SEC: Clear Path For Crypto Asset Custody?

The US Securities and Exchange Commission’s decision last year to fine Galois Capital for violating its custody rule as well as potential changes to that regulation under the new crypto-friendly Trump administration are fueling speculation about whether one of the critical stumbling blocks to the institutionalization of the crypto asset market– the safekeeping of crypto assets– can be overcome.

“Fund managers and crypto custodians are hoping that the changing of the guard in Washington, DC., and the SEC this year could make it easier for institutional investors investing in crypto assets to determine where to custody those assets in line with the SEC’s expectations,” says David Adams, a partner in the law firm of Mintz in Washington DC. Institutional momentum has ensured North America’s dominance in the global crypto market with an estimated US$1.3 trillion in on-chain value between July 2023 and July 2024, according to research firm Chainanalysis.

One of the clear signs institutional investors are taking over the top spot once held by retail investors is the surge in Bitcoin-based exchange-traded funds with BlackRock’s recent entry as a certain game-changer. In addition to cryptocurrency Bitcoin, common crypto assets include cryptocurrency Ethereum, stablecoin USDC, and investment token DAI.

With trading volume soaring in crypto assets, so comes the need for safeguarding assets. While retail investors might rely on hardware wallets, institutional investors are required to have more security. Under the custody rule, a provision of the Investment Advisers Act of 1940, RIAs must use a qualified custodian to safekeep their investors assets, but there is ambiguity over which crypto assets are affected, and which provider meets the criteria for the role. “If fund managers can’t find a qualified custodian for crypto assets they won’t invest, leaving institutional investors out in the cold,” says Michael McDonald, an attorney focused on investment fund regulation at Davis Wright Tremaine in Washington, D.C. Another option, warn other legal experts, is that fund managers trading in crypto assets will try to fly under the SEC’s radar by not meeting the litmus test for registration by value of assets.

The tide appears to be changing in favor of the crypto market with pro-crypto market attorney Paul Atkins tapped to step in later this year as the SEC’s chief to fulfill President Donald Trump’s campaign promise of positive change for the industry. On January 21, new acting SEC Commissioner Mark Uyeda assigned his former colleague SEC Commissioner Hester Peirce to create a task force to provide more regulatory certainty for crypto assets as opposed to governing by enforcement practiced under the regime of former SEC Commissioner Gary Gensler. He resigned as soon as President Trump officially took office on January 20 amidst sharp criticism for his anti-crypto tenure which targeted crypto exchanges for allegedly selling securities without being registered as a broker-dealer. Among those is Coinbase, which also claims to be the US’ largest custodian for crypto assets.

Two days after Uyeda’s decision, President Trump issued an executive order calling for a task force to promote the development of the crypto asset market in sharp contrast to the Biden administration’s goal to protect investors from fraud. Fund managers and banks quickly breathed a sigh of relief that same day when the SEC rescinded a 2022 staff accounting bulletin. Rule SAB 121 would have forced custodians of crypto assets to list them on their balance sheets as liabilities using their fair market values. In addition, custodians would need to disclose the technological, legal, and regulatory risks associated with safeguarding crypto assets. The new requirements marked a stark departure from the current off-balance sheet treatment of custodied assets.

“SAB 121 made it cost-prohibitive for traditional banks to provide custody services for crypto assets, whereas SAB 122 gives them more flexibility,” explains Colleen Corwell, head of US financial services compliance and regulation in New York for Kroll, a global risk management and advisory firm. SAB 122, which replaces SAB 121, permits financial firms holding crypto assets to use US generally accepted accounting principles or international accounting standards to decide whether to include a crypto asset as a liability on their balance sheets based on whether a financial loss will occur and whether they can calculate the loss.

The SEC’s move to grant Bank of New York an exemption from SAB 121 was also met with criticism from rivals for its lack of transparency leaving them uncertain of how to expand into the lucrative crypto asset market dominated by crypto-centric players such as Coinbase, BitGo, Gemini and Anchorage Digital. However, even if the pool of crypto asset custodians expands thanks to SAB 122, fund managers must still worry about whether previously proposed changes to the custody rule floated in 2023 will be implemented.

On February 4 Commissioner Peirce publicly announced she wants to work with registered investment advisers to find a feasible solution to what she and others in the crypto market, including acting SEC chair Uyeda, criticized as unfeasible amendments to the current custody rule. The proposed new custody rule, coined the safeguarding rule, would sweep all crypto assets under a broader category of affected assets regardless of whether fund managers think they are securities or funds. Although the amendments to the custody rule are supposed to be asset-neutral, the SEC mentioned crypto assets over 200 times in the proposing release leading the crypto asset industry to believe the safeguarding rule targeted the new alternative market.

