SEC pushes for tougher custody rules for assets including crypto

Wall Street’s top regulator has proposed tougher safeguards around investors’ assets after the collapse of several high-profile crypto companies last year revealed that client funds were not as safe as advertised.

The US Securities and Exchange Commission on Wednesday agreed to propose rules that would force investment advisers to secure all client assets they manage, including so-called alternatives, such as cryptocurrencies and art, with qualified custodians.

The aforementioned crackdown on custody follows a series of failures in the markets for digital assets. Companies promoted funds as segregated and separate, only for consumers in a bankruptcy to discover that their holdings were treated as unsecured assets and part of the estate of the collapsed company.

While the SEC’s proposed custody rules are designed to cover all assets, most discussions focused on how it would apply to crypto.

“While some crypto trading and lending platforms may require depositing investors’ crypto, that does not mean they are qualified custodians,” SEC Chairman Gary Gensler said in remarks introducing the proposal. “[This] The proposal, by covering all asset classes, will cover all crypto assets – including those currently covered as funds and securities and those that are not funds or securities.”

In an effort to expand the scope of existing rules, the SEC is making use of powers given to it in 2010 after the Bernard Madoff scandal, when it was found that clients of the fraudster had lost billions in what was effectively a Ponzi scheme.

The proposals come after a year of acute turbulence for crypto markets, which has left millions of creditors queuing at bankruptcy court following the unraveling of groups including lending platform Celsius and exchange FTX. Many crypto exchanges act as custodians of client funds, but also borrow from and lend assets to clients. Some of FTX’s former managers have been charged with misuse of customer funds.

Under the proposed rule, investment advisers would have to draft written agreements with qualified custodians to ensure that a client’s assets were segregated and protected in the event of the custodian’s collapse. Eligible custodians are usually highly regulated financial groups such as banks, broker-dealers and trust companies.

The proposal was supported by four of the five SEC commissioners and will now be subject to public comment as well as another vote before possible implementation.

Earlier in its meeting, the SEC finalized rules that will halve the two-day window for settling stock deals, an initiative that gained more urgency after brokers like Robinhood were rocked by a surge in trading during the 2021 frenzy in meme stocks.

Subsequently, the need for brokers to provide additional collateral to clearinghouses to cover settlement risk was cited as a spur in their controversial decisions to limit clients’ ability to buy certain in-demand stocks.

Market makers and brokers have argued that the current two-day window poses a risk to the financial system. In volatile periods, clearing houses that stand between buyers and sellers may require more margin, or insurance, to cover any failed deals.

The vote on the rule was passed with the support of three of the five commissioners. Two, Hester Peirce and Mark Uyeda, voted against the measure after expressing concern that the May 2024 deadline was too tight to allow all systems to be fully tested.

Several industry participants had argued for the transition to occur in September 2024 to coincide with Canada’s plans to do the same.

“We appreciate the commission finalizing its rule to provide certainty, but we strongly disagree with the May 2024 implementation date,” said Kenneth Bentsen, head of Sifma, the securities industry group.