Congress Should Give Fintechs Access To Fed’s Settlement Services

Last week, the Federal Reserve released new guidelines for providing access to its master accounts and payment services, and then asked a federal judge to dismiss a lawsuit filed by Custodia Bank Inc. Both events demonstrate why Congress should require the Fed to provide nonbank financial firms with access to its master accounts and payment services.

These events are highly reminiscent of a controversy that occurred in the 1970s, one that was only settled when Congress passed the Depository Institutions Deregulation and Monetary Control Act of 1980. Then, as today, firms that were not traditionally viewed as part of the payment system–the thrift companies that were primarily mortgage lenders–wanted access to the Fed’s payment services.

Without such access, those firms would have had no choice but to rely on a third party, either a commercial bank with access to the Fed’s master accounts, or special automated clearing firms that were developed by commercial banks and the Fed itself. The commercial banks, unsurprisingly, saw the thrift industry as a threat, and viewed “the industry’s attempts to gain direct access to ACH services as an attempt to circumvent the legal restrictions that prohibited thrifts from offering demand deposits.”

Ultimately, Congress settled these issues by amending the U.S. Code to include (among other things) new pricing and access requirements for the Fed.

Now, special purpose financial companies, such as fintech firms, are facing the same sort of problems.

For instance, fintech companies that provide digital stablecoin-based payment services want Fed master accounts. Without those accounts, the fintechs have no choice but to run their business through a commercial bank (as a correspondent) to access the Fed’s settlement services. That relationship, of course, requires the fintechs to become customers of their (at least potential) competitors.

Naturally, commercial banks do not want competitors, least of all those who do not fall under the same–incredibly costly–regulatory structure. But technology has now advanced to the point that financial firms can more easily unbundle the services previously available only from the commercial banks, so placing all fintechs and banks under the same regulatory framework makes less sense. (No one should assume that the existing regulatory framework is either necessary or sufficient in any way, but that’s another topic.)

As of this writing, very few special purpose nonbank financial firms have been granted master accounts at the Fed, and it appears that the Fed revoked access for the only fintech firm it had granted access.

In June, after waiting 19 months, the fintech firm Custodia (formerly Avanti) sued the Fed over its “delay in approving an application to set up a master account.” Custodia asked the court to “require the central bank to ‘promptly provide a decision on the application and articulate the reasons for the decision’ and ‘the standards.’”

The Fed argues that under current law master account access is “a privilege and not a right,” and that “account applications are fully within the discretion of regional Fed banks to approve or deny.” They are not, in fact, “subject to any statutory deadline” to grant access.

To the extent that the Fed is correct, they’ve identified a problem that Congress should address. At the very least, Congress should require the Fed to grant master accounts to fintech payment service providers within an explicit period, such as six months.

Without congressional action, most fintech companies will remain in limbo.

The Fed argues that its new guidelines “provide a consistent and transparent process to evaluate requests for Federal Reserve accounts and access to payment services.” But the guidelines merely state that the Fed will consider various risks when reviewing applications. They fail to provide any clarity to the fintech firms that have had the most trouble gaining master accounts.

For instance, the new guidelines establish a three-tiered framework that lists federally insured banks in the first tier and uninsured eligible institutions that are “subject (by statute) to prudential supervision by a federal banking agency” in the second tier. The third tier consists of “Eligible institutions that are not federally insured and are not considered in Tier 2.”

The guidelines state that the Fed will provide more scrutiny to firms that fall in the higher tier, essentially on the premise that insured depository institutions (and other banks) are already heavily regulated at the federal level. Naturally, most of the fintech firms who want master accounts fall into highest tier because they are not federally regulated depository institutions.

The guidelines do nothing at all to clarify what these companies need to do to gain access to the master accounts, thus leaving them no better off than before the guidelines were released. State-chartered special purpose entities, even if they provide fully backed payment services, remain entirely at the mercy of the Federal Reserve District Banks.

This entire episode highlights so much that is wrong with federal financial regulation. The structure of the Federal Reserve System is outdated and counterproductive. Federal agencies can dictate the competitive structure of financial markets. The federal framework is a top-down paternalistic system that fails to keep the financial system safe and stable, one that is wholly misguided and based on faulty principles. The United States has too many regulators with unnecessary and overlapping authority.

The list goes on, but I’ll stick to the non-bank master account issue.

Congress needs to act soon to ensure that the financial industry–particularly the digital currency sector–does not become overly concentrated or insufficiently “contestable.” If the status quo remains, the digital currency market is likely to be dominated by “a small number of insured banks (or, if the Fed also enters the market, by them and the Fed).”

Failure to act all but ensures people will have fewer financial options, with lower quality and higher fees than a market with more competition and innovation. The Fed’s new guidelines do nothing to address this problem.