The reason: without explicit rules from either federal securities or banking regulators, attorneys aren’t willing to tell any registered investment advisor it is on solid legal ground if it picks a Wyoming bank as its custodian for digital assets. Of course, neither will attorneys render any legal opinions verifying that any of the existing digital asset custodians meet the US Securities and Exchange Commission’s requirements to be classified as a qualified custodian.
Now making its way through Wyoming’s legislature, SF 125 is one of a handful of measures aimed at providing some clarity to the digital asset market and its service providers. Yet it is the one generating the most interest for institutional investors who want to be reassured that any custodian their fund selects is acceptable to the SEC.
Digital assets is a broad-reaching category covering everything from cryptocurrencies, such as Bitcoin, to initial token offerings. So far, the cryptomarket has been dominated by retail investors and active traders. Institutional investors — pension plans, endowments and insurance firms — have remained on the sidelines mainly due to market volatility and regulatory uncertainty. While there is no official count of what percentage of the growing cryptoasset market can be attributed to institutional investors, industry talk suggests it could be anywhere from 10 percent to 20 percent.
Most cryptofunds — the new buzzword for investment funds focused on investing in cryptoassets — have managed to fall outside the radar of the SEC simply because of their size. Because they often manage under US$150 million in assets, they don’t need to sign up with the SEC as registered investment advisors. As a result, many cryptofunds have resorted to self-custody of digital assets, which the SEC has publicly flagged as worrisome. Even funds with over US$150 million in cryptoassets have claimed that because the SEC has not classified cryptoassets as assets they don’t have to use a qualified third-party custodian.
That stance doesn’t always sit well with institutional investors who might consider taking the crypto-plunge if only an independent accredited custodian were involved. Therefore, if cryptofunds want to attract institutional investors they will ultimately need to address the regulatory challenge. Here is the problem: the SEC’s “custody rule” in the Investment Advisers Act of 1940 requires registered investment advisers to select a qualified custodian to safekeep their assets. A qualified custodian must fall under one of the following categories: a bank, a trust company, a financial commission merchant, a registered broker-dealer or a foreign financial institution.
On the surface, it would seem that current digital asset custody providers meet the SEC’s definition. Case in point: Kingdom Trust and BitGo fall under South Dakota’s law as trust companies while itBit and Coinbase fall under New York law as trust companies. So far, none of the brand-name mainstream custodians for equities, fixed-income instruments and and derivatives have launched services, despite plenty of talk about being interested. Wyoming’s proposed ed law “SF 125” would also suggest that a bank falling under the new rules might also make the SEC’s cut.
Might is the operative word. While promoters of Wyoming’s SF 125 and its other bills are eager to discuss specific details of the digital asset custody provision, they are also quick to sidestep any legal guarantees. “We have been careful not to say a Wyoming digital asset custodian would qualify as a qualified custodian under the SEC’s custody rule,” says Caitlin Long, co-founder of the Wyoming Blockchain Coalition. “We have only said that the SEC raised obvious issues and we addressed them in the proposed bills.”
So what does that mean? While non-committal, Long goes on to say that SF125 allows Wyoming banks to opt into an enhanced regulatory regime. “The only banks that will likely opt into this [enhanced regime] are banks that want to service institutional clients due to the enhanced costs,” says Long. That enhanced regulatory regime specifies investor protection measures such as segregation of customer assets and audits, but doesn’t mention anything about insurance from the Federal Insurance Deposit Corporation (FDIC).
It doesn’t have to, says Long. SF 125 allows any type of Wyoming bank to opt into the proposed enhanced custody regime including those that don’t have FDIC insurance. The digital asset custody service would be offered through the trust department of a Wyoming bank, not the bank itself. As a rule of thumb, digital assets or any other assets for that matter handled through the trust department of any bank are not considered deposit liabilities of a bank. Therefore, they are not insured by the FDIC. Neither the FDIC nor the Office of the Comptroller of the Currency has expressed any support for their chartered institutions becoming deeply involved in the cryptobusiness although some banks have been servicing wealthy clients in connecting with crypto-transactions out of their private bank operations. Still, their services do not include custody for cryptocurrencies.
So who does the Wyoming legislation really help out? Newcomers to the digital asset custody market who might be willing to forgo RIAs as clients. Why? “Registered investment advisers still need to evaluate whether their digital asset custody providers meet the SEC’s definition of qualified custodian,” says Richard Levin, a partner in the law firm of Polsinelli in Washington, D.C and Denver. “While the states are adopting laws and rules to promote the development of digital assets and blockchain technology there are questions about how the SEC’s custody rule will be applied.”
The SEC’s “custody rule” doesn’t appear to explicitly require that a bank selected by an RIA fall under FDIC insurance. Since a bank’s trust functions are not backed by the FDIC, it might ultimately be up to the SEC to clarify whether SF 125 fulfills the requirements of its “custody rule.” Levin has separately filed two petitions to the SEC on behalf of his client Templum Markets, a New York-based operator of an alternative assets trading platform, seeking clarity on the regulation of digital assets and the regulation of custodians, clearinghouses and transfer agents for digital assets.
Do digital asset custodians which have accreditation as trust banks have a leg up on a Wyoming accredited bank for digital asset custody? Not exactly. “The SEC has not explicitly said whether any of those other digital asset custodians meet its definition,” explains Daniel Alter, a partner with the law firm of Murphy & McGonigle in New York. However, as Alter notes, it stands to reason that practically speaking financial institutions with New York trust licenses might fare better — as in attract more registered investment advisers — than those with a Wyoming license because of the New York Department of Financial Services’ track record of strict oversight. Wyoming still needs to prove the same, according to Alter who was once the general counsel at New York’s DFS.
Even if Wyoming doesn’t solve that question of whether its digital asset custody rules will be blessed by the SEC as meeting the definition of a qualified custodian, the state’s pending legislation tries to close another key shortcoming at the federal level. That is the lack of a clear definition of whether digital assets are actually assets. The legislation– SF125– appears to define those assets in the categories of virtual currencies, digital securities and digital consumer tokens. It also outlines what investors have to do to “perfect their interests” in each category. That means how investors have to do to prove they owned the assets in the event of the digital asset custodian’s bankruptcy.
Wyoming doesn’t allow for the rehypothecation of assets and the wind-up procedures for banks are much clearer than they are for trust companies, claims Long in suggesting that Wyoming’s law for digital asset custodians would offer investors greater protection than New York’s trust law. None of the other attorneys who spoke with FinOps Report either on or off the record would offer their opinions. “We’re in untested waters,” was all one would say.
Ultimately, at the very least Wyoming has put itself on the map of US states — and some countries — that are trying to establish themselves as financial hubs for blockchain service providers. Mauritius has just laid claim to being the first to set operational and capitalization rules for digital asset custodians. The devil is in the details on how successful Wyoming will be in achieving that goal. At this point, all legal experts can agree on is that institutional investors would be best served to evaluate the capitalization of any Wyoming bank involved in digital asset custody as well as the rigor of the state’s regulatory regime. The SEC declined to respond to questions posed by FinOps Report on Wyoming’s law or any interpretations of its “custody rule.”