The Federal Reserve Board has denied the membership application of Custodia Bank, Inc., a state-chartered special-purpose depository institution focused on the crypto-asset sector.
The board cited concerns about Custodia’s managerial, financial, and corporate powers factors as reasons for the denial. The bank had applied for membership in the Federal Reserve System under section 9 of the Federal Reserve Act, seeking to become “a compliant bridge” between the U.S. dollar payment system and the crypto-asset ecosystem.
Managerial factor: Lack of risk management system and controls
The Federal Reserve Board’s review of Custodia’s membership application revealed significant deficiencies in its risk management system and controls for core banking activities.
These deficiencies include insufficient compliance with the Bank Secrecy Act (BSA) and U.S. sanctions, inadequate information technology, internal audit, financial projections, and liquidity risk management practices.
Custodia has proposed to expand its operations to focus almost exclusively on novel crypto-asset-related activities soon after approval for membership.
However, the bank has not yet developed a sufficient risk-management framework for its proposed crypto-asset-related activities.
Additionally, some products estimated to be significant sources of revenue are still in the “conceptualization phase,” and policies, procedures, and processes related to planned crypto-asset-related activities remain in the early stages of development, especially in the area of compliance.
As such, Custodia has been unable to demonstrate that it could conduct an undiversified business focused on crypto-asset-related activities in a safe and sound manner and in compliance with BSA and Office of Foreign Assets Control (OFAC) requirements.
Financial factor: Lack of diversification and dependence on crypto-asset markets
Custodia’s proposed business model relies almost solely upon the existence of an active and vibrant market for crypto-assets, making it vulnerable to significant volatility.
Recent events, including the bankruptcies of crypto-asset intermediaries Celsius, Voyager, BlockFi, and FTX, have highlighted that the global and largely unregulated or noncompliant crypto-asset sector lacks stability, and that dislocations in the sector can result in stress at financial institutions focused on serving the crypto-asset sector.
Additionally, while Custodia appears to have sufficient capital and resources to sustain initial operations, its pro forma financial statements assume that it would be permitted to engage in several novel crypto-asset-related activities.
However, the Board would prohibit Custodia from engaging in a number of those activities because Custodia has not demonstrated that it can conduct the activities in a safe and sound manner and, in some cases, also because the activities would be impermissible for a national bank.
Without the ability to conduct these crypto-asset-related activities, the financial condition, including the future earnings prospects of the institution, is uncertain.
Custodia’s proposed business model would focus almost exclusively on the crypto-asset sector and aim to create further connections between traditional financial intermediaries and the crypto-asset ecosystem by engaging in crypto-asset-related activities that are novel and unprecedented for state member banks.
Given the speculative and volatile nature of the crypto-asset ecosystem, the Board does not believe that this business model is consistent with the purposes of the Federal Reserve Act.
Also, if the Board were to approve Custodia’s membership application, it would prohibit Custodia from engaging in a number of the novel and unprecedented activities it proposes to conduct—at least until such time as the activities conducted as principal are permissible for national banks and Custodia can demonstrate that it can conduct the activities in a safe, sound, and compliant manner.
