SEC proposal would apply custody rules to crypto

The Securities and Exchange Commission voted Wednesday to expand asset custody rules for investment advisers to cryptocurrencies and require financial institutions that oversee crypto assets to obtain federal and state registrations to do so.

The proposed rule, approved by a 4-1 vote of SEC commissioners, would mandate that investment advisers maintain custody accounts for crypto similar to those for other client assets, such as stocks, bonds or mutual funds.

Investment advisers retain banks, broker-dealers and other financial institutions to “hold” client securities and related assets in custodial accounts. These institutions receive a fee for their services and must follow strict regulatory guidelines.

The SEC proposal comes amid a wave of crypto exchange bankruptcies, including FTXs, that have fueled calls for a regulatory crackdown on a nascent industry that has faced limited federal and state oversight. Custody becomes a problem during such bankruptcies if there is no separation between the investor’s funds and the assets of the custody platform. During the bankruptcy proceedings of Celsius Network, a federal bankruptcy judge ruled that customer deposits on the network belonged to Celsius and not the customers.

Gary Gensler, the SEC’s chairman, said the changes will help ensure that investment advisers do not “use, lose or abuse” investors’ crypto assets.

“Investors who work with advisors will receive the time-tested protection they deserve for all their assets, including crypto assets,” Gensler said.

However, Hester Peirce, the only SEC commissioner to vote against the proposal, said she is concerned that small investment advisers may have trouble complying with the changes and could reduce the number of qualified crypto custodians.

Some regulators have discouraged banks from maintaining custodial assets for crypto accounts, with crypto exchanges often acting as custodians for their investors.

Peirce said most crypto assets with investment advisers are already held in broader funds or accounts already covered by existing custodial regulations. She added that SEC statements equating crypto-assets with securities are misleading.

“These statements encourage investment advisors to withdraw immediately from advising their clients with respect to crypto,” Peirce said. “More generally, it also appears that the sweeping ‘virtually all crypto assets are a security’ is part of a broader strategy to want complete jurisdiction over crypto to exist.”

Max Schatzow, co-founder and partner of RIA Lawyers LLC, a firm that represents investment advisers, downplayed Peirce’s concern about custodians. Most crypto exchanges, he said, have registrations similar to federally and state-controlled banks.

“So there is a path forward for (crypto exchanges) to meet the definition of a qualified custodian under the (proposed) rules,” Schatzow said.

While a number of crypto custodian firms said they were reviewing the SEC’s new rules, Coinbase ( COIN ) which has been critical of the SEC’s recent regulatory actions has backed the regulator’s move today.

“We wholeheartedly agree that investors deserve to feel confident that their assets are safe – as a reminder, our clients’ assets are segregated and secured. We support the Commission’s efforts to provide all investors with the protections already available to CCTC clients, Coinbase’s Chief Legal Officer Paul Grewal said in a statement.

However, crypto investors should realize that Wednesday’s proposal won’t apply to their holdings if they don’t use an adviser, Schatzow said.

“The rule proposed today would only affect crypto investors to the extent they work through a registered investment advisor (RIA),” he said. “If they’re not working with a registered investment adviser, that proposition has absolutely no meaning for them.”