Cryptofirms Can No Longer Custody Customer Assets Under New Regulations Proposed by SEC Chair Gensler

Gary Gensler, the chairman of the Securities and Exchange Commission, proposed sweeping changes to federal regulations on Wednesday in an effort to expand custody rules to include crypto assets and to require companies to be registered in order to hold those assets for customers.

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There has been a proposal to amend federal custody rules, in the hope of "expanding the scope" of those rules to cover all client assets in the custody of those investment advisors. It is currently the case that federal regulations will only cover assets like funds or securities, and investment advisors, such as Fidelity or Merrill Lynch, will need to hold those assets with a federally chartered or state-chartered bank, with a few highly specific exceptions.

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In order to effectively put a stop to even regulated cryptocurrency exchanges that have substantial institutional custody programs serving high-net-worth individuals and entities that manage investors' assets, like hedge funds or retirement investment managers, it would be the SEC's most overt effort to rein in them.

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Crypto exchange custody programs have been under threat from this move, as other federal regulators have actively encouraged custodians, such as banks, to refrain from holding cryptocurrencies for their customers. Also, the amendments come at a time when the SEC is aggressively accelerating the enforcement efforts it is undertaking.

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Although the amendment does not mention crypto companies, Gensler said in a separate statement, “though some crypto trading platforms claim to hold investors' crypto, that does not mean they are qualified custodians.”

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If a financial institution decides to custody any client asset - including crypto assets - following the new rules, it would need to have the right charters, qualify as a registered broker-dealer, a futures commission merchant, or be a certain kind of trust institution or foreign financial institution to be able to do so.

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Officials of the Securities and Exchange Commission (SEC) said that the proposal does not alter the requirements that must be met to become a qualified custodian and that there is nothing that prevents state-chartered trust companies, such as Coinbase or Gemini, from serving as qualified custodians.

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The official stressed the fact that the proposed amendments did not make a decision regarding which cryptocurrencies the SEC considered to be securities based on the proposed amendments.

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There will also be a requirement for a written agreement between custodians and advisors, as well as a requirement for an expanded "surprise examination" and enhanced recordkeeping requirements.

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Before now, the SEC had sought public feedback on whether crypto-friendly state-chartered trusts, like those in Wyoming, were “qualified custodians.”

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Gensler said in a statement that today's rule, the 2009 rule, covers a significant amount of crypto assets, and there should be no mistake about that. It is important to keep in mind that, as stated in the release, most crypto assets are likely to be funds or crypto asset securities that are covered by the current rules. Furthermore, even though some crypto trading platforms may claim custody of investors' coins, that doesn't make them qualified custodians.

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It was Gensler's proposal, however, that seemed to undercut comments from SEC officials, who insisted the move was designed with "all assets" in mind, as opposed to Gensler's proposal. There has been a spate of high-profile crypto bankruptcy filings in recent months, including those of Celsius, Voyager, and FTX, according to the SEC chair.

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“This is a new concept we have seen a lot of in recent years. Investors' assets have often become the property of failed companies as a result of these platforms going bankrupt, leaving investors in line at bankruptcy courts,” Gensler said.

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According to material released by the SEC on Wednesday, the proposed changes will also provide for the proper segregation of client assets, as well as the holding of those assets in accounts designed to protect those assets in the event of a qualified custodian bankruptcy or another insolvency, thereby protecting them.

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Coinbase already has an arrangement in place similar to this one. The exchange specified in its most recent earnings report that it keeps customer crypto assets "bankruptcy remote" from hypothetical general creditors but pointed out that since crypto assets are "novelty assets", there is a possibility that courts will not understand how to deal with them.

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Among the other lucrative revenue streams that crypto institutions like Coinbase are already targeting, the SEC is already targeting, which is the only publicly traded crypto exchange in the United States that is also a pure crypto exchange. SEC announced last week that it had reached a settlement with crypto exchange Kraken over its staking program, alleging that it was an unregistered offering and sale of securities.

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Brian Armstrong, the Coinbase CEO at the time, stated that the company would take a "terrible path" if it moved against staking.

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As of September 30, 2022, Coinbase reported $19.8 million in institutional transaction revenue, as well as $14.5 million in custodial fee revenue for the three months ending Sept. 30, 2022. Coinbase's institutional revenue for the same period of time accounted for about 5.8% of the $590.3 million in revenue that Coinbase generated for that same period. This percentage, however, does not include any revenues from blockchain rewards or interest income from institutional clients with whom the company has custody agreements.

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Grayscale Bitcoin Trust (GBTC), one of the largest bitcoin trusts in the world, for example, holds billions of dollars worth of bitcoin on Coinbase Custody, equating to about 3.4% of all bitcoins in May 2022. GBTC's relationship with Coinbase could be threatened if the proposed amendments are approved.

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Despite Coinbase Custody's qualified custodian status as a New York state-chartered trust, a person familiar with the matter is not expecting any adverse impact on the relationship, pointing out that investment advisors may even be able to transition from directly holding bitcoin to holding GBTC shares in the wake of the proposed amendments.

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Attempts to reach Coinbase representatives for comment did not result in a response within an hour.