure will be a disappointment to the crypto industry, expert says

The Federal Reserve Board on Friday rejected a Wyoming-based crypto-centric bank's application to become a member of the central bank's exclusive payment system.

In a press release, the Fed said the firm's proposed business plan, and focus on crypto assets, presented significant safety and soundness risks.

The bank, called Custodia, does not have federal deposit insurance. The company describes itself as a "special purpose depository institution."

It told the Fed it planned to engage in activities that include issuing crypto assets on decentralized networks, according to a press release from the central bank.

Custodia, which was previously known as Avanti, uses a special state license from Wyoming for banks that deal with cryptocurrencies. In 2022, Avanti sued the Kansas City Federal Reserve Bank for delaying a decision to grant it special access to the Fed, known as a master account.

"Custodia is surprised and disappointed by the Board's action today," said Caitlin Long, chief executive officer of Custodia, in a statement. "The Board's denial is unfortunate but consistent with the concerns that Custodia has raised about the Federal Reserve's handling of its applications, an issue we will continue to litigate."

Recently, the Fed highlighted that crypto activities are inconsistent with safe and sound banking practices, as shown by the significant volatility in the crypto industry in the past year.

"We do not see the decision as a surprise. To us, the Fed wants to prevent states from chartering entities to support crypto that can access the payment system and Fed liquidity programs," said Jaret Seiberg, managing director at Washington-based research group Cowen, in an email to MarketWatch.

"We believe this explains why it blocked Custodia from becoming a state-member bank and why it issued the broader policy statement. We do not expect the Fed to give Custodia a Master Account," he added.

On Friday, the Federal Reserve Bank of Kansas City denied Custodia's request for a master account, according to a U.S. district court filing.

A master account allows firms to access payment systems and Fed-related payment services. Several crypto firms with state charters have applied for masters accounts to allow more seamless transitions between crypto and official currency, according to Congressional Research Service, a public policy research group that operates within the Library of Congress.

"Once you get a master account then you have access to Fed facilities and two things happen," said Dennis Kelleher, President and CEO of Better Markets, a group that's against financial deregulation, in an interview with MarketWatch. "One is that it's a legitimizing activity, and many more people will do business with you when you get the external validation from the Fed for your financial activities. and that enables them to market those activities to many more people and increase their revenue."

The other thing, said Kelleher, is once you get interconnected with the Fed, the banking agencies end up in a position where once a firm's activities reach critical mass, then the central bank has an interest in not failing because of the collateral consequences of that failure.

Other figures see the move by the Fed as a bad one for crypto regulation and risk management.

"[A]ctions by the Fed are not about one particular applicant, but instead about whether digital assets should be regulated. As long as digital assets are left outside the regulatory perimeter, the risks to our financial system will grow, not abate," said Senator Cynthia Lummis, who became the first crypto holder in the Senate's history, in an email to MarketWatch. Sen. Lummis added that Chair Jerome Powell "has failed in his responsibility to ensure digital assets are properly regulated and the risks managed."

In a separatebut related move on Friday, the Fed also issued a policy statement with the goal of encouraging an equal playing field for all banks with a federal supervisor, regardless of deposit insurance status.

Typically, the Federal Deposit Insurance Corporation provides insurance that protects bank accounts if a bank fails. The Fed statement on Fridayindicated that uninsured and insured banks supervised by the Board will be subject to the same limitations on activities.

"The decision isn't surprising, but it's bluntly worded," said Ian Katz, managing director at Capital Alpha Partners, an independent provider of strategic policy research, in an email to MarketWatch. "The Fed did note that banks could still in some cases provide crypto custodial services if they're conducted in a safe and sound manner, but it's clearly trying to make sure banks' direct exposure to crypto is limited. It sends a message that the Fed doesn't want banks to run the risk of becoming infected by holding potentially risky crypto assets."

Banks will need to demonstrate in their applications that activities they engage in are allowed under the law, and have risk management processes, internal controls, and other measures in place that are "appropriate and adequate for the nature, scope, and risks of its activities," according to the statement.

"The crypto industry and its political allies have been trying to get access to and interconnected with the core of the banking system because that would be incredibly lucrative for their profits," said Kelleher, who believes the move is beneficial for taxpayers. Custodia's failure will be a disappointment to the crypto industry, he added.

"The problem is, once you get interconnected with the banking system, the risks that are in your business, including as the Fed properly identified here -- novel and untested activities -- they get integrated and interconnected with the banking system. We saw this with subprime mortgages before the 2008 crash."

-Anushree Dave

(END) Dow Jones Newswires

January 30, 2023 17:52 ET (22:52 GMT)

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