The SEC has proposed a rule that could put other crypto platforms under pressure

As a result of the collapse of the trading platform FTX, Wall Street's regulator proposed a rule that could make it more difficult for many asset managers to invest their customers' money in cryptocurrency. The Securities and Exchange Commission voted 4-1 to expand the types of assets that investment advisers, such as hedge funds and pension funds, must hold using qualified custodians.

The proposal also includes new requirements for qualified custodians and acknowledges that certain characteristics of cryptocurrency may make them difficult to safeguard by the rules. The proposal would restrict how asset managers can handle their customers' crypto assets while imposing no new requirements on individual investors who manage their portfolios. Banks, trust companies, and broker-dealers are examples of qualified custodians. However, the peculiarities of keeping assets such as bitcoin safe from theft or hacking have led Coinbase Global Inc. and similar crypto platforms to begin offering the service in recent years.

SEC Chair Gary Gensler has stated repeatedly that crypto firms' custody practices may fail to clear the legal hurdles required to protect their customers' assets in the event of bankruptcy. "The current business model in cryptocurrency exchanges does not meet the qualified custodial standard," Mr. Gensler stated following the vote. He pointed out that investment advisers have already lost money as a result of the bankruptcies of Celsius Network LLC, Voyager Digital Ltd., and FTX because those companies mixed customer assets with their own. Thousands of institutional customers use its Prime platform to protect their assets, and the company is a qualified custodian.

Fees from custodial services totaled US$68.4 million in the first nine months of 2022, a 21% decrease from the previous year. Coinbase's chief legal officer, Paul Grewal, stated that the company is confident that its New York-chartered trust entity "will remain a qualified custodian." Coinbase states in its SEC filings that in the event of bankruptcy, customers whose crypto assets it holds "could be treated as our general unsecured creditors." Hester Peirce, the only SEC commissioner to vote against the proposal, said it could shrink the number of qualified custodians for crypto assets. "We may leave investors in crypto assets even more vulnerable to theft or fraud," she warned.

Prices for crypto stocks and currencies rose in tandem on Wednesday, indicating that investors were bracing for tougher rules, such as prohibiting crypto firms from using state-chartered trusts to protect assets from being qualified custodians. The SEC proposed the rule at the same time that it and other regulators are cutting off access to some products and services central to the digital-currency business. The SEC recently fined Kraken and forced it to discontinue offering a popular service known as staking to US investors.

It notified another cryptocurrency firm, Paxos Trust Co., of a potential enforcement action involving a dollar-pegged cryptocurrency the firm issues. The Federal Reserve warned banks in January not to get too involved in cryptocurrency. Platforms based in the United States, such as Coinbase, have argued that the digital tokens they allow investors to buy and sell and those they custody do not meet the definition of securities. This is a major point of contention with Mr. Gensler, who has stated that the vast majority of crypto tokens are securities.

Investment advisers are typically required by decades-old regulations to keep their customers' funds and securities with a qualified custodian. Some cryptocurrency platforms claim that the custody regulations do not apply to them. The proposed rule on Wednesday would broaden qualified-custodian requirements to include virtually any asset held in a client's name by an adviser, including all cryptocurrencies and even some physical assets such as artwork. Cryptocurrencies are frequently transferable by anyone with access to a "private key." As a result, according to the SEC's proposal, it may be more difficult for a custodian to demonstrate exclusive crypto control than traditional assets such as stocks and bonds.

Several executives from custody firms predicted that the proposed rules would eventually add new requirements for what it means to be an authorized custodian. They predict that some existing providers will choose not to stay in business. They also stated that the SEC's proposal may encourage investment firms to entrust their crypto assets to mainstream banks, despite that bank regulator scrutinizing crypto activities. Republican SEC Commissioner Mark Uyeda stated that the proposal raises concerns about whether an investment adviser looking to offer cryptocurrency could ever meet the regulatory requirements. Nonetheless, he applauded the decision to advance crypto policy through rulemaking rather than enforcement and voted in favor of the proposal.