Custodia Bank is not your typical bank. It isn't a bank at all, in the sense that most people understand it. In fact, it's exactly the type of financial institution that financial regulators imply they need.

I'll explain. When the New York Department of Financial Services gets upset with a bank, one of the things it looks for is someone to put under the spotlight in future investigations. Specifically, it wants compliance functions housed in New York and it wants a named person in charge.

Custodia Bank, at its simplest, takes on those compliance risks for crypto-businesses that can't or don't want to do it themselves. It's actually quite a lot more complicated than that but let's take that simplified approach so this Opinion doesn't become over-complicated.

In the world of FinTech and Crypto, regulation is still an utter shambles, in part because a business can be subject to regulation in its home state of, say, California but it needs a separate licence to do business with people in New York. That means that, to do business nationally, each of them needs 50 odd licences outside its home state. But there is a system by which banks, as distinct from FinTech and Cryto businesses, can get a single multi-state approval.

This is what Custodia says about its services:

A regulatorily compliant platform for businesses to transact across digital assets and the traditional financial system.

As a chartered bank, Custodia operates under the first special purpose depository institution legal and regulatory framework in the United States. This allows us to offer a full suite of financial services for both U.S. dollars and digital assets that is tailored to business customers looking for enhanced regulatory clarity and minimised transactional risk.

The Bank says that its customer-base includes digital asset businesses, fintechs, banks, corporate treasurers, trusts, pension funds and many more.

So, basically, it's a bank that takes in pretty much anything as its customers' assets and holds onto them until the customer wants them back or wants them transferred to someone else.

That, for those who have trouble understanding financial services, is what banking is and banking is only that. All the other service banks provide are ancillary to that core function.

Custodia provides deposit services. You know those: they are the accounts your money goes in when you take it to a bank or post office, for example. It provides a custodian service. You know those, too: it's just the same as your stockbroker who holds the record of your shareholding because companies rarely issue physical share certificates. It also provides what it calls "Prime Services" and you understand those too: it's essentially a bureau de change where digital assets of various types can be converted into other digital assets or (the techies are going to hate this expression) sold for fiat currency.

So far so simple. So where has it all gone wrong?

First, it's gone wrong because the USA is far from united. Custodia's Wyoming Authorisation is recognised by only 35 states and, mostly, they aren't the big commercial states. Custodia wants to operate nationally. So it applied to the Federal Reserve Board to join the Federal Reserve System. The Fed said no. So Custodia applied to the Federal Reserve Bank of Kentucky for a "master account" which would have allowed Custodia to perform a wide range of transactions including wholesale payment systems without needing to "pass through" a federally recognised (which is not the same as federally regulated) bank. Kentucky rejected the application at the end of January.

Custodia is convinced that Kentucky was nobbled by the national Fed.

Part of the problem may be that Wyoming registration. It's not a full banking licence as such things are generally known: it's a "special-purpose depository institution."

This is what the Wyoming Division of Banking says;

Wyoming-chartered Special Purpose Depository Institutions are banks that receive deposits and conduct other activity incidental to the business of banking, including custody, asset servicing, fiduciary asset management, and related activities.

Special Purpose Depository Institutions will likely focus on digital assets, such as virtual currencies, digital securities and digital consumer assets. For example, Special Purpose Depository Institutions may elect to provide custodial services for digital assets and, in accordance with customer instructions, undertake authorised transactions on behalf of customers. Special Purpose Depository Institutions may also conduct activity under Wyoming regulations tailored to digital assets, which address issues such as technology controls, transaction handling, and custody operations for digital assets. As a final example, Special Purpose Depository Institutions operate under Wyoming law that defines digital assets in conjunction with the Wyoming Uniform Commercial Code and describes, among things, perfection and priority of security interests in digital assets.

Special Purpose Depository Institutions may focus on traditional assets as well. They also may serve as a vehicle for business cash management, operational accounts, and any other purpose permitted under applicable law.

It goes on to say that, unless specifically authorised, the special purpose depository institution is not permitted to make loans of its customers' deposits.

So The Department of Banking Regulation may be in cowboy country but it's not a cowboy outfit when it comes to designing its regulations. Custodia is a proper bank with custody services but it's not "a lender." Those who went to FTX might wish that it had been regulated in Wyoming. And the regulator goes even further: "they must at all times maintain unencumbered level 1 high-quality liquid assets valued at 100% or more of their depository liabilities. Given this, Special Purpose Depository Institutions are not required to obtain insurance from the Federal Deposit Insurance Corporation—though they may do so." Lots of shareholders in Wall Street banks in the early 2000s would have liked that provision in the charter of those banks.

Custodia has amended its complaint against the Federal Reserve to allege interference in the independent decision-making to which the Kentucky Fed should be entitled.

The timing is coincidental if not downright suspicious.

The Kentucky Fed rejected Custodia's application on 27th January. That was the same day that the White House issued a briefing paper called "The Administration's Roadmap to Mitigate Cryptocurrencies' Risks." You can read it here: https://www.whitehouse.gov/nec/briefing-room/2023/01/27/the-administrat…

But here's the thing: reading that report makes one thing clear - the government expects to see responsible and carefully structured controls in relation to crypto-currencies and it singles out "stablecoins" as a particular risk and there is no valid argument against that position.

But it's all irrelevant to the services provided by Custodia.

The Fed appears to not understand banking.

Custodia is a bank. It takes in deposits and it appropriates them to the specific customer. If the asset plunges in value, it doesn't affect Custodia or any of its other customers because it's a deposit not a security. If a customer wants to withdraw, convert or transfer an asset, then that happens at current value, just as it does in a multi-currency bank account with yen, pounds and dollars in it. It's no different.

Collective Punishment

The Geneva Convention on the protection of civilians in times of war (1949) defines collective punishment as applying punishment to the many for the actions of the few (or words to that effect). We can't say that the actions of governments against crypto are "in times of war" but except for that, the US government does seem to be running scared of Crypto and acting against the entire industry because of the failings of some.

In the paper of 27 January, the White House says "Agencies have redoubled their efforts to fight fraud, including the proliferation of false or misleading claims about crypto assets being insured by the FDIC."

There's a point there but one has to ask whether such a representation is due to fraud or innocent mistake. FDIC, where it provides insurance, insures deposits up to USD250,000. It's not a huge leap to think that some bankers think that value is value is value, regardless of how it is held. Does FDIC insure deposits of gold? The answer is "no" and FDIC says "The FDIC does not cover Stock investments, Bond investments, Mutual funds, Crypto Assets. Life insurance policies. Annuities. Municipal securities, Safe deposit boxes or their contents. U.S. Treasury bills, bonds or notes."

But it does say that its insurance "enables consumers to confidently place their money" in FDIC insured banks with confidence (up to USD250,000). As governments cannot decide if crypto-currencies are "money" what hope do those in small banking institutions have? Well, it doesn't matter because there is a clear exclusion.

The White House is also in fantasy land, by the way. In that report of 27 January, it says "while the United States is already a global leader in fighting money laundering and terrorist financing, enforcement agencies are devoting increased resources to combatting illicit activities involving digital assets." Yeah, right, at least in relation to the first part.

And then the report comes to the crunch. Custodia is outside its primary sphere of concern: "Congress should expand regulators’ powers to prevent misuses of customers’ assets—which hurt investors and distort prices—and to mitigate conflicts of interest. " Well, OK. But that can't happen with Custodia unless it goes outside its legal and regulatory framework.

So, taking all of this it turns out that it really is as simple as indicated at the beginning. Custodia is a bank which also provides authorised ancillary services, being custodianship and limited exchange services.

So, Fed, where's the problem?