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Regulation In The Post-FTX Environment: SEC’s Proposed Enhanced Custody Rule And Its Effects On Crypto

07 March 2023

Proskauer Rose LLP

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When it rains, it pours. On January 23, 2023, the New York
Department of Financial Services announced that it had issued certain Guidance
on Custodial Structures for Customer Protection in the Event of
Insolvency in which it emphasized the importance of sound custody
and disclosure practices to protect customers in the event of an
insolvency or similar proceeding. This month, the Securities and
Exchange Commission (“SEC”) followed suit.

On February 15, 2023, the SEC proposed amendments to the Custody Rule under
the Investment Advisers Act of 1940, which, among other changes,
expands the current custody rule’s application to a broader
array of client assets under the rule managed by registered
investment advisers and clarifies certain aspects of the existing
rule (see more digestible SEC Fact Sheet here).

The SEC’s proposed amendments are aimed at reducing the risk
of loss of client assets by expanding the types of assets covered
by the rule beyond “funds and securities” that will be
subject to custodial safeguards and helping ensure assets are
properly segregated. The proposed amendment would also impose
certain reporting and compliance requirements on investment
advisers, including requiring them to provide information about
their practices in safeguarding client assets. Notably, if the
amended rule is adopted after the 60-day comment period, which is
not certain, then crypto assets will undoubtedly be affected. In a
statement discussing the proposed amendments,
SEC Chair Gary Gensler noted that the rule “covers a
significant amount of crypto assets” and that “most
crypto assets are likely to be funds or crypto asset securities
covered by the current rule.”

Custody is a safekeeping activity by a financial institution
involving storing, protecting, and securing assets separately from
those of other customers or the investment firm itself. TradFi
investment advisers are typically required to maintain customer
funds and securities with a qualified financial firm (i.e., a
custodian). Most assets are intangible assets held “on
account” with a broker-dealer (i.e., stocks and bonds, which
are rarely held in certificate form), though some assets may
consist of physical certificates, cash, or other tangible assets.
On the other hand, crypto custody consists primarily of bookkeeping
because there is no physical asset and no centralized ownership
record for a digital asset: the blockchain records wallet activity
and balances. While there is the option for self-custody of crypto
assets, a crypto investor may allow a custodian or crypto exchange
to hold their private keys for them, enabling the custodian to use
the wallet to transact. This arrangement potentially opens up a
range of risks, including the risk of hacking, insolvency risk, or
malfeasance involving the commingling of investors’
cryptoassets with those of other investors or institutional

As we have previously reported, in the post-FTX dawn, regulators
are zeroing in on insolvency risks to customer assets. Several
high-profile bankruptcies have highlighted custodial issues,
leading to questions surrounding the ownership of customer assets.
First, the FTX proceedings, where, among others, the SEC has
alleged co-founder Samuel Bankman-Fried concealed the diversion of
FTX customer funds to the co-founder’s private crypto hedge
fund. Second, the Celsius proceedings, where the chief judge for
the United States Bankruptcy Court for the Southern District of New
York issued a decision holding that Celsius’ Terms of Use made
clear that customer deposits into Earn Accounts became Celsius’
property at the time of deposit, such that the digital assets now
constitute property of the debtors’ bankruptcy estate. In
Celsius, customers argued that the deposits in the Earn Accounts
were held by Celsius as a custodian, but the court found that the
plain language of the Terms of Use made clear that ownership
interest had passed to the debtors.

As discussed in our recent article, New York Department of Financial Services Issues
Guidance on Cryptoasset Custody in Wake of Recent High-Profile
, state financial regulators in New York moved to
protect customer’s cryptoassets in the event of bankruptcies by
issuing guidance that makes clear that customer assets should
remain segregated and the property of the customer.

It appears that the SEC took note as well. In his statement,
Gensler referenced how customer assets “often have become the
property of the failed [platform], leaving investors in line at the
bankruptcy court.”

Notable changes under the proposed amendments include:

