The Breakdown - Why the Newly Proposed Custody Role Could Represent a De Facto Ban on Crypto

Episode Date: February 18, 2023

On this edition of the “Weekly Recap,” NLW looks at the newly proposed custody rule from the Securities and Exchange Commission. While the rule has broader implications other than crypto, many in the crypto industry are concerned that Chairman Gary Gensler may use the rule as a roundabout way to expand the SEC’s jurisdiction and therefore cut investment advisers off from the crypto industry.  Enjoying this content?   SUBSCRIBE to the Podcast Apple:  https://podcasts.apple.com/podcast/id1438693620?at=1000lSDb Spotify: https://open.spotify.com/show/538vuul1PuorUDwgkC8JWF?si=ddSvD-HST2e_E7wgxcjtfQ Google: https://podcasts.google.com/feed/aHR0cHM6Ly9ubHdjcnlwdG8ubGlic3luLmNvbS9yc3M=   Join the discussion: https://discord.gg/VrKRrfKCz8   Follow on Twitter: NLW: https://twitter.com/nlw Breakdown: https://twitter.com/BreakdownNLW c - “The Breakdown” is written, produced and narrated by Nathaniel Whittemore aka NLW, with editing by Michele Musso and research by Scott Hill. Jared Schwartz is our executive producer and our theme music is “Countdown” by Neon Beach. Music behind our sponsor today is “Foothill Blvd” by Sam Barsh. Image credit: A Mokhtari /Getty Images, modified by CoinDesk.  Join the discussion at discord.gg/VrKRrfKCz8.   Join the most important conversation in crypto and Web3 at Consensus 2023, happening April 26-28 in Austin, Texas. Come and immerse yourself in all that Web3, crypto, blockchain and the metaverse have to offer. Use code BREAKDOWN to get 15% off your pass.  Visit consensus.coindesk.com.  

Welcome back to The Breakdown with me, NLW. It's a daily podcast on macro, Bitcoin, and the big-picture power shifts remaking our world. The Breakdown is produced and distributed by CoinDes. What's going on, guys? It is Saturday, February 18th, and that means it's time for the weekly recap. Before we dive in, a quick note, there are two ways to listen to The Breakdown. You can hear us on the CoinDesk podcast network feed, which comes out every afternoon alongside other great Coin desk shows, or you can listen on the breakdown only feed, which comes out a few hours later in the evening. Wherever you're listening, I would so appreciate it if you would take

the time to leave a rating or a review. It makes a huge difference. All right, friends, welcome back. I hope you are having a great weekend so far. This was one of those weeks that was so full of news that I have to use the weekly recap slot to catch up on one of the most consequential bits of news that I just didn't have a chance to cover yet. And this one once again involves the SEC, so that's where we're going to focus today. On Wednesday, the SEC proposed a rule which would effectively require registered investment advisors to go outside the crypto industry for their custody solution. The rule, if approved, would limit crypto custody to being provided by a qualified custodian. Current rules only apply to cash and securities, but would be extended to cover all

assets. So hedge funds, pension funds, and some venture capital firms would be required to comply with these new rules as registered investment advisors. Currently, exchanges and dedicated crypto custodians provide most of the custody in the industry. The proposal from the SEC was not subtle in pointing out the intention to cut these firms off from providing this service. In a statement, Chair Gary Gensler said, Make no mistake. Based upon how crypto platforms generally operate, investment advisors cannot rely on them as

qualified custodians. Though some crypto trading and lending platforms may claim to custody investors' crypto, that does not mean they are qualified custodians. end quote. It's unclear how many firms would be able to register with the SEC as qualified custodians. Some dedicated custody firms such as Anchorage Digital already are registered, in their case with the Office of the Comptroller of the Currency, while other firms hold state trust bank charters with crypto-friendly jurisdictions like Wyoming. Existing qualified custodians for cash and securities are generally banks or other large financial services providers. One stated purpose of the rule

is to ensure that crypto firms who custody customer assets do so with a higher standard of investor protection. A key requirement of a designated custodian is to hold customer assets in a segregated and individually identifiable account. Gensler said, rather than properly segregating investors' crypto, these platforms have commingled those assets with their own crypto and other investors' crypto. When these platforms go bankrupt, something we've seen time and again recently, investors' assets often have become property of the failed company, leaving investors in line at the bankruptcy court. Commissioner Hester Perse was the sole dissenter and explained her myriad of objections in a statement, saying that the implementation period of one year was too short

