Alternative Investment

New Crypto Custody Rules?

What’s being proposed and what it could mean for RIAs and crypto

Registered investment advisors, take note: Amendments to the U.S. Securities and Exchange Commission (SEC) “2009 Custody Rule” appear to be headed your way – with the potential to complicate things for your business in the very near future.

The amendments aim to strengthen safeguards around custody of client assets, crypto in particular. To that end, the proposed new rule would mandate RIAs to store digital assets only with a “qualified custodian” and not on crypto platforms per common practice.

What’s a qualified custodian, you ask? Generally speaking, the SEC defines it as any entity that falls into one of these five categories:

• federal or state-chartered bank or savings associations
• trust companies
• registered broker-dealers
• registered futures commission merchants
• foreign financial institutions

That definition essentially disqualifies any RIA not registered as an exchange or bank, domestic or otherwise.

It would also require U.S. and offshore firms to jump through extra hoops to become qualified custodians. At a minimum, unqualified custodians would need to segregate all custodied assets, not just cryptocurrencies, and submit to annual audits from public accountants to ensure transparency.

What sparked these actions? Under the 2010 Dodd-Frank Act, the SEC has the power to propose the new rule, spurred in part by the FTX collapse and increased scrutiny of crypto platforms.

What are the chances the SEC will greenlight this new rule? While the proposal moved ahead after a 4-1 vote in mid-February, it’s not yet in force. And it has its detractors, among them SEC Commissioner Hester Peirce who said the proposal “seems designed for immediate effect” to dismantle the crypto industry.

“These statements encourage investment advisers to back away immediately from advising their clients with respect to crypto,” Peirce said.

She found flaws in the proposal, including the one-year deadline it would impose on RIAs to implement the changes. She also feels it would unfairly impact many entities that already have measures in place to guard against data breaches. And she points out it could drive crypto investors away – or backfire altogether.

“By insisting on an asset-neutral approach to custody we could leave investors in crypto assets more vulnerable to theft or fraud, not less,” Peirce said.

What to watch for next. Any SEC proposal of this scale must undergo a 60-day comment period once it’s published in the Federal Register. And that will almost surely turn the tables, subjecting the proposed rules to harsh scrutiny from the crypto industry.

Once the 60-day comment period ends, the SEC feedback review begins, a process likely to take months. A revised draft of the rule and another round of voting would follow.

Note: This is not the first time the SEC has put custody issues up for public commentary. The last came in 2020 and netted no official policy changes. Have questions this blog post hasn’t answered? Email Richey May Alternative Investments Partner Steve Vlasak.