The SEC’s first enforcement action involving violations of the current custody rule affecting digital assets came in September 2024 with its US$220,000 penalty against private fund adviser Galois for not selecting a qualified custodian for its crypto assets. A prominent player in the crypto hedge fund sector, the defunct Galois was co-founded by Kevin Zhou who was well-known for his contrarian market bets. Although the penalty also reflected unclear redemption policies, it is the fine for Galois’ loss of US$40 million or half of the value of its assets in the collapse of its custodian, exchange FTX Trading, that prompted the most attention. It showed the SEC remained fixated on the idea of crypto assets falling into the category of securities and funds.

Even if the new safeguarding rule isn’t adopted, the SEC’s stance against Galois might prompt fund managers to always select a qualified custodian for their crypto assets rather than worry about getting second guessed by the SEC. Given the number and variety of crypto assets fund managers could still face a hard time finding a qualified custodian to accommodate all of them.

The possible requirement under the proposed new safeguarding rule that a qualified custodian have exclusive “possession or control” of a fund manager’s assets to participate in any change in beneficial ownership will also make the decision on a service provider that much harder. Unlike stocks and bonds, crypto assets are held on a blockchain ledger and transfer of ownership is done through digital wallets. Access to the crypto wallets occurs through private keys– actually secret codes– and those keys are typically held by multiple parties, including the custodian. The keys are typically held in several shards or pieces. Therefore, passing the new litmus test of exclusive possession or control of assets might be impossible.

Legal experts specializing in crypto assets, who spoke to FinOps Report, say that should the proposed new safeguarding rule be resurrected for review, one or both of two alternative approaches would be ideal. The first relates to the categories of financial institutions which could be classified as qualified custodians; the current custody rule allows certain US banks, broker-dealers, futures commission merchants, and foreign financial institutions to take on the role. The second approach would allow fund managers to act as their own custodians for their crypto assets. “The crypto asset industry needs confirmation that state-chartered limited trust companies and other market participants are qualified custodians as well as whether self-custody is permitted,” says Mintz’s Adams.

Coinbase and most of its rivals operate under state trust licenses. Anchorage Digital is the only crypto asset custodian which is a federally chartered bank operating under the purview of the Office of the Comptroller of the Currency (Anchorage Digital says it does not report to the SEC). While the SEC’s current custody rule suggests that state-chartered limited trust companies meet the definition of a qualified custodian because they act similar to banks, former SEC Chairman Gensler didn’t think so. The possible reason– they cannot meet the test of having fiduciary powers, the way national banks do. The 1940 Advisers Act exempts from the definition of a bank a firm operating solely for the purpose of evading the requirements of the act.

Fund managers are also hoping the SEC makes an exemption for crypto assets if a fund manager cannot find a suitable qualified custodian. The rationale is that the current custody rule already has an exemption for privately- held securities under certain circumstances, so why not do the same for crypto assets. “There is no reason why the SEC could not adopt a similar exemption to permit self-custody for crypto assets subject to certain enhanced controls which could include an independent auditor to monitor and verify on-chain transactions involving the wallets holding the self-custodied assets,” writes the law firm of Wilkie Farr & Gallagher in a recent article.

It remains to be seen whether even a crypto-enlightened SEC would feel an adviser’s fiduciary duty would be enough to look after a client’s assets. Relying on a self-custody approach may also not be feasible. Technological difficulties aside, fund managers would still be subject to substantial liabilities. “A fund manager could end up either accidentally losing a private key or even absconding with client assets if protections are not in place,” explains Adams. As a result, only the largest fund managers would consider such an idea so third-party custody might remain the norm. What’s more, say some legal experts, it is unclear whether self-custody could meet the definition of possession or control if an independent auditor were needed to monitor and verify on-chain transactions. The auditor would presumably need access to the private key governing the wallet holding the self-custodied assets.

Regardless of what happens to the custody of digital assets two outcomes are certain. The first is that a decision will likely be made this year. A task force established by President Trump’s executive order has set a series of deadlines the first of which is 30 days from its launch to decide whether to keep or change current regulations. “The quick timetable indicates the lightning speed of the decision-making process for a quick resolution,” says Kroll’s Corwell.

The second outcome is that easing the requirements for qualified custodians could also prompt more competition as new entrants to the market emerge. With competition comes some hard choices in deciding which provider is best. Cost and security will likely be critical factors in picking a crypto asset custodian, but there is no guarantee that assets will remain safe.

The question then remains as to whether the new SEC would penalize a fund manager for any losses it incurred using a qualified custodian as a violation of its new safekeeping rule even if the fund manager made its decision based on a best effort. Fund managers active in the crypto asset market likely want a safe haven. Hopefully, they will have an answer sooner than later or worse after the fact– an enforcement action.