The SEC is proposing a rule that may tighten restrictions on crypto custody

The Securities and Exchange Commission voted 4-1 on Wednesday to propose sweeping changes to federal regulations that would extend custody rules to assets like crypto and require companies to obtain or maintain registration to hold those client assets.

The proposed changes to state custody rules would “broaden the scope” to include all client assets held in custody by an investment adviser. Current federal regulations only cover assets such as funds or securities and require investment advisors such as Fidelity or Merrill Lynchhold those assets with a federal or state bank, with a few very specific exceptions.

It would be the SEC’s most blatant attempt to curb even regulated crypto exchanges that have extensive institutional custodial programs that serve high net worth individuals and companies that hold investor assets such as hedge funds or annuity managers.

The move poses a new threat to crypto exchange custodial programs as other federal agencies actively prevent custodians such as banks from holding clients’ crypto assets. The changes also come as the SEC is aggressively accelerating enforcement attempts.

While the change does not specify crypto companies, Gensler said in a separate statement that “although some crypto trading and lending platforms may claim to custodian investors’ crypto, it does not mean they are qualified custodians.”

Under the new rules, in order to hold client assets — including and specifically crypto — an institution would need to hold deeds or qualify as a registered broker-dealer, futures commission dealer, or be some type of trust or foreign financial services institution, under the new rules.

SEC officials said the proposal would not change the requirements for a qualified custodian and that nothing precludes state-licensed trust companies, including coin base or twins, prevented from acting as qualified administrators.

The officials emphasized that the proposed changes do not make a decision on which cryptocurrencies the SEC considers to be securities.

The amended regulation would also require a written agreement between custodians and advisers, expanding “surprise audit” requirements and improving record-keeping rules.

The SEC previously solicited public feedback on whether crypto-friendly state-chartered trusts like the one in Wyoming are “qualified custodians.”

“Make no mistake: Today’s rule, the 2009 rule, covers a significant amount of crypto assets,” Gensler said in a statement. “As per the press release, most of the crypto assets are likely to be funds or crypto asset securities that fall under the current rule.” Although some crypto trading and lending platforms claim custody of the crypto from investors does not mean that they are qualified custodians.”

But Gensler’s proposal appeared to undermine comments from SEC officials, who insisted the moves were designed with “all assets” in mind. The SEC chairman alluded to several high-profile crypto bankruptcies in recent months, including those of Celsius, Voyager, and FTX.

“When these platforms go bankrupt — something we’ve seen a lot lately — investors’ assets have often become the property of the failed company, leaving investors queuing up in bankruptcy court,” Gensler said.

The changes proposed by the SEC are also intended to “ensure that client assets are properly segregated and held in accounts designed to protect assets in the event of a qualifying custodian bankruptcy or other insolvency,” according to material released by the agency Wednesday.

Coinbase has already reached a similar agreement. In its most recent earnings report, the exchange said it kept client crypto assets “away from hypothetical general creditors,” but noted that the “newness” of crypto assets meant it was uncertain how courts would treat them.

The SEC has already started targeting other lucrative revenue streams for crypto institutions such as Coinbase, which is the only publicly traded crypto-only exchange in the US and does not offer and sell securities.

At the time, Coinbase CEO Brian Armstrong said that a possible move against staking would be a “terrible path” for consumers.

Coinbase reported $19.8 million in institutional transaction revenue and $14.5 million in custody fee revenue for the three months ended September 30, 2022. Collectively, these institutional revenues accounted for about 5.8% of Coinbase’s $590.3 million in revenue for the same period. However, this percentage does not include income from blockchain rewards or interest income from institutional custodial clients.

“Coinbase Custody Trust Co. is already a qualified custodian and after listening to today’s SEC meeting we are confident that we will remain a qualified custodian even if this proposed rule is implemented as proposed,” said Paul Grewal, Coinbase’s Chief Legal Officer. “We agree on the need for consumer protection – as a reminder, our client assets will be segregated and protected in any event.”

Grayscale Bitcoin Trust (GBTC), for example, holds billions of dollars worth of bitcoin with Coinbase Custody and held around 3.4% of the world’s bitcoin as of May 2022.

After the SEC’s approval vote, comments from commissioners made it unclear what the full extent of the SEC’s proposed rulemaking would be and how it might affect existing partnerships. Grayscale is not a Registered Investment Adviser and therefore would not appear to have a material impact on its Custody Arrangement under the proposed changes.

A person familiar with the matter did not expect the relationship to be adversely affected, noting Coinbase Custody’s qualified custodian status as a trust chartered by the State of New York, and noting that investment advisers have moved from directly holding Bitcoin to owning GBTC as a result -Shares could deviate from the proposed changes.

Within the Commissioner’s ranks there were disagreements and questions about the nature of the proposed rules. “The proposed disclosure goes to great lengths to paint a ‘no-win’ scenario for crypto assets,” said SEC Commissioner Mark Uyeda. “In other words, an advisor can hold crypto assets with a bank, but banks are warned by their regulators not to hold crypto assets.”

But Uyeda also noted that the proposal is more of a step toward rulemaking than what he called a historic use of “enforcement action to introduce novel legal and regulatory theories.”

It was a sentiment shared by Coinbase’s Chief Legal Officer who stressed the need for clarity, a fanfare that has echoed across the industry. “We encourage the SEC to begin the rulemaking process on what should and should not be considered crypto-collateral, especially given that today’s proposal recognizes that not all crypto assets are securities. Rulemaking on this issue could bring the clarity that consumers, investors and the industry need,” Grewal said.

– CNBC’s Kate Rooney contributed to this report.

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