The U.S. Securities and Exchange Commission proposed a new rule on Wednesday that may back crypto companies further into a corner as regulators continue to crack down on the space.
The SEC voted 4-1 for a proposal that would direct registered investment advisers (RIAs) — like wealth managers or hedge funds — to keep customers’ money and securities with qualified custodians like a bank, broker-dealer or trust company when storing digital assets, mainly leaving crypto companies on the outskirts.
The proposal aims to keep customer assets segregated appropriately, so if an adviser or custodian files for bankruptcy or becomes insolvent, it could protect the users’ assets, the SEC stated.
“If there’s anything we should learn from the FTX collapse, it’s that assets should be stored until required for trading by external, qualified, regulated and insured custodians,” Mike Belshe, CEO of BitGo, told TechCrunch. “This creates a check and balance for verifying reserve assets under any exchange’s control.”
As it stands, crypto trading and lending platforms usually offer custody for users, but some don’t fit the “qualified custodian” title under the SEC’s rule because they aren’t registered with the SEC or Commodity Futures Trading Commission.
The SEC’s proposal isn’t just focused on an RIA using qualified custodies for crypto, but wants to change the guidelines across all asset classes. “Certain aspects of the proposal impact digital asset custody specifically, but other aspects fall on custody of traditional securities. The rule (and proposal) does not apply specifically to custodians. Instead, the rule (and proposal) speaks to a RIA’s need to use a ‘qualified custodian’ to custody certain customer assets.”
For context, BitGo offers fully regulated and qualified custodians via state-chartered trust companies in both South Dakota and New York.
Applying the Custody Rule to digital asset investment advisers is “bullish for bitcoin and digital assets,” Belshe said. “Pension funds have been longing for clarity on the Custody Rule with respect to digital assets, and today’s statements will resolve that barrier.”
Many exchanges, crypto-lending and -trading platforms, and software providers hold themselves out as “custodying” crypto assets, Jeff Horowitz, chief compliance officer at BitGo, said. “The SEC’s proposal is attempting to make a clear distinction between unregulated small ‘c’ custody and regulated ‘Qualified Custody’ through regulated entities, which can include certain banks, broker-dealers, FCMs or state-chartered trust companies.”
“Today’s SEC rule proposal would require registered investment advisers to hold all customer assets, including crypto assets, with a regulated and qualified custodian like BitGo, who acts as a fiduciary while holding client crypto assets in fully segregated accounts and in a bankruptcy remote manner from its non-qualified offerings,” Horowitz said.
Most crypto assets are likely to be funds or crypto asset securities covered by the current rule, but the proposed rule would enhance protections for certain securities and physical assets that can’t be maintained by a qualified custodian, the SEC said in its announcement.
Present rules cover a “significant amount of crypto assets,” SEC Chair Gary Gensler said in a statement following the announcement.
But modifying it would also help ensure that advisers don’t inappropriately use, lose or abuse investors’ assets and that the rule covers all crypto assets — including those that are not funds or securities, he added.
The SEC has been cracking down on the space in other areas, too. Earlier this month, crypto exchange Kraken settled charges with the SEC and shut down its on-chain staking program. Kraken agreed to pay $30 million in charges for “disgorgement, prejudgment interest and civil penalties.” But as part of the settlement, Kraken has neither admitted nor denied the SEC’s allegations, the exchange’s spokesperson noted at the time.
This proposal follows a series of Chapter 11 bankruptcy filings from mega crypto institutions, including FTX, BlockFi, Three Arrows Capital, Celsius Network, Voyager Digital and most recently Genesis Global Trading, to name a few. All these companies are in the midst of legal battles with customers who are trying to pry back some or all of their locked funds after they filed in mid- to late 2022 (with the exception of Genesis, which filed in January).
“The market structure where customers have to keep their money with the exchange is fundamentally flawed,” Belshe said. “You don’t have to know anything about crypto to see why that is not a good idea. Suppose the Nasdaq approached the SEC about being its own custodian. That conversation would never happen.”
Giving regulators “clear authority over those selling financial assets to U.S. retail and other U.S. investors,” is one way to prevent another FTX-like explosion from happening, said Terrence Yang, managing director at Swan Bitcoin.
“Of course, crypto custodians need heavy regulation to match other financial assets like stocks, mortgage-backed securities, trust certificates, etc.,” Yang added. “There’s a reason Bank of NY Mellon custodies $46 trillion successfully. Startups rolling their own custodian and not meeting the qualified custodian standard is part of a grander crypto casino scheme that doesn’t respect customer safety long term.”
SEC Commissioner Hester Peirce opposed the proposal and criticized it for potentially impeding the crypto sector as it could be “likely shrinking the ranks of qualified crypto custodians,” and found that the rule seemed geared toward forcing advisers to discourage their clients from engaging with the crypto industry.
“When these platforms go bankrupt — something we’ve seen time and again recently — investors’ assets often have become property of the failed company, leaving investors in line at the bankruptcy court,” Gensler said in his statement. “Make no mistake: Based upon how crypto platforms generally operate, investment advisers cannot rely on them as qualified custodians.”
The effects — both short and long term — are unclear. If the proposal is approved, it could harm the number of qualified crypto custodians and deter advisers from diving into the space. But it could also make the industry safer overall.
“The problem isn’t just that it’s just too easy to dip your hand into the cookie jar,” Belshe said. “Even if you are completely honest, there’s still a problem with counterparty risk.”
But it may also not significantly affect the SEC’s stance, as Gensler has already said he believes most cryptocurrencies are securities that should be registered with the government.
The proposed rule is in a 60-day comment period, during which crypto institutions have the opportunity to voice their concerns.