Last week the US regulator said it was looking at tightening up the regulations around custodians, which would extend to custodians of virtual assets. The move comes in the wake of the FTX blow-up in November, and follows news that fund managers were also caught on the hop because of the way exchanges have historically held crypto assets.
The SEC wants to make sure that investments held in crypto assets are being properly protected by an independent custody regime. In the case of FTX this was not the case, with many fund managers holding millions in crypto assets on exchange when FTX blew up.
1. Investment advisers cannot currently rely on qualified custodians
There is currently a major crisis of faith at the SEC in the way crypto assets are currently custodied. This is why the majority of the SEC commissioners are behind the proposals. SEC chairman Gary Gensler has said that “based upon how crypto platforms currently operate, investment advisers cannot rely on them as qualified custodians.” In fact the co-mingling of custody with other activities on the part of many exchanges already rules them out as custodians under current rules.
2. Annual review regime on the cards
The new reforms will hit the relationship which fund managers have with exchanges. The Armchair Trader has spoken to a number cryptocurrency hedge funds that survived the FTX blow up. While many had exposure to FTX, they had limited the size of their portfolio that sat on one exchange and were also making active use of cold wallets. The new regime would require written agreements between funds and qualified custodians, plus annual evaluations from accountants, account statements, and easy access to records for the regulator.
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3. Will it create more fraud?
Bear in mind these reforms are more wide ranging and not aimed only at the crypto sector. Other alternative assets like art and real estate are being caught in the net. There has been some opposition: Republican Commission Hester Pierce has argued that restricting the number of legitimate custodians might force investors to store crypto assets in some less reputable corners of the market.
“If we had a better framework in the U.S. [for crypto], I think you would see more activity happening [here]. But now people have so many questions that a lot of stuff ends up happening outside of the United States. And that means that when U.S. persons participate, they won’t have the protection of the U.S. regulatory framework,” she has said.
4. Who will custody crypto assets?
Traditionally cryptocurrency exchanges have acted as custodians, and in the case of the majority of retail traders this has always been the case. Many investors are now making more use of off-exchange storage solutions following the FTX drama. Banks have complained that current SEC requirements make the holding of cryptocurrency too expensive. But Gensler says he is determined to bring crypto into line with the existing norms within the markets system. FTX seems to have given him the ammunition to do so.
5. Where to next?
The proposals are out for public comment although the SEC has said it is in favour of the changes. They will still require another vote before they can be finalised. They are unlikely to come into force until later this year. We have felt there was a major tightening up of regs around crypto for over a year now and FTX was symptomatic of the need for more investor protection, especially when it comes to providing the framework for more institutional participation in the market.
“Our view is that Gensler’s custody proposal today is just the latest example of his concerns in this space,” said prime broker Cowen & Co in a note to fund managers this week. “The goal is to require segregation of retail crypto assets to keep them bankruptcy remote and to prevent their misuse by the platform. We believe the agency is likely to bring numerous enforcement actions against stable coins, staking services, deposit products and custody services. The goal would be to fundamentally change how retail crypto assets are custodied in order to better protect retail investors from the failure of a platform or theft of assets.”
