SEC Proposed Custody Rule
On February 15th, the Securities and Exchange Commission (SEC) published and voted on a proposed rule entitled “Safeguarding of Advisory Client Assets” (put more simply, the “safeguarding rule”). The 434-page proposal envisions several changes to the SEC’s existing custody rule.
To recap, the custody rule requires that registered investment advisers (RIAs) that hold custody of client assets must do so with a “qualified custodian”that is subject to specific disclosure requirements and surprise examinations by independent accountants.
Among others, the proposed rule would make three important changes.
First, the rule would expand the scope of assets covered by the custody rule’s requirements beyond funds and securities to include all assets—including “all crypto assets, even in the instances where such assets are neither funds nor securities.”
Second, it imposes new standards for qualified custodians, requiring them to demonstrate “exclusive possession or control” over the assets. This is determined by finding “whether the qualified custodian is required to participate in a change of beneficial ownership of an asset,” proven for instance, by generating and maintaining “private keys for the wallets holding advisory client crypto assets in a manner such that an adviser is unable to change beneficial ownership of that crypto asset without the custodian’s involvement.”
Third, the rule expands the scope of when the custody rule applies to include the discretionary trading of those assets.
What does this mean?
While the proposed changes to the custody rule do not have direct implications for DeFi, they would have significant secondary effects by raising the barriers to entry for RIAs to invest in the space and custody crypto-assets. As we’ve said in the media, this is yet another attempt by the SEC to circuitously constrict US investment and activity in the digital asset ecosystem.
Overall, the proposal seems to intentionally create, as Commissioner Mark Uyeda expressed, a “no-win” scenario for crypto assets.
First, there is ambiguity regarding which entities can act as qualified custodians. Under the proposed rule, qualified custodians include banks that are nationally chartered and those “doing business under the laws of any State or of the United States, a substantial portion of the business of which consists of receiving deposits or exercising fiduciary powers similar to those permitted to national banks….” The ambiguity with respect to when state-chartered banks meet this definition has been a longstanding issue, and it is not clarified in the proposal.
Second, the proposed rule requires RIAs to custody clients’ crypto assets with qualified custodians while banking regulators caution banks about the risks of crypto assets or crypto-related businesses.
Third, as Commissioner Uyeda noted, “because crypto assets trade on platforms that are not qualified custodians – an adviser that trades crypto assets on a platform would violate the proposed rule.”
Finally, while the SEC does not have jurisdiction over qualified custodians, it does require RIAs to use qualified custodians that meet certain standards, and the SEC has never acknowledged that they can hold crypto assets to the standard required under the existing rule, adding another layer of ambiguity.
With all that said, we will submit comments to the SEC; stay tuned.
Senate Banking Committee Holds “Crypto Crash” Hearing
On February 14th, the Senate Banking Committee on Banking, Housing, and Urban Affairs held a hearing titled “Crypto Crash: Why Financial System Safeguards are Needed for Digital Assets.”
Ranking Member Tim Scott (R-SC) opened the meeting by calling on Chair Gary Gensler to join them for their next hearing, expressing that he hopes to “see him very soon.” He continued by questioning whether we’d need to hold this sort of hearing had “the SEC had provided even the slightest bit of guidance,” a question many in the industry have also raised. Senator Scott opened his line of questions by reiterating this point, explaining that “[h]ad the SEC provided anything besides hostility to the crypto industry, we may have been able to save investors from losing billions of dollars.”
In her opening statement, witness Linda Jeng, General Counsel at the Crypto Council for Innovation and adjunct professor at Georgetown Law, noted that “[t]he SEC has not initiated any formal rulemaking process to update securities laws that are decades old, to account for the unique attributes of digital assets that are determined to be securities.” Further, she urged Congress to consider “pass[ing] thoughtful comprehensive legislation that establishes a federal regulatory framework with digital assets, addressing both securities and non-securities in this complex and nuanced space.”
Senator Elizabeth Warren (D-MA) also took her time to reintroduce an anti-money-laundering bill to the floor that seeks “to clamp down on crypto crime.”
What does this mean?
Despite the fact that there is a consensus around the need for some kind of legislation, we believe enacting crypto regulatory bills (and really bills of any variety) will be a heavy lift in this divided congress. This reality has its pros and cons. On the one hand, hostile bills like the one presented by Senator Warren are unlikely to become law. On the other hand, without congressional action, agencies like the SEC are and will continue to test the bounds of their authority and their regulation-by-enforcement approach.
EU Releases the Draft Law Imposing Strict Crypto Rules for Banks
On Friday, the European Parliament published a draft law that confirms stringent capital requirements for banks holding crypto assets. The proposed rules would mandate banks to hold euro capital on par with their crypto holdings until December 30, 2024.
Moreover, if the EU Parliament agrees on the proposal, the European Commission would be required to implement additional rules by June 2023, including specific liquidity requirements for cryptocurrency exposures, criteria for categorizing cryptocurrencies by risk, and disclosure requirements.
What does this mean?
As we've previously stated, this is probably a good idea for the time being.