to allow existing firms to adjust, that there was an underlying assumption that crypto assets were securities and hence within the SEC's jurisdiction. Purses wrote, the commission does not have the authority to regulate custodians directly, but we propose to regulate them indirectly. Overall, she viewed the rule as having the effect of, quote, likely shrinking the ranks of qualified crypto custodians. She also stated that the rules, quote, encourage investment advisors to back away immediately from advising their clients with respect to crypto. Another commissioner, Mark Ueda, raised the point that if the SEC is essentially making a rule that crypto custody should be done by banks and other traditional custodians, while at the same time, the Federal Reserve is warning banks

that they should have nothing to do with crypto assets, isn't that simply a roundabout way of telling advisors that they should not be dealing in crypto assets? He said that the proposal in multiple ways appears to, quote, mask a policy decision to block crypto activity, although he still agreed to support the proposal in this first instance. The proposal will now be open for a 60-day public comment period, after which the commissioners will hold another vote on passing the rule. A huge, huge part of how disruptive this rule would be to the industry rests on how easy it ends up being for crypto firms to satisfy the requirements of qualified custodian registration. That's an application process managed by the SEC, so the outcome of the outcome of the

policy will ultimately be determined by how restrictive they are in issuing registrations. Not something that as a crypto firm I would be hugely optimistic about. So that is the news in a nutshell, and here's the big blaring thing to me. This seems like a not particularly subtle but ultimately roundabout way to shadow ban crypto from interacting with any sort of traditional financial structure. Miller White House Levine, policy director at the Defi Education Fund, wrote, This should end any doubt that Common and Register is a fig leaf for the SEC

usurping Congress to block crypto in the U.S. It requires investment advisors to custody all assets with qualified custodians while saying it's unlikely crypto can be custodied in compliance with the rule. And that, to me, is the rub of it. But there was a ton of chatter and discourse about this, so let's get some takes from the Twitter sphere

to try to better understand what's going on. We start with Larry Floreo, general counsel at Delphia. He writes, TLDR, this is a huge change and a ton of even medium-sized managers are going to struggle. The proposed rule expands the need for a qualified custodian or QC from just funds and securities to all client assets. This is a major shift. I'm not really sure how you'll even get a QC to hold your lumber.

Exotic cars and wine. Forget about tokens and NFTs. This is going to have a huge impact on any SEC registered VC manager, since either they'll need to change their business model or every startup taking venture money is going to be begging the major banks to handle their cap tables. Another big one, even trading authority, is within the scope of when an RIA is deemed to have custody. This is a long-time carve-out

and will have a ton of implications for wealth managers working with retail and high-not-worth individual clients. The extra cost could run them out of business. I could even see the proposed rule causing more scrutiny on non-discretionary managers, and wouldn't be surprised if some of them started exploring broker-dealer registration in lieu of investment advisor. Foreign financial institutions now have a seven-part test

in order to be considered QCs, including having the requisite financial strength to provide due care for client assets. This seems like a hindsight gotcha waiting to happen. While it seems totally reasonable on its face, what happens in a 2008-style blow-up where major banks and companies go down? What's the level of diligence you need to conduct in order to have met your fiduciary duty in selecting a QC? What about if it just turns out you were wrong? Another requirement is that all QCs need to have a SOC-style internal control report, which used to be just for affiliate QCs due to the extra conflicts. That's a big and expensive undertaking for anyone wanting to even be a QC.

Once again, only the biggest players can compete. And indeed, that big players only was a huge theme of the discourse. This next thread comes from Ramalawalia who writes, The SEC is proposing a modification to the custody rule that impacts crypto. Here are the winners and losers. Number one, big winner, Anchorage, the only national bank that can custody crypto. Anchorage has a monopoly.

Number two, Cowan, bank-backed Prime Brokerage, the first bank to do Prime Brokerage and fill the gap from Genesis. Three, runner-up winners. Trust banks like Coinbase Prime, Gemini, etc. The license is good, but does not enjoy federal preemption like number one. Losers, pure exchanges without a banking license or trust bank. Four, non-consensus winner. A decentralized MPC solution for bankless crypto natives and their advisors. This technology would enable clients to control their keys, digitally sign, custody on, on chain, all while still enabling advisors to advise compliantly. One other conclusion? Regulators will continue to push crypto activity inside the regulated bank perimeter.

