On Wednesday, the Securities and Exchange Commission voted 4-1 to propose broad changes to federal regulations that would broaden custody rules to include assets such as cryptocurrency and require companies to obtain or maintain registration in order to hold customer assets.
The proposed changes to federal custody rules would “extend the scope” to include any client assets under an investment advisor’s custody. With a few highly specific exceptions, current federal regulations only include assets such as funds or securities and require investment advisors such as Fidelity or Merrill Lynch to hold those assets with a federal- or state-chartered bank.
It would be the SEC’s most visible attempt to rein in even regulated crypto exchanges with significant institutional custody programmes serving high-net-worth individuals and entities that custody investor assets, such as hedge funds or retirement investment managers.
Other federal regulators actively discourage custodians like banks from holding customer crypto assets, so this move poses a new threat to crypto exchange custody programmes. The amendments also come as the SEC ramps up its enforcement efforts.
While the amendment does not mention crypto companies specifically, Gensler stated in a separate statement that “while some crypto trading and lending platforms may claim to custody investors’ crypto, that does not mean they are qualified custodians.”
To custody any client asset, including and especially cryptocurrency, under the new rules, an institution must hold the charters or qualify as a registered broker-dealer, futures commision merchant, trust, or foreign financial institution.
The proposal, according to SEC officials, would not change the requirements for being a qualified custodian and would not preclude state-chartered trust companies, such as Coinbase or Gemini, from serving as qualified custodians.
The officials emphasised that the proposed amendments did not decide which cryptocurrencies were considered securities by the SEC.
The amended regulation would also require a written agreement between custodians and advisors, expand the requirements for “surprise examinations,” and improve recordkeeping rules.
Previously, the SEC sought public input on whether crypto-friendly state-chartered trusts, such as those in Wyoming, were “qualified custodians.”
“Make no mistake: today’s rule, the 2009 rule, covers a sizable portion of crypto assets,” Gensler said in a statement. “According to the press release, ‘the majority of crypto assets are likely to be funds or crypto asset securities covered by the current rule.’ Furthermore, just because some crypto trading and lending platforms claim to hold investors’ crypto does not mean they are qualified custodians.”
However, Gensler’s proposal appeared to contradict SEC officials’ claims that the moves were designed with “all assets” in mind. The SEC chair mentioned several high-profile cryptocurrency bankruptcies in recent months, including Celsius, Voyager, and FTX.
“When these platforms fail—as we’ve seen recently—investors’ assets frequently become the property of the failed company, leaving investors in line at bankruptcy court,”
Gensler
The SEC’s proposed changes are also intended to “ensure client assets are properly segregated and held in accounts designed to protect the assets in the event of a qualified custodian bankruptcy or other insolvency,” according to information released by the agency on Wednesday.
A similar arrangement already exists at Coinbase. The exchange stated in its most recent earnings report that it keeps customer crypto assets “bankruptcy remote” from hypothetical general creditors, but that the “novelty” of crypto assets made it unclear how courts would treat them.
The SEC has already begun to target other lucrative revenue streams for crypto institutions such as Coinbase, the only publicly traded pure crypto exchange in the United States. The SEC announced a settlement with crypto exchange Kraken last week, alleging that its staking programme constituted an unregistered offering and sale of securities.
Coinbase CEO Brian Armstrong said at the time that a move against staking would be a “terrible path” for customers.
For the three months ending September 30, 2022, Coinbase reported $19.8 million in institutional transaction revenue and $14.5 million in custodial fee revenue. That institutional revenue accounted for approximately 5.8% of Coinbase’s $590.3 million in revenue during the same time period. However, this figure excludes any revenue from blockchain rewards or interest income from institutional custody clients.
“After listening to today’s SEC meeting, we are confident that Coinbase Custody Trust Co. will remain a qualified custodian even if this proposed rule is enacted as proposed,” Coinbase chief legal officer Paul Grewal said. “We agree that consumer protections are necessary — as a reminder, our client assets are segregated and protected in any event.”
Grayscale Bitcoin Trust (GBTC), for example, uses Coinbase Custody to store billions of dollars in bitcoin, holding roughly 3.4% of the world’s bitcoin in May 2022.
Following the SEC’s approval vote, commissioners’ comments made it unclear what the full scope of the SEC’s proposed rulemaking would be, and how it might impact existing partnerships. Grayscale is not a registered investment advisor, and thus their custody arrangement appears to be unaffected by the proposed amendments.
A person familiar with the situation said he did not expect the relationship to be harmed, pointing out Coinbase Custody’s qualified custodian status as a New York state-chartered trust and observing that investment advisors may even switch from directly holding bitcoin to owning GBTC shares as a result of the proposed amendments.
Dissent and questions about the nature of the proposed rules arose among the commissioners. “The proposed release goes to great lengths to paint a ‘no-win’ scenario for crypto assets,” said SEC commissioner Mark Uyeda. “In other words, an adviser may custody crypto assets at a bank, but banks are cautioned not to custody crypto assets by their regulators.”
Uyeda, on the other hand, noted that the proposal was a step towards rulemaking rather than what he called a historical use of “enforcement actions to introduce novel legal and regulatory theories.”
It was a sentiment shared by Coinbase’s chief legal officer, who emphasised the importance of clarity, a call that has been heard throughout the industry. “We encourage the SEC to begin the rulemaking process on what should or should not be considered a crypto security, especially given that today’s proposal acknowledges that not all crypto assets are securities. “Rulemaking on that topic could provide consumers, investors, and the industry with much-needed clarity,” Grewal said.