  1. Expanding of the current rule beyond client funds and
    securities to bring any client assets of which an adviser
    has custody into the rule’s scope. Specifically the proposed
    rule defines “assets” as “funds, securities, or
    other positions held in a client’s account.” As outlined
    in the proposed rule, assets under the rule also would include
    “financial contracts held for investment purposes, collateral
    posted in connection with a swap contract on behalf of the client,
    and other assets that may not clearly be funds or securities
    covered by the current rule,” language that was undoubtedly
    influenced by recent losses during the crypto winter. Moreover, the
    proposal states that “other positions held in the client’s
    account” covers current asset types and asset types that
    develop in the future regardless of their status as funds or
    securities, include “crypto assets when not otherwise covered
    by the rule’s references to funds and securities.”
    Although this portion of the new proposal has received a lot of
    media attention, the SEC, in the proposed amendments, stated that
    its position is that “most crypto assets are likely to be
    funds or crypto asset securities covered by the current rule.”
    In a footnote, the SEC noted that “the application of the
    current rule turns on whether a particular client investment is a
    fund or a security.”
  2. Stating that discretionary trading authority triggers the
    application of the rule unless the trades are limited to those
    effected on a delivery versus payment (DVP) basis. The effect of
    this is to deem advisers whose client assets include bank loans and
    other securities to have custody of those assets.
  3. Requiring that advisers enter into written agreements with and
    obtain reasonable assurances from qualified custodians to ensure
    clients receive standard custodial protections when an adviser has
    custody of the assets. Such assurances would require, among other
    things, that qualified custodians undergo annual evaluations from
    public accountants, provide account statements, and provide records
    upon request. The effect of this provision would be to attempt
    through contract to extend SEC regulation to activities of bank and
    other custodians over which the SEC does not have regulatory
  4. Expanding the availability of the current rule’s audit
    provision as a means of satisfying the surprise examination
    requirement, which requires an adviser to undergo a surprise
    examination by an independent public accountant to verify client
    assets. Note this would codify an SEC Staff Response to Questions about the Custody
  5. Amending the investment adviser recordkeeping rule requiring
    advisers to keep more detailed records of trade and transaction
    activity, including position information for each client account of
    which it has custody.
  6. Imposing additional restrictions on foreign financial
    institutions that serve either as qualified custodians or as
    sub-custodians to a qualified custodian, the consequence of which
    may be to restrict the ability of a non-US client to retain its
    non-US custodian if it engages a US registered adviser.
  7. Amending Form ADV to revise reporting obligations with the
    proposed safeguarding rule’s requirements and to improve the
    accuracy of custody-related data available to the Commission, its
    staff, and the public.

Like the recent
NYDFS guidance
on crypto asset custody, the SEC asserts that
the amended rules are designed, in part, to ensure client assets
are segregated and held in accounts designed to protect assets in
the event of a qualified custodian bankruptcy or other insolvency.
(“[S]ince its adoption [the Custody Rule] has been designed to
safeguard client funds and securities from the financial reverses,
including insolvency, of an investment adviser and to prevent
client assets from being lost, misused, stolen, or
misappropriated”). The crux of the proposed amendment is that
qualified custodians must maintain crypto assets, which promotes
proper segregation.

One potential concern is that the proposed amendments suggest
that an adviser trading crypto assets on a platform might violate
the proposed rule if those platforms are not qualified custodians.
If this is indeed the case, advisors should note the SEC’s
renewed focus on this and will need to find avenues to comply.

Critics of the proposed amendments additionally argue that
crypto investors and users may become more vulnerable to theft and
fraud by forcing investors to use self-custody or unregulated
custody arrangements, while also discouraging capital formation if
the rule is adopted. This appears to be contrary to the SEC’s
mission. Indeed, the proposed rule states that entities that
provide platform users with the ability to transact in crypto
assets that do not wish to take on the additional compliance
burdens as a qualified custodian would have to give up custody of
such assets back to investors or another qualified custodian. In
addition, as argued by SEC Commissioner Hester Peirce in her statement, the rule’s broad effect could
shrink the number of qualified custodians that handle crypto assets
and cause investors to remove funds from platforms that may already
practice robust safeguarding procedures (“The proposal would
expand the reach of the custody requirements to crypto assets while
likely shrinking the ranks of qualified crypto custodians. By
insisting on an asset neutral approach to custody we could leave
investors in crypto assets more vulnerable to theft or fraud, not
less”). The proposed amendments also make it more costly for
hedge funds, private equity funds, and pension funds to invest in
crypto and hold custody of such assets for their clients,
effectively blocking access to crypto as an asset class to those
advisors that are unwilling to take on additional compliance
burdens. Critics are further concerned that this will not only push
innovation offshore but also investors, users, and firms to seek
offshore services that are not as well-regulated, leaving investors
in a similar situation that led to the FTX implosion. On the other
hand, given the lingering crypto winter and the fallout of the FTX
collapse and the resulting erosion of investor confidence in
certain types of crypto assets, investors wary of this asset class
might be reassured to see custodial safeguards put in place at the
federal regulatory level. Additionally, in the proposed amendment,
the SEC sees multiple benefits from its proposal. It contends that
“the proposed amendments will reduce the risk of loss of
client assets by expanding the types of assets covered by the rule
beyond ‘funds and securities’ and that expansion of the
rule’s scope will “reduce uncertainty over the status of
assets under advisement that must be held in the custody of a
qualified custodian, thereby reducing the legal uncertainty and
risk associated with advisory services and custodial arrangements
for the assets.” Under this reasoning, the SEC contends that
perhaps, such actions “may increase investment opportunities
and the availability of advisory services for [crypto

The 60-day comment period begins following the publication of
the proposing release in the Federal Register. During this period,
expect the SEC to further debate with stakeholders. Already some in
the industry have stated that could comply with the proposed
amendments; yet, others have concerns. While the form and timing of
a final rule remains uncertain regulators are looking to
rulemaking, guidance and enforcement actions to address perceived
shortcomings in the crypto industry, particularly in the absence of
federal legislation.

Regulation In The Post-FTX Environment: SEC’s
Proposed Enhanced Custody Rule And Its Effects On Crypto

The content of this article is intended to provide a general
guide to the subject matter. Specialist advice should be sought
about your specific circumstances.

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