Secretary Yellen appears to have segregation of duties as a North Star, meaning no single legal entity can perform custody, exchange, and brokerage functions under one roof. TLDR, the few banks that have the technical chops and can get regulatory approvals will have a moat with low competition. Justin Slaughter, policy director at Paradigm, summed up Ram's thread and said, so the SEC's qualified custodian rule one doesn't unbank crypto. Two, creates a quote-unquote monopoly for custodial services in crypto. Three, probably increases costs for a bunch of non-crypto-QCs. This creates moats around current crypto giants. Coinbase seemed to affirm this as well,

with Chief Legal Officer Paul Grewell saying, another busy morning, we've now dug through the SEC proposed rulemaking, and I'm glad to see the SEC recognizes Coinbase Custody Trust Co as a qualified custodian. After today's SEC proposed rulemaking, we are confident that it will remain a qualified custodian. We support the Commission's efforts to provide all investors with the protections of already available to CCTV clients. And we fully agree, investors deserve to feel confident their assets are safe. We appreciate that the SEC is following the standard course and undertaking a public rulemaking process to address this topic. Public engagement in the comment process will help the SEC to ensure that the rule meets the needs of investors and the market. We also

encourage the SEC to begin the rulemaking process on what should or should not be considered a crypto security, especially given that today's proposal acknowledges that not all crypto assets are securities. Rulemaking on that topic could offer needed clarity to customers, investors, and the industry. Now, I think what you're seeing from Paul is pretty restrained language. Obviously, Coinbase is not about to pick this as a fight too when it appears that they're in the clear, even in this new paradigm. However, they're also publicly calling out and thanking the SEC for it doing what it's supposed to, which is going through a public rulemaking process. And finally, it's roundabout getting at what some others pointed out before,

which is this sort of assumes crypto assets or securities, without going through a process to actually determine that. But again, Coinbase in this situation is in the catbird seat. They appear to be one of the giants that is positioned to benefit. What about someone who's building a new type of financial institution that could be challenged? Caitlin Long, the founder and CEO of Custodia Bank, wrote a summary as well. She says, TLDR, it doesn't kill crypto custody. It's a move against state charter trust companies. There's one big issue, though, which will trigger huge pushback. The big issue, and I haven't

seen anyone point this out yet, is the requirement for custodians to indemnify for, quote, negligence, recklessness, or willful misconduct. All the banking, Wall Street, commodities, and crypto industries will push back together on this because it could kill custody business broadly. What's the issue? Proposal would apply custody rule to all asset classes including commodities in crypto, i.e. not just securities. Okay, fine. But the SEC also wants custodians to indemnify the full asset value for losses in which custodian played any role. E.G. an oil tanker sinks, cows die. That's the implication of expanding the custody rule with such indemnity to physical assets like oil, cattle, wheat, and crypto. History. Custody originated under

the concept of bailment, which is the same law as coat checks and valet parking. Bailments usually have limited liability. Next time you check your coat, look at the receipt you receive. It limits liability because you are expected to ensure your own asset. This makes sense because you didn't turn over legal title to the asset to your custodian. You continue to own it. Custodian typically has a duty of care. So you see the issue. The SEC would essentially require qualified custodians to blanket indemnify clients against the full risk of loss, i.e. fully guarantee the asset value for assets that custodians don't even own. For commodities that will upset longstanding and insurance terms, no dice. So I think there will be a wall of united pushback against this

indemnity provision. SEC is correct in its assessment that market practice varies widely. It does, and with good reason, especially for commodities, because for physical assets, it really matters whether and when the title is transferred. Join CoinDesk's Consensus 20203, the most important conversation in crypto and Web 3, happening April 26 through 28th in Austin, Texas. Consensus is the industry's only event bringing together all sides of crypto, web, 3 and the Metaverse. Immerse yourself in all that blockchain technology has to offer creators, builders, founders, founders, brand leaders, entrepreneurs, and more.

Use code breakdown to get 15% off your paths. Visit consensus.coindesk.com or check the link in the show notes. What about the rest of the SEC proposal? I call it like it is. There's a lot of good in it. Segregation of customer assets, audit statements, who could argue with doing those things? The next most controversial provision pertains to state chartered trust companies.

