SEC Weighs New Rule for Custody of Clients’ Crypto Assets in Wake of FTX Debacle

The SEC introduced a proposal on Wednesday that would strengthen protections for client assets held by investment advisers and extend it to cover crypto assets.

The proposal will ensure that the customer’s assets are properly segregated, and help to protect assets should the adviser or custodian go bankrupt. This comes after major crypto platforms including Voyager Digital, Celsius Network, FTX, BlockFi and Genesis Global Capital went bankrupt in recent months, leaving clients in limbo and unable to access any funds.

“Make no mistake: Today’s rule covers a significant amount of cryptoassets,” SEC Chairman Gensler said in a statement. “Based on how crypto platforms generally operate, investment advisers cannot rely on them as qualified custodians…Through our proposed rule, investors will get the time-tested protection and, yes, qualified custodians they deserve.”

FTX bankruptcy filings in particular have shown that the firm commingled client and household assets, allowing client money to be used for purposes users had not consented to, such as crypto trading, real estate purchases and political donations.

While the efforts have been well publicized, many non-bankrupt crypto platforms have also failed to deliver the transparency investors demand to know their money is safe.

In the United States, investment advisers include asset managers such as registered investment advisers, hedge funds, and wealth managers who are required to register with the SEC if they manage more than $110 million in assets.

Most crypto assets are likely funds or crypto securities covered by the current rule, according to the SEC. Gensler said that while some crypto trading and lending platforms may require custody of investors’ crypto, that does not mean they are qualified custodians.

“Instead of separating investors’ crypto, these platforms have mixed these assets with their own crypto or other investors’ crypto,” Gensler said. “When these platforms go bankrupt – something we’ve seen time and time again recently – the investors’ assets have often become the property of the failed company, leaving the investors in line at the bankruptcy court.”

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In addition to expanding the custodian rule to apply to all assets including cryptocurrencies, the proposal also requires, for the first time, that advisers and qualified custodians enter into written agreements with each other that help guarantee a custodian’s protection.

The rule applies to crypto assets held with advisors. The Adviser will be required to hold clients’ crypto with a qualified custodian, separate from any crypto trading platform based on how they currently operate.

The proposal will also require advisers and custodians to enter into a written agreement guaranteeing protection. The agreement will include qualified trustees who undergo annual evaluations from public accountants and provide bank statements and other records upon request.

The SEC’s depository rule for investment advisers, first adopted in 1962, was last updated in 2009 in response to the financial crisis. Congress gave the agency new authority in 2010 after the $64 billion Bernie Madoff scandal.

In both the Madoff scandal and other incidents related to the financial crisis, the SEC was accused of failing to hold companies and private sector executives accountable. Among other things, it urged registered investment advisers to place client funds in custody with an independent firm or otherwise subject advisers to “surprise examinations” and third-party reviews.

In a crypto-focused Senate Banking Committee hearing held on Tuesday, Republican members of the committee sat down with the SEC and called for Chairman Gensler to testify.

Already in 2023, the SEC has delivered four enforcement actions against crypto firms. On Monday, stablecoin issuer and trust company Paxos stated that it had received a Wells notice from the agency informing the firm of a potential enforcement action related to the Binance USD stablecoin.

The SEC will hold a commission meeting to vote on this proposal Wednesday morning. After approval, the proposal will be open for public comment.

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