SEC proposal could prevent investment advisers from keeping assets with crypto firms

The US Securities and Exchange Commission (SEC) is set to propose a rule that would effectively require registered investment advisers to step outside the crypto industry to store digital assets, under its first formal policy push that leans heavily into the cryptocurrency sector.

The rule, which was slated for proposal by the SEC on Wednesday, would expand the agency’s existing rules that say an investment adviser must hold clients’ money and securities with a “qualified custodian.” The new version, if approved, will increase the protection requirement for all assets entrusted to investment advisers – including crypto.

Right now, crypto trading and lending platforms routinely offer custody for crypto clients, but they are not “eligible custodians” under this rule. An appropriate custodian under the SEC’s regulations will generally mean a chartered bank or trust company, a broker-dealer registered with the SEC or a futures commission dealer registered with the Commodity Futures Trading Commission (CFTC).

Although officials said the rule was not specific to crypto, the industry featured heavily in formal comments previewing it. “Make no mistake: Based on how crypto platforms generally work, investment advisors have

cannot rely on them as qualified fiduciaries,” SEC Chairman Gary Gensler said in a statement. “While some crypto trading and lending platforms may claim to deposit investors’ crypto, that does not mean they are qualified custodians.”

Aside from requiring investment advisers to trust only regulated financial institutions with clients’ money — mostly leaving crypto businesses on the outside — the SEC’s proposal also says the qualified custodians would be subject to independent audits, regular disclosures and would have to segregate client assets into accounts under the customers’ identity.

Gensler’s agency is exercising a power granted under the 2010 Dodd-Frank Act, an overhaul of the regulatory landscape that was ushered in after the last major financial collapse. SEC officials said the agency has been working on this proposal for a long time, not in response to any of crypto’s recent spectacles, although the SEC has reportedly been looking into crypto custody issues recently.

“Instead of properly segregating investors’ crypto, these platforms have commingled these assets with their own crypto or other investors’ crypto,” Gensler said. “When these platforms go bankrupt – something we’ve seen time and time again recently – the investors’ assets have often become the property of the failed company, leaving the investors in line at the bankruptcy court.”

When asked if the regulator had collected any data to illustrate the extent of digital assets linked to registered investment adviser clients, officials at the agency said they had not. They could only confirm that advisors represent a portion of the assets now held at crypto firms.

So the actual effect of the proposal is not clear. If eventually approved as an official rule, it may not significantly change the industry’s standing with the US securities regulator, which already considers the sector’s trading platforms to be generally out of compliance.

In some ways, Gensler’s own crypto-rhetoric makes this proposal less dramatic. The SEC chairman is already saying that most tokens are securities that should be registered. Under the existing rules for investment advisers, securities must already be in the hands of “qualified custodians.” So in Gensler’s view, the current standards already affect the vast majority of digital assets.

If he’s right, this audit effort just comes in and makes sure no crypto assets are left out.

The latest proposed rule leaves some questions about the role of companies like Anchorage Digital, which is a crypto-oriented trust regulated by the Office of the Comptroller of the Currency (OCC), or state-chartered institutions like those in Wyoming. SEC officials said that as long as a company can meet a list of requirements, it can seek to act as a qualified custodian.

Proposed rules do not always succeed. The agency is planning a 60-day comment period where the crypto industry is sure to make itself heard. The SEC will have to review and consider outside submissions, which is usually a months-long process.

The SEC has sought public input on custody issues before, such as a request for comment in 2020 after Wyoming said a state-regulated entity could be a qualified custodian. No formal guidelines were proposed at the end of the comment period.