SEC Chairman Gensler’s new proposal tightens restrictions on crypto custody

US Securities and Exchange Commission (SEC) Chairman Gary Gensler testifies before the Senate Banking, Housing and Urban Affairs Committee during an oversight hearing on Capitol Hill in Washington, September 15, 2022.

Evelyn Hockstein | Reuters

Securities and Exchange Commission Chairman Gary Gensler on Wednesday proposed sweeping changes to federal regulations that would expand custody rules to include assets such as crypto and require companies to obtain or maintain registration to hold those customer funds.

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

It would be the SEC’s most overt attempt to rein in even regulated crypto exchanges that have significant institutional custodian programs that serve high-net-worth individuals and entities that custodian investor assets, such as hedge funds or pension managers.

The move poses a new threat to crypto exchange custody programs, as other federal regulators actively discourage bank custodians from holding customers’ crypto assets. The changes also come as the SEC is aggressively speeding up enforcement efforts.

While the amendment does not specify crypto companies, Gensler said in a separate statement that “while some crypto trading and lending platforms may require depositing investors’ crypto, that does not mean they are qualified custodians.”

Under the new rules, in order to hold a client asset – including and specifically crypto – an institution must hold the charter, or qualify as a registered broker-dealer, futures commission merchant, or be a certain type of trust or foreign financial institution.

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

The officials emphasized that the proposed changes did not make a decision about which cryptocurrencies the SEC considered securities.

The amended regulations will also require a written agreement between trustees and advisers, expand the requirements for “surprise investigation” and improve the rules for record keeping.

The SEC had previously sought public feedback on whether crypto-friendly state-chartered trusts, like those in Wyoming, were “qualified trustees.”

“Make no mistake: Today’s rule, the 2009 rule, covers a significant amount of cryptoassets,” Gensler said in a statement. “As the release states, ‘most cryptoassets are likely to be funds or cryptoasset securities covered by the applicable rule.’ Furthermore, although some crypto trading and lending platforms may require depositing investors’ crypto, this does not mean they are qualified custodians.”

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

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

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

Coinbase already has a similar arrangement in place. In its latest earnings report, the exchange specified that it keeps clients’ crypto assets “bankruptcy remote” from hypothetical general creditors, but noted that the “newness” of crypto assets meant it was uncertain how the courts would treat them.

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

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

Coinbase reported $19.8 million in institutional transaction revenue and $14.5 million in custody fee revenue for the three months ending September 30, 2022. Combined, the institutional revenue represented about 5.8% of Coinbase’s $590.3 million in revenue for the same time period . But this percentage can be much higher when taking into account blockchain rewards and interest income from institutional custodians.

Grayscale Bitcoin Trust (GBTC), for example, custodians billions of dollars in bitcoin using Coinbase Custody, and holds approximately 3.4% of the world’s bitcoin in May 2022. Under the proposed changes, GBTC’s relationship with Coinbase could be at risk.

Representatives for Coinbase did not immediately return a request for comment.

— CNBC’s Kate Rooney contributed to this report.