SEC’s proposed crypto custody rule faces pushback from states
An SEC effort to impose a uniform standard on investment funds for storing client assets, including cryptocurrencies, has set up a potential clash with state regulators with their own rules for providing custody services.
The US Securities and Exchange Commission proposed on February 15 to establish a standard for banks and other entities that want to safely store client funds entrusted to hedge funds, private equity funds, pension funds and other investment companies.
The proposal comes in the wake of several high-profile crypto firm collapses and raises concerns about the ability of state-chartered banks to meet an unprecedented federal standard.
“Some state regulators may be pulling back for a few reasons, one of which is that they probably don’t want the SEC to limit their authority over state-controlled banks,” said Jiaying Jiang, a professor at the University of Florida’s Levin College of Law.
Some states, including New York and Wyoming, have their own trust bank charters that allow banks to provide depository services without federal deposit insurance or being a member of the Federal Reserve System.
‘Common Denominator’
The SEC’s proposed update to custodial services follows the implosion of crypto firms such as FTX which announced that customers’ crypto tokens were being stored separately from the company’s assets. When these promises turned out to be false, customers lost their money when the companies went bankrupt.
The SEC will require all custodians to have written agreements with investment advisers that client funds will be properly segregated and protected in the event of a bankruptcy or insolvency. Pointed out in the rule’s preamble, it states its concern that “new entrants” to the depository market, including banks operating under state charters, “offer, and are regulated to provide, the type of protection that we believe a qualified depository bank should provide under rule .”
The proposal also includes a number of questions about how to deal with state-chartered banks, from cutting them out of the ranks of qualified custodian banks to imposing SEC rules on them. Banks may operate under federal or state charters, with the latter encompassing banks at virtually all levels from smaller community institutions to large commercial enterprises.
“By changing the definition, the SEC seeks to establish a common denominator across states, create more uniformity and reduce regulatory arbitrage,” said Yuliya Guseva, head of the Blockchain and Fintech Program at Rutgers University Law School.
These concerns followed recent statements by the Federal Reserve, the Federal Deposit Insurance Corp. and the Office of the Comptroller of the Currency that cryptocurrency activities may not be consistent with safety and soundness standards for banks – and specific concerns raised about state cryptocurrency regulations.
SEC Commissioner Mark Uyeda, a Republican, approved the proposal but noted in a statement that the actions of federal regulators “suggest that state-regulated banking entities are less trustworthy than federally chartered ones.”
Extends the range
The SEC’s proposal is an extension of existing qualified depository rules to asset classes where they previously did not apply, said Mellissa Campbell Duru, special counsel at Covington & Burling LLP and a former SEC attorney.
Coinbase Global Inc., which operates a crypto exchange platform, says its custody services already comply with the SEC’s proposed new requirements. In the same way, large custodian banks such as
“This definition is still tied to the previous or existing definition of a qualified trustee,” Campbell Duru said.
But state regulators like the Wyoming Division of Banking issue trust companies that don’t require banks to have deposit insurance or be Fed member banks. The Fed has already raised objections to these types of institutions having access to the federal banking system.
The New York Department of Financial Services has had a special charter for crypto depository services since 2015. Coinbase is among the companies to be chartered with the State of New York. An agency spokesperson said the department was reviewing the SEC plan.
“DFS has and continues to offer the technical expertise gained from seven years of virtual currency regulation to our federal and global counterparts,” the spokesperson said in a statement.
A spokesperson for the Conference of State Bank Supervisors said the group was reviewing the proposal. The Wyoming Division of Banking did not immediately respond to a request for comment.
These, and potentially other, state agencies are expected to push back hard on the SEC’s assumption that state-regulated banks offer less safe depository services than those with federal charters and are unlikely to want additional requirements imposed on their banks.
“Any time state regulators look like institutions they oversee could be disadvantaged by a federal regulation, state regulators will have a concern,” said Karen Solomon, senior counsel at Covington and a former top OCC official.
