What do the newly passed custody rules mean for crypto institutions as U.S. regulators tighten their grip again?
After the collapse of FTX, the U.S. SEC has been tightening its regulation of cryptocurrency institutions step by step...Author: Nianqing, ChainCatcher
On February 15 local time, the U.S. Securities and Exchange Commission (SEC) voted 4 to 1 to approve a proposal regarding Proposed Rules Regarding Investment Adviser Custody, which will expand the types of assets that investment advisers, such as hedge funds and pension funds, must hold with qualified custodians, aiming to raise the threshold for improper use and abuse of client assets by investment advisers.
The Wall Street Journal commented that this proposal could make it more difficult for asset management firms to invest client funds in cryptocurrencies. So what potential impacts does the proposal have on crypto custody institutions?
Specifically, the proposal covers all asset classes that advisers may custody, such as privately issued securities, real estate, and derivatives, of course including all crypto assets, with the key points as follows------
- First, the proposal requires advisers to properly segregate their investors' assets and obtain reasonable assurances from qualified custodians. Under current rules, specifically the 2009 rules, advisers and qualified custodians must separate investors' funds and securities, while today's proposal will extend these protections to all assets. Additionally, advisers will need to use qualified custodians that provide bankruptcy protection;
- Second, the proposal requires advisers and qualified custodians to enter into written agreements for the first time to help ensure the protections of custodians. The written agreements will include, among other requirements, that qualified custodians accept annual assessments by public accountants, provide account statements, and supply records upon request.
- The proposal will raise the requirements for foreign financial institutions acting as qualified custodians or sub-custodians. These new requirements for foreign financial institutions will explicitly include, among other things, provisions for segregation and bankruptcy protection. These enhanced requirements will help ensure that advisers fulfill their obligations to investors—regardless of where the qualified custodians or sub-custodians are located.
- The proposal will clarify that the safeguards of custody rules apply to discretionary trading—when advisers seek to buy and sell assets on behalf of investors. This indicates that advisers trading investor assets cannot evade custody rules and the protections they provide.
SEC Chairman Gary Gensler specifically emphasized that the current rules (i.e., the 2009 rules) cover a significant amount of crypto assets. However, despite some cryptocurrency trading and lending platforms claiming to custody investors' cryptocurrencies, it does not mean they are qualified custodians; some platforms do not properly segregate investors' cryptocurrencies but instead mix client assets. The custody practices of crypto companies may not clear the legal hurdles necessary to ensure the safety of client assets in the event of bankruptcy. Through this expanded custody rule, investors working with advisers will receive the protections their assets (including crypto assets) deserve.
Although the proposal was ultimately passed by the SEC vote, the SEC commissioner known as "Crypto Mom," Hester M. Peirce, cast the sole dissenting vote, expressing her concerns in a speech------
Requiring custodians to enter into written agreements and provide the necessary reasonable assurances may be difficult for advisers and costly for clients. Small advisers may find it challenging to comply with these requirements. Additionally, regarding the "requirement for qualified custodians to obtain internal control reports," very few custodians can submit reports that meet the new rule's standards, making it difficult for qualified custodians to obtain these reports. The proposed discretionary trading custody method, whether based on delivery versus payment ("DVP") or non-DVP settlement, may pose significant challenges.
Furthermore, the proposal will expand the scope of custody requirements to crypto assets, which may narrow the pool of qualified crypto custodians. Adhering to an asset-neutral custody approach is likely to make crypto asset investors more susceptible to theft or fraud, rather than less. Finally, Hester mentioned that she does not agree with the rule classifying most crypto assets as securities, believing such a blanket statement seems to aim for a "full jurisdiction" strategy over crypto.
If these concepts are not clarified and the proposal is enacted immediately, it is highly likely that investment advisers will promptly abandon providing advice to clients regarding cryptocurrencies. She also noted that while the intentions are good, for investors, some mandatory costs may outweigh the benefits. Because custodians and investors themselves will set fees based on the risk and liability allocation agreed upon by both parties, once "rules" are incorporated into this private business relationship, requiring custodians to protect investors according to SEC's high standards may indirectly raise costs for investors.
In interviews with the Wall Street Journal, several executives from custody firms predicted that the proposed rules would ultimately add new requirements for becoming authorized custodians, and some existing providers might choose not to continue operating. Additionally, the SEC's proposal may encourage investment firms to entrust their crypto assets to mainstream banks, even as banking regulators are reviewing crypto activities.
It is reported that after the SEC commissioners voted to approve this proposal, the SEC will also publicly solicit opinions from the public and then conduct another vote a few months later before finalizing it.
