The US Federal Reserve rejected Custodia Bank’s application for a master account on January 27. Last week, it released a document explaining its reasoning for the rejection.
Like Kraken founder Jesse Powell, many fans of Custodia (formerly Avanti) praised its fully backed, non-fractional reserve banking application. However, almost no one spoke about Custodia’s shadowy plan to mint its own stablecoin with “implicit backing” from the Fed that would, according to regulators, add “a new, meaningful, volatile source of demand for Federal Reserve liabilities.”
Aside from Custodia’s founder Caitlin Long, the bank had no bigger cheerleader than Powell. Indeed, he tweeted his support for Custodia regularly.
Unsurprisingly, he has a long history of supporting other shadowy stablecoins, especially Tether.
Jesse Powell’s advocacy for Tether
Tether has a long, curious history with Powell and Kraken. For significant periods, Kraken offered the only USD-denominated trading pair for Tether on any publicly-quoted market.
Despite years of lies by Tether executives, Powell has been a staunch proponent of the so-called stablecoin since 2018.
Read more: Tether transparency: A lesson in lying
Kraken would also allow Tether traders to blow out any possible short positions priced using Kraken’s USD reference price for Tether (many OTC and derivative financial products use reference pricing from major exchanges like Kraken). On May 11, 2019, for example, Tether traded at $1,000 per USD on Kraken.
Allowing further thrashing of bets against Tether’s peg, on May 12, 2022, Tether traded at $0.92 per USD on Kraken. The exchange processed a staggering $1 billion worth of Tether transactions at various prices throughout that single day.
As the founder of one of the industry’s oldest exchanges and with experience working for Mt. Gox itself, Powell’s support for Custodia led many to believe in the merits of fully reserved banking.
However, there are few examples of non-fractional reserve banks, which generate little profit and struggle to compete with other banks with access to favorable leverage into fixed-income markets. Despite Powell’s endorsements, fully backed bank accounts are not a reality of modern life.
Instead, Custodia planned to earn profit in other, less conventional ways.
Destined for failure
The Federal Reserve’s rejection letter refers to Custodia’s description of itself as “a compliant bridge” between digital assets and the mainstream payments system.
Custodia also shot itself in the foot by inviting greater scrutiny of its application and the fact that it didn’t seek deposit insurance with the Federal Deposit Insurance Corporation (FDIC).
In addition, the Fed expressed concern about Custodia’s lack of risk management protocols and its novel financial offerings. Authorities especially cited Custodia’s focus on digital assets — including its plan to issue its own digital token.
As expected, the Federal Reserve noted digital assets’ association with “illicit finance” and “safety and soundness risks.”
Custodia had planned to issue a stablecoin called Avit, something the Fed derided. It said Custodia could plan to hold its Avit reserves in its Fed-supported master account, creating the impression that it had “implicit backing” by the central bank.
This could create the veneer of legitimacy needed to scale quickly and enable pseudonymous blockchain transactions with perceived backing by the US government.
Custodia pushed back, claiming that it planned to hold $1.08 in cash for every dollar of Avit outstanding. It said keeping excess reserves should have reduced concerns about bank runs. Custodia planned to be able to cover all withdrawals in full, without issues suffered by recently-failed banks like Credit Suisse or Silicon Valley Bank.
In June 2022, Custodia filed a lawsuit challenging the Federal Reserve’s delay in approving its master account application. It updated that suit with an amended complaint in February 2023. The Federal Reserve’s decision to publish its reasoning for the rejection in public is a likely response to their lengthy delay.
Read more: Federal Reserve ‘illegally’ delaying Kraken’s master bank account, says Senator
Why Custodia Bank sought master account approval
Some banks have master accounts with the Federal Reserve. Approval elevates their offering from growing on a state-by-state basis to a truly national service.
The Congressional Research Service describes master accounts as one major motivation to seek a federal bank charter. Its report, Federal Reserve: Master Accounts and the Payment System, mentions the risks of digital asset banks with state bank charters applying for a federal charter.
Federal bank charters, which come with access to master accounts, can enable seamless transactions between digital assets and the US dollar. Banks typically use master accounts to hold their cash reserves and use wholesale payment systems to settle payments.
The report refers to the speed at which the Federal Reserve can approve traditional banks’ applications for a federal bank charter. Non-traditional financial services often face delays or, like Custodia, get rejected.
The Federal Reserve attempted to make the application process more transparent with guidance published in August 2022. However, it also had to reconsider eligibility requirements for a federal charter with the rise of non-traditional banks.
Caitlin Long and Jesse Powell complain
For her part, Caitlin Long expressed frustration with financial regulators. She claims she attempted to alert authorities about illegal activity and potential bank runs only for her warnings to be lost in a bureaucratic maze. She claims Senator Richard Durbin placed her and Custodia in the same group as FTX founder Sam Bankman-Fried in comments he made on the Senate floor.
Powell says he similarly tried to warn federal authorities about illegal activity only to be brushed off. He claims the authorities said they were “watching everybody” but were limited in what they could do because the parties he warned about were offshore entities.
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Source: https://protos.com/kraken-founder-promoted-custodias-doomed-bank-and-stablecoin/