SEC Proposes Rule That Would Tighten Crypto Custody Restrictions

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The Securities and Exchange Commission voted 4-1 on Wednesday to propose sweeping changes to federal regulations that would expand custody rules to include assets like crypto and require companies to obtain or maintain registration in order to hold those client assets. .

Proposed changes to federal custody rules would “broaden the scope” to include all client assets in the custody of an investment adviser. Current federal regulations only include assets such as funds or securities, and require investment advisers, such as Fidelity or Merrill Lynch, to hold those assets with a federally or state-chartered bank, a few very specific exceptions.

It would be the SEC’s most overt effort to rein in even regulated crypto exchanges that have large institutional custodial programs serving high net worth individuals and entities that guard investors’ assets, like hedge funds or money managers. retirement investments.

The move poses a new threat to crypto exchange custody programs as other federal regulators actively discourage custodians such as banks from holding customer crypto assets. The changes also come as the SEC aggressively ramps up enforcement attempts.

Although the amendment does not specify crypto companies, Gensler said in a separate statement that “although some crypto trading and lending platforms may claim custody of investors’ crypto, that does not mean that they are qualified custodians”.

Under the new rules, in order to hold any client asset, including and specifically crypto, an institution would have to hold the charters, or qualify as a registered broker, futures commissioner, or be some type of trust or institution. foreign finance.

SEC officials said the proposal would not change the requirements to be a qualified custodian and nothing precludes state-chartered trust companies, including Coinbase or Gemini, from serving as qualified custodians.

Officials stressed that the proposed changes do not make a decision on which cryptocurrencies the SEC considers securities.

The amended settlement would also require a written agreement between custodians and advisers, expand “snapshot” requirements and improve record keeping rules.

The SEC had previously sought public comment on whether state-chartered cryptocurrency-enabled trusts, like those in Wyoming, were “qualified custodians.”

“Make no mistake: today’s rule, the 2009 rule, covers a significant amount of crypto assets,” Gensler said in a statement. “As the statement states, “most crypto assets are likely funds or securities of crypto assets covered by the current rule.” Additionally, while some crypto trading and lending platforms may claim to hold the crypto investors, it does not mean they are qualified custodians.”

But Gensler’s proposal appeared to undermine comments from SEC officials, who insisted the moves were designed with “all assets” in mind. The SEC Chairman alluded to several high-profile crypto bankruptcies in recent months, including those of Celsius, Voyager, and FTX.

“When these platforms fail, which we’ve seen time and time again recently, investors’ assets have often become the property of the bankrupt company, leaving online investors in bankruptcy court,” Gensler said.

The SEC’s proposed changes are also intended to “ensure that client assets are properly segregated and held in accounts designed to protect the assets in the event of a qualified custodian’s bankruptcy or other insolvency,” according to information published by the agency on Wednesday.

Coinbase already has a similar arrangement in place. In its latest earnings report, the exchange clarified that it was keeping client crypto assets “at arm’s length” from hypothetical general creditors, but noted that the “newness” of crypto assets meant it was uncertain how which the courts would deal with them.

The SEC has already started targeting other lucrative revenue streams for crypto institutions like Coinbase, which is the only publicly traded pure crypto exchange in the US Last week, the SEC announced a settlement with the crypto exchange Kraken on its staking program, alleging that it constituted an unregistered offer and sale of securities.

At the time, Coinbase CEO Brian Armstrong said a potential ruling against staking would be a “terrible path” for consumers.

Coinbase reported $19.8 million in institutional transaction revenue and $14.5 million in custodial fee revenue for the three months ending September 30, 2022. Together, this institutional revenue represented approximately 5.8% of $590.3 million in revenue from Coinbase for the same period. But this percentage does not include any income from blockchain rewards or interest income from institutional custodial clients.

“Coinbase Custody Trust Co. is already a qualified custodian, and after listening to today’s SEC meeting, we are confident that we will remain a qualified custodian even if this proposed rule is enacted as proposed,” said Coinbase chief legal officer Paul Grewal. “We agree with the need for consumer protections as a reminder, our clients’ assets are segregated and protected in all eventualities.”

Grayscale Bitcoin Trust (GBTC), for example, holds billions of dollars worth of bitcoin using Coinbase Custody, holding around 3.4% of global bitcoin as of May 2022.

Following the SEC’s vote of approval, the commissioners’ comments were unclear as to what the full scope of the SEC’s proposed regulation would be and how it might impact existing partnerships. Grayscale is not a registered investment adviser and therefore under the proposed amendments there would not appear to be a material impact on its custodial arrangement.

A person familiar with the matter did not expect the relationship to be adversely affected, noting Coinbase Custody’s qualified custodian status as a New York State-licensed trust, and observing that investment advisers could even switch from directly owning bitcoin to owning GBTC shares as a result. proposed changes.

Within the commissioner’s ranks, there were disagreements and questions about the nature of the proposed rules. “The release proposal strives to paint a ‘no-win’ scenario for crypto assets,” SEC Commissioner Mark Uyeda said. to hold crypto assets.”

But Uyeda also noted that the proposal was a step towards rule-making, rather than what he called a historic use of “enforcement actions to introduce new legal and regulatory theories”.

It was a sentiment shared by Coinbase’s chief legal officer, who pointed to a need for clarity, a clarion call that has been echoed across the industry. “We encourage the SEC to begin the process of developing rules on what should and should not be considered cryptographic security, especially since today’s proposal recognizes that not all crypto assets are “Developing rules on this topic could provide much-needed clarity to consumers, investors and the industry,” Grewal said.

— CNBC’s Kate Rooney contributed to this report.

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