Most crypto custodians today are state chartered trust companies, so this is a big deal for crypto. The SEC for years has signaled it doesn't believe most trust companies are qualified custodians. That the SEC has been working on this for over 10 years shows crypto was just the trigger, not the target for the new rule. Well, what's the issue? I've tweeted about it since before 2018. State chartered trust companies generally can't guarantee the segregation of assets if they go bankrupt. Why? Because a bankruptcy judge can generally break contracts of any corporation subject to the U.S. bankruptcy code. Whose subject to the U.S. bankruptcy code? Basically every corporation except for those

under statutory receivership regimes, namely banks and broker dealers. So banks and broker dealers, subject to special receivership regimes, can guarantee asset segregation during insolvency when it matters most, while state charter trust companies generally cannot. That's a huge difference. The SEC cares a lot about that as well it should. That the SEC moved against state charter trust companies surprises no one working in this area. It has been in the works for years, but will the states sit by and let the SEC do this, and why DFS may fight, or states can always enact special receivership regimes for trust companies? I was pleasantly surprised the SEC left limited-purpose banking entities alone,

including Wyoming SPDI banks. So most likely there won't end up being a difference between state and federally chartered banks, and there shouldn't be. Where does this leave us if the SEC's proposed rule is enacted? It's generally a good outcome for investors. Qualified custodians must not only be able to segregate customer assets, but also to ensure that those assets remain segregated in the event of insolvency. This is a reasonable policy goal and the SEC is not wrong to pursue it. So this is kind of more optimistic, right? This is a person who could be in the line of fire and seems to think that there are goals at least here that are worthy of attention. Still, I think that we have to analyze it, not just in the letter of what it says, but also in the way that it's being presented by Chairman Gensler.

Sarah Brennan, the GC of Ventures and research at Delphi Digital says, well, it is incredibly disappointing that the proposal custody rule is moving forward. Really appreciate Hester Purse and Mark Ueda, pointing out in the open that the rule represents continued governmental efforts at denial of service attacks on crypto. As Chairman Gensler eventually set out in the open, broadening these rules from covering securities to all assets is a jurisdictional grab to cover crypto.

It would be very helpful to spend as much effort and urgency on enabling guidance as with efforts to expand your jurisdiction, set up roadblocks, and chase projects and service offerings out of existence. In the absence of fraud, the SEC routinely becomes the cause of harm. And by the way, Sarah is not the only one upset. The Twitter account for Republicans on the House Financial Services Committee tweeted, Yesterday's SEC proposal on the custody rule for investment advisors raises several concerns, both on process and approach.

Once again, Gary Gensler is attempting to unilaterally expand the SEC's authority beyond that granted to the commission by Congress. Republicans believe safeguarding customer assets is critical. Customer assets must be properly segregated and protected from being lost, misused, stolen or misappropriated, as well as in the event of insolvency or bankruptcy. Chair Gensler's approach, paired with staff accounting bulletin 121 and other recent regulatory actions, only seek to chill digital asset markets. This is not the right approach and leaves us with more questions than solutions.

The proposed amendments to expand the current custody rule to include all client assets, including all digital assets, should be debated and decided by Congress, not an expansive reading of the authorities granted in Dodd-Frank beyond congressional intent. At the very least, the SEC should demonstrate the extent to which digital assets are linked to registered investment advisors' clients before considering this proposal, as it appears intended to compel advisors to sever connections with the digital asset ecosystem. We urge stakeholders to submit public comments on the proposed amendments to ensure the custody rule for investment advisors is modernized appropriately.

I'm glad to read those words, but I also resonate with Nick B. who replied, You have the power to stop him, so why don't you? Anyways, guys, look, the best part of this is the public comment period. At least the SEC is going through a normal channel and a normal process for this one, even if it is a big jurisdictional grab. As cynical as it may seem, I believe that when it comes to the SEC right now, we have to assume bad faith, with anything relating to digital assets. And so I would urge us to use this period.

to actually comment and engage in this process and make it clear that the SEC as constituted today will not be able to make such sweeping changes without political ramifications. Anyways, guys, as you can see, this was an important one to get to this week. I appreciate you listening. Until tomorrow, be safe and take care of each other. Peace.