Crypto custody needs clarity, not mandate

Custody and custodial services are a mainstay of the modern financial system, and recent comments from the Securities and Exchange Commission (SEC) risk undermining well-intentioned players in the crypto space who attempt to provide these services.

Recent announcements from the SEC, and public comments from SEC Chairman Gensler, continue to send shock waves reverberating through the crypto sector. As if the recent spate of enforcement actions, Wells Notices and other pronouncements that have been filed were not enough, the SEC has also recently weighed in on the issues surrounding qualified fiduciaries. The publication by the Investors Advisory Committee, framed in the context of increasing investor protection, instead looks like another attack on the crypto sector.

Some of the requirements that are part of this publication include requiring firms, in order to operate as a qualified custodian, to separate client funds from institutional assets, undergo annual audits by a public accounting firm, and implement several other transparency measures. Additional comments that have been provided tend to focus on the potential of these proposed rules to address issues that have arisen during 2022 and early 2023. In particular, the rules that have been advanced focus on customer funds, the rights of depositors and investors during bankruptcy , and make the audit process that crypto firms have to go through more consistent and comparable.

While this all sounds reasonable on the surface, let’s take a look at some of the reasons why trying to create and/or change existing regulations on this matter will not help the crypto industry mature and develop.

Regulation by order. Time and time again, and even cited by SEC commissioners in dissenting opinions on multiple occasions, the regulatory outlook appears to be one that continues to pivot to regulation-by-edict versus productive and comprehensive conversation. Although many lawsuits are pending, with the likelihood of more increasing by the day, the SEC has yet to issue authoritative guidance, frameworks or checklists for operators in the area who wish to operate in compliance with the regulations.

Cryptoassets and blockchain-based technology represent perhaps the most dynamic shift in technology and financial instruments since the Internet broke into the mainstream. There will always be volatility in any such industry, and viewed from a historical perspective it should be clear that the volatility so far is not unusual or an aberration. What is different, however, is the approach of regulators and legislators; a proactive and sensible approach to the Internet has led to US-headquartered firms leading the sector forward.

Crypto should be treated in the same way, and not referred to the quagmire of the legal system to adopt rules.

Pushing innovation abroad. Starting from this point, it is almost impossible to overstate how global and decentralized the blockchain and crypto industry is; decentralization has driven the space forward, leading to several breakthrough innovations in real-world applications. The United States is the leader in the financial markets, and has the privilege of issuing the global reserve currency, but this leadership position is not guaranteed. The largest crypto exchange in the world, Binance, is not headquartered in the United States, nor is it subject to the rules and regulations that govern American financial markets.

Given the environment that has grown up around the blockchain and cryptoasset space, it should be clear that the industry – along with the capital and personnel that it continues to attract – will go where they are best treated. The United States, instead of cracking down on firms that, with all externally available data, have attempted to operate in compliance and cultivate a domestic crypto industry, should engage with said firms in a productive manner.

Cracking down on bad actors isn’t the problem; Punishing well-intentioned firms will only succeed in driving innovation abroad.

Supervision is still under development. The latest SEC edicts related to custody and safekeeping of crypto assets also highlight the reality that while the SEC has tried to regulate the crypto sector through injunctions and lawsuits, the accounting, auditing and reporting components are still evolving. Traditional accounting audits are not equipped to properly investigate and audit blockchain-based assets, and even the largest audit firms in the world have only cautiously entered the space.

After the fallout from FTX, and questions raised about the audits of that – and other – exchanges, several firms have actually left the space altogether.

In the absence of authoritative guidance, although it is due to change by the end of 2023, the industry has been left to develop work arounds on their own. Proof of Reserve Commitments was proposed as at least a partial solution to the problems associated with blockchain audits, but several issues have arisen with respect to how these commitments are executed and managed.

The crypto and blockchain sectors continue to struggle under an increasingly antagonistic regulatory regime; this makes it important that transparency and objectivity become priorities for everyone involved in the future.

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