Aspiring Crypto Bank’s Plight Shows Binance’s Issues Are Just Part of the Story

Custodia Bank’s membership rejection by the Federal Reserve Board is more alarming for crypto banking than the recent troubles of Binance, Juno and Signature Bank combined.

AccessTimeIconFeb 8, 2023 at 4:29 p.m. UTC
Updated Feb 8, 2023 at 6:53 p.m. UTC
AccessTimeIconFeb 8, 2023 at 4:29 p.m. UTCUpdated Feb 8, 2023 at 6:53 p.m. UTC
AccessTimeIconFeb 8, 2023 at 4:29 p.m. UTCUpdated Feb 8, 2023 at 6:53 p.m. UTC

Two weeks ago, Caitlin Long-founded Custodia Bank (formerly Avanti Bank), which is not yet in operation, learned the U.S. Federal Reserve Board had denied its application for membership, which would have formalized an association with the general reputation of the U.S. central bank.

Then, this week Binance, the biggest cryptocurrency exchange in the world by trading volume, confirmed it was temporarily suspending U.S. dollar bank transfers as of Feb. 8. Almost none of Binance’s customers make U.S. dollar bank transfers, and Binance’s U.S. division is not affected by the suspension. So there may not be cause for concern.

But add a lawsuit filed against Signature Bank and then add crypto bank Juno halting and then restarting services after a vendor shut down operations – and suddenly there is plenty of online chatter about banks and crypto.

Now we can cue the public outcry.

It makes sense, in a way: Binance is one of the most recognizable brands in crypto, lawsuits against banks are big and flashy (especially when connected to FTX) and Juno offers FDIC-protected checking accounts.

Binance has had plenty of run-ins with U.S. regulators, so are we really surprised it is struggling with a U.S. banking relationship? The Signature lawsuit is just a lawsuit, and Matt Damon, Stephen Curry and Tom Brady know lots of people who have been sued in crypto, don’t they? And Juno is a crypto bank that offers interest on its FDIC-insured accounts, so is it shocking that something hurt its operational flow given how bad 2022 was?

No, not really. Where this does get surprising is when you add in Custodia. The news of its rejection by the Federal Reserve Board was more worthy of a reaction than all of these other stories combined.

Custodia does crypto banking differently: So what’s the problem?

At risk of sounding like Adam Neumann, Custodia is trying to do banking differently. The goal of Custodia (when it finally launches) is to act as a compliant bridge between digital assets and the U.S. dollar payments system. With that in mind, consider the Federal Reserve’s following statement in defense of its rejection of Custodia’s application:

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“The firm's novel business model and proposed focus on crypto-assets presented significant safety and soundness risks. The Board has previously made clear that such crypto activities are highly likely to be inconsistent with safe and sound banking practices.”
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OK – that seems somewhat reasonable.

The “previously made clear” is a reference to a multi-agency joint statement from Jan. 3 that cited crypto’s many risks to the banking system including fraud, scams and inaccurate disclosures by crypto companies. The statement also cited other things including legal uncertainties related to custody practices, market volatility, stablecoin run risk, contagion risk and – my personal favorite – “risk of open, public, and/or decentralized networks or similar systems.”

Where it becomes unreasonable is when you consider Custodia’s stated strategy and mission and this sentence from the Fed’s rejection:

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“It is important that risks related to the crypto-asset sector that cannot be mitigated or controlled do not migrate to the banking system.”
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But mitigating or controlling that risk is exactly what Custodia is trying to do. Custodia is a Wyoming-chartered Special Purpose Depository Institution (SPDI), which means it is a bank mostly engaged in the custody of assets, with its main focus on keeping assets safe and settling transactions efficiently. Very critically due to this designation as a SPDI, Custodia would be required to maintain unencumbered liquid assets (e.g., cash, U.S. Treasurys) valued at 100% or more of its deposits. For every dollar of deposits from its customers, Custodia would have at least one dollar in reserve.

Full reserves make a difference

What that means is, unlike almost all banks Custodia doesn’t need Federal Deposit Insurance Corporation (FDIC) insurance – which protects a customer’s bank deposits from bank failures.

Although that sounds petrifying, it isn’t. The reason most banks need FDIC insurance is because they aren’t required to hold a dollar in reserve for every dollar of deposits. Almost all banks, certainly the biggest ones, practice fractional reserve banking where only a fraction of bank deposits are required to be available at all times for customer withdrawal. If that sounds petrifying, it’s because it sort of is. As we’ve learned, at our peril, it all works really well until it doesn’t.

If things get really bad and a bank is in trouble, customers will run to the bank to pull their money out. In fractional reserve banking, there might not be enough money available to be withdrawn. This triggers a bank run. Bank runs are bad.

Guess what? You can’t have a bank run if the assets are there. It really is that simple.

Without Custodia in this mix of bank-related crypto news, I’m not sure this piece of the news cycle would have anything worth paying close attention to for long. A lot of crypto is predicated on trading, gambling and “number-go-up technology” butting up against nebulous financial securities laws – so skittishness around Binance, Signature and Juno doesn’t raise eyebrows on its own.

Skittishness around a fully reserved bank that just so happens to service crypto businesses does.

This isn’t an advertisement for Custodia. It isn’t even an advertisement for full-reserve banking requirements. As a bitcoiner, I’m not likely to get close to advertising banks at all.

But I am advocating for more common-sense regulations. Why is this conversation even necessary? Crypto is not illegal, so a fully reserved, chartered bank looking to provide financial services to crypto companies should not be blocked from doing so.

Unless, of course, there is something else going on at the Federal Reserve or other agencies that makes them skittish to see, hear or read the word “crypto.”


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George Kaloudis

George Kaloudis was a research analyst and columnist for CoinDesk.