SEC proposes tougher rules as part of its crypto custody crackdown

The new proposals set forth by the Gensler-led SEC seek to “expand the scope” of rules set out by the 2009 Custody Rules.

A five-member panel of the United States Securities Exchange Commission (SEC) has voted 4-1 in favor of a proposal that may make it more difficult for cryptocurrency firms to serve as digital asset custodians in the future.

The proposal, which is yet to be officially approved by the SEC, recommends amendments to the “2009 Custody Rule” will apply to custodians of “all assets” including cryptocurrencies, according to a Feb. 15 statement from SEC Chairman Gary Gensler.

Gensler stated that currently, some crypto trading platforms that are offering custody services are not actual “qualified custodians.”

According to the SEC, a qualified custodian is generally a federal or state-chartered bank or savings association, trust company, a registered broker-dealer, a registered futures commission merchant, or a foreign financial institution.

In order to become a “qualified custodian” under the newly proposed rules, U.S. and offshore firms would additionally need to ensure that all custodied assets — including cryptocurrencies — are properly segregated, while these custodians will be required to jump through additional hoops such as annual audits from public accountants, among other transparency measures.

We @SECGov just proposed to expand & enhance the role of qualified custodians when registered investment advisers custody assets on behalf of investors.

Thru our rule, investors would get the time-tested protections—and qualified custodians—they deserve.

What does this mean? ⬇️ pic.twitter.com/RerUGnpArI

— Gary Gensler (@GaryGensler) February 15, 2023

While Gensler said these amendments would “expand the scope” to all asset classes, he specifically took a shot at the crypto industry:

Make no mistake: Today’s rule, the 2009 rule, covers a significant amount of crypto assets. [...] Further, though some crypto trading and lending platforms may claim to custody investors’ crypto, that does not mean they are qualified custodians. Rather than properly segregating investors’ crypto, these platforms have commingled those assets with their own crypto or other investors’ crypto.

“When these platforms go bankrupt—something we’ve seen time and again recently—investors’ assets often have become property of the failed company, leaving investors in line at the bankruptcy court,” the SEC Chairman added.

Gensler also pointed to the industry's track record to suggest that few crypto firms would be reliable enough to serve as qualified custodians:

Make no mistake: Based upon how crypto platforms generally operate, investment advisers cannot rely on them as qualified custodians.

However, not every SEC member is on board with Gensler’s plans.

Commissioner Hester Peirce’s statement in response to the proposed rule changes on investment adviser custody set out by SEC Chairman Gary Gensler. Source: SEC.

While the proposal isn’t “regulation by enforcement” per se, Commissioner Hester Peirce said “the latest SEC statement seems designed for immediate effect” to take down the crypto industry:

Such sweeping statements in a rule proposal seem designed for immediate effect, a function proposing releases should not play. These statements encourage investment advisers to back away immediately from advising their clients with respect to crypto.

As for the proposal itself, Peirce believes it would do more harm than good.

She explained that such stringent measures will force investors to remove their assets from entities that have developed sufficient safeguarding procedures to mitigate and prevent fraud and theft:

The proposal would expand the reach of the custody requirements to crypto assets while likely shrinking the ranks of qualified crypto custodians. By insisting on an asset neutral approach to custody we could leave investors in crypto assets more vulnerable to theft or fraud, not less.

As for the next steps, Peirce noted the agency will soon schedule in a 60-day comment period once the proposal has been published in the Federal Register.

However, the commissioner is concerned that this timeframe isn’t sufficient to allow the public to analyze all aspects of the proposal.

Those who voted in favor of the proposal are hoping to implement the new rules within 12-18 months, according to Peirce, adding that it was an "aggressive timeline" given the changes being proposed