Fed published its detailed case against Custodia’s crypto bank model

The Federal Reserve Board published its 86-page order on March 24, 2023 explaining why it had denied Custodia Bank’s application for membership in the Federal Reserve System. The disclosure turned a decision announced on January 27 into a detailed statement of how the central bank viewed an uninsured, crypto-focused bank that proposed to connect dollar payments, digital-asset custody and blockchain-based instruments.

The chronology is important. The Board did not make a new denial on March 24. Its order was effective January 27 and was released on March 24 after a review for confidential information. What became newly public was the reasoning—and a warning that Custodia’s combination of crypto concentration, uninsured deposits and proposed activities did not satisfy the Board’s membership standards.

Three independent grounds for denial

The Board said Custodia’s application was inconsistent with the managerial, financial and corporate-powers factors it was required to consider under the Federal Reserve Act. It concluded that each factor independently supplied sufficient grounds for denial. All seven listed Board members voted for the January 27 order.

On management, the order identified deficiencies in risk management and controls relative to Custodia’s proposed activities, including concerns involving anti-money-laundering, sanctions, cybersecurity and operational risk. These were the regulator’s examination findings and legal conclusions; the public order did not provide an outside audit against which every supervisory judgment could be independently tested.

On financial condition, the Board focused on an undiversified business model tied to the crypto sector and on earnings that depended heavily on activities the Board might prohibit. It said Custodia’s limited initial banking operations would not make the business viable over the medium or long term.

The corporate-powers analysis reached beyond conventional deposit and payment services. Custodia proposed holding bitcoin and ether as principal, facilitating crypto borrowing and lending, and offering services connected to trading. The Board said it was unaware of another state member bank performing that combination of activities.

Avits put tokenized dollars inside the banking question

A central part of the order concerned “Avits,” Custodia’s proposed dollar-denominated electronic transferable records. Custodia planned to issue them on Ethereum and the Liquid sidechain and to back each Avit with one dollar held in a Federal Reserve master account, if one were granted.

The Board distinguished Avits from ordinary bank instruments because noncustomers could acquire and transfer them through public blockchain networks, hold them in unhosted wallets, trade them, or use them in decentralized-finance protocols. It said Custodia had not demonstrated a risk-control framework capable of operating the product safely, particularly when intermediate holders and network validators could be unknown to the bank.

That conclusion was specific to the proposed structure and application record. The order did not outlaw every tokenized deposit or establish a general federal statute for stablecoins.

Why the order mattered after a banking shock

Custodia was a Wyoming-chartered special purpose depository institution. Wyoming law barred such institutions from making loans and required unencumbered assets worth at least 100% of depository liabilities. Custodia was not seeking Federal Deposit Insurance Corporation coverage.

The Board nevertheless reasoned that admitting a deposit-taking institution without federal deposit insurance would be unprecedented since federal deposit insurance was created in 1933. It said the absence of insurance could increase run and contagion risks, especially for a business concentrated in crypto. The order acknowledged that federal law allowed an uninsured depository institution to become a state member bank, but found Custodia’s controls and business model insufficient to overcome the concerns.

That distinction mattered in March 2023, when Silvergate’s wind-down and the failures of Silicon Valley Bank and Signature Bank had intensified scrutiny of bank funding and digital-asset exposure. The order supplied a concrete regulatory record: full reserves under state law did not, by themselves, answer federal concerns about governance, earnings, illicit-finance controls, resolution and contagion.

The order also stated that the membership application was separate from Custodia’s request for a Federal Reserve master account. It denied membership without prejudice to a future application; it did not finally resolve every legal dispute over payment-system access or declare all crypto banking impermissible.