A New SEC Rule Challenges the Ties Between Crypto Platforms and Hedge Funds

Platforms that hold digital assets belonging to hedge funds and private equity firms are likely to face a new set of hurdles in the near future as they attempt to hold these assets. 

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There was a proposal by the Securities and Exchange Commission on Wednesday to expand the scope of what is considered a qualified custodian, by including virtual currencies among the assets. As the industry continues to reel from a regulatory crackdown, the sweeping changes to those long-standing rules may have a particularly devastating impact on the crypto industry.

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As a result of a series of meltdowns in the crypto world over the last year, including FTX's sudden wipeout in November, watchdog concerns about the safety of investors' tokens held by crypto platforms have been heightened. Custodians would be required to ensure that money-manager client assets are properly segregated and protected if the custodian goes bankrupt, or if the custodian goes insolvent, as a condition to having the right to hold those assets. 

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According to Gary Gensler, chair of the Securities and Exchange Commission, the crypto platforms cannot be relied upon to act as qualified custodians because of the way these platforms function. Under the existing rules, crypto exchanges that are supposed to provide custodial services alongside other business activities do not qualify as custodians for investment advisers due to the fact that they combine custodial services with other business activities. 

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Money managers under the SEC plan must enter into an agreement with a qualified custodian in order to operate their funds. In addition to being evaluated on an annual basis by public accountants, intermediaries, including crypto companies, would also have to provide account statements and turn over records upon request from public accountants. 

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In accordance with the SEC's proposal, the proposed changes do not affect asset values or technology in any way. All custodians - regardless of the industry in which they operate - would have to abide by these standards once they become effective since they would also apply to physical assets such as art and real estate.

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Even so, it is expected that the plan will have a significant impact on the crypto sector, especially as it historically had far fewer formalized processes for handling client funds than most other sectors. 

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In the event that cryptocurrency platforms do not meet the new requirements, it is unclear who will take on the custodial duties for digital assets. Some banks have raised concerns about the cost of holding cryptoassets on behalf of clients after the SEC issued guidance last March that made holding cryptoassets on behalf of clients an unattractive proposition. 

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Hester Peirce of the Republican Party opposed the proposal and questioned whether limiting the number of firms that can safely hold investors' assets would put them at greater risk of fraud and loss.

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A number of times, Gensler has claimed that crypto exchanges violate SEC regulations. The governor has urged digital-asset firms to comply with regulatory requirements, and last week he stated that they inadequately safeguard the assets of their clients, and do so in a manner that mixes them with their own funds. 

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Following the majority vote of the SEC commissioners to propose the rule, it will now be issued for public comment and would then need to go to another vote before it could be finalized months after the majority voted to propose it.