The SEC has proposed regulations that would limit the crypto firms that can custody of customer assets

Gary Gensler, Chairman of the SEC
  • Gary Gensler, chairman of the SEC, proposed expanding the federal custody requirements to include crypto assets, which would necessitate additional regulatory approval for crypto exchanges.
  • Even though regulators are increasing their scrutiny of crypto companies and making it more difficult to secure regulatory approval for crypto products, the proposed changes would require custodians, including crypto exchanges, to secure or maintain certain federal or state registrations.

By a 4-1 vote on Wednesday, the Securities and Exchange Commission approved sweeping changes to federal regulations that would require businesses to obtain or maintain registration in order to hold customer assets and broaden custody rules to include crypto assets.

Any client assets in the custody of an investment advisor would be included in the “expand the scope” of the proposed amendments to federal custody regulations. With a few very specific exceptions, investment advisors like Fidelity and Merrill Lynch are required to hold assets like funds or securities with a federally or state-chartered bank under current federal regulations.

Even regulated cryptocurrency exchanges that have substantial institutional custody programs serving high-net-worth individuals and entities that custody investor assets, such as hedge funds or retirement investment managers, would be the most obvious target of the SEC’s efforts to restrict them.

Because other federal regulators actively discourage custodians like banks from holding customer crypto assets, the move presents a new threat to crypto exchange custody programs. Additionally, the amendments come at a time when the SEC is aggressively accelerating its enforcement efforts.

Gensler stated in a separate statement that “though some crypto trading and lending platforms may claim to custody investors’ crypto, that does not mean they are qualified custodians” despite the fact that the amendment does not specify crypto companies.

In accordance with the new regulations, an institution would be required to hold the charters, and qualify as a registered broker-dealer, futures commission merchant, or a specific type of trust or foreign financial institution, in order to custody any client asset, specifically crypto.

State-chartered trust companies like Coinbase and Gemini can still serve as qualified custodians, according to SEC officials, who said that the proposal would not change the requirements for being a qualified custodian.

The officials emphasized that the SEC did not decide which cryptocurrencies it considered securities based on the proposed amendments.

In addition, a written agreement between custodians and advisors would be required by the amended regulation, the requirements for “surprise examinations” would be expanded, and recordkeeping regulations would be improved.

In the past, the SEC had asked the public if crypto-friendly state-chartered trusts like those in Wyoming were “qualified custodians,” and the response was mixed.

“Don’t be mistaken: A significant number of crypto assets are covered by the current rule, which dates back to 2009, Gensler stated in a statement. “Most crypto assets are likely to be funds or crypto asset securities covered by the current rule,” according to the release. Additionally, just because some cryptocurrency lending and trading platforms assert that they have custody of investors’ crypto does not mean that they are qualified custodians.

However, Gensler’s proposal appeared to contradict SEC officials’ claims that the moves were planned with “all assets” in mind. The chair of the SEC made mention of the bankruptcy of Celsius, Voyager, and FTX, three well-known crypto companies, in recent months.

According to Gensler, “investors’ assets frequently have become property of the failed company when these platforms go bankrupt, something we’ve seen time and time again recently.” As a result, investors have to wait in line at the bankruptcy court.

According to SEC documents released on Wednesday, the agency’s proposed changes also aim 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 another insolvency.”

Similar arrangements are already in place at Coinbase. The exchange stated in its most recent earnings report that it keeps customer crypto assets “bankruptcy remote” from potential general creditors. However, the exchange also said 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 cryptocurrency institutions like Coinbase, the only publicly traded pure cryptocurrency exchange in the United States. Last week, the SEC announced a settlement with crypto exchange Kraken over its staking program, claiming that it constituted an unregistered offering and sale of securities.

Brian Armstrong, CEO of Coinbase at the time, stated that a move against staking would be a “terrible path” for customers.

For the three months ending September 30, 2022, Coinbase reported revenue from institutional transactions of $19.8 million and revenue from custodial fees of $14.5 million. Coinbase’s $590.3 million in revenue during the same time period was approximately 5.8% of that institutional revenue. However, neither blockchain rewards nor interest income from institutional custody clients are included in that percentage.

According to Coinbase chief legal officer Paul Grewal, “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.” As a reminder, our client assets are kept separate and protected in case of emergency, and we agree that consumer protections are necessary.

For instance, Grayscale Bitcoin Trust (GBTC) holds approximately 3.4% of all bitcoin worldwide in May 2022 and uses Coinbase Custody to store bitcoin worth billions of dollars.

Comments made by commissioners after the SEC’s approval vote made it unclear what the SEC’s proposed rulemaking would include and how it might affect existing partnerships. Since Grayscale is not a registered investment advisor, the custody arrangement between the two parties would not appear to be significantly affected by the proposed amendments.

Due to Coinbase Custody’s qualified custodian status as a New York state-chartered trust and the possibility that investment advisors will even switch from directly holding bitcoin to owning GBTC shares as a result of the proposed amendments, a person familiar with the situation did not anticipate that the relationship would suffer.

There was disagreement and concern about the proposed rules within the ranks of the commissioner. Mark Uyeda, the commissioner of the SEC, stated, “The proposing release takes great pains to paint a “no-win” scenario for crypto assets.” To put it another way, a bank can keep crypto assets in the custody of an adviser, but banks are warned by their regulators not to.

The sentiment was echoed by Coinbase’s chief legal officer, who emphasized a need for clarity, a clarion call that has been echoed throughout the industry. However, Uyeda also noted that the proposal was a move toward rulemaking rather than what he called a historic use of “enforcement actions to introduce novel legal and regulatory theories.” Given that the current proposal acknowledges that not all crypto assets are securities, we urge the SEC to begin the rulemaking process on what constitutes crypto security. Grewal stated, “Rulemaking on that topic could provide consumers, investors, and the industry with the needed clarity.”