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SEC weighs new rule for safekeeping customers' crypto assets in wake of FTX debacle

The SEC introduced a proposal Wednesday that would bolster protections for customer assets being held by investment advisers, expanding it to cover crypto assets.

The proposal would ensure customer assets are properly segregated, helping to protect assets should the adviser or custodian go bankrupt. This comes after major crypto platforms including Voyager Digital, Celsius Network, FTX, BlockFi, and Genesis Global Capital went bankrupt in recent months, leaving customers in limbo and unable to access some funds.

"Make no mistake: Today's rule covers a significant amount of crypto assets," SEC Chair Gensler said in a statement. "Based upon how crypto platforms generally operate, investment advisers cannot rely on them as qualified custodians… Through our proposed rule, investors would get the time-tested protections and, yes, qualified custodians they deserve."

In particular, FTX bankruptcy documents have shown the firm commingled customer and house assets, allowing customer money to be used for purposes users hadn't agreed to such as crypto trading, real estate purchases, and political donations.

While efforts have been well-publicized, many non-bankrupt crypto platforms also have not delivered the transparency investors are demanding to know their funds are safe.

In the U.S., investment advisers include asset managers such as registered investment advisers, hedge funds, and wealth managers which are required to register with SEC if they manage more than $110 million in assets.

Most crypto assets are likely to be funds or crypto securities covered by the current rule, according to the SEC. Gensler said while some crypto trading and lending platforms may claim custody of investors' crypto, that doesn't mean they are qualified custodians.

U.S. Securities and Exchange Commission (SEC) Chairman Gary Gensler, testifies before the Senate Banking, Housing and Urban Affairs Committee during an oversight hearing on Capitol Hill in Washington, U.S., September 15, 2022. REUTERS/Evelyn Hockstein
U.S. Securities and Exchange Commission (SEC) Chairman Gary Gensler, testifies before the Senate Banking, Housing and Urban Affairs Committee during an oversight hearing on Capitol Hill in Washington, U.S., September 15, 2022. REUTERS/Evelyn Hockstein (Evelyn Hockstein / reuters)

"Rather than properly segregating investors' crypto, these platforms have commingled those assets with their own crypto or other investors' crypto," said Gensler. "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."

Alongside expanding the custody rule to apply to all assets including cryptocurrencies, the proposal also requires for the first time that advisers and qualified custodians enter into written agreements with each other that help guarantee a custodian's protections.

The rule applies to crypto assets held with advisers. The adviser would be required to keep clients' crypto with a qualified custodian, separate from any crypto trading platform based on how they currently operate.

The proposal would also require advisers and custodians to enter a written agreement guaranteeing protection. The agreement would include qualified custodians undergoing annual evaluations from public accountants and providing account statements and other records on request.

The SEC's custody rule for investment advisers, first adopted in 1962, was last updated in 2009 in response to the financial crisis. Congress granted the agency new authority in 2010 following the $64 billion Bernie Madoff scandal.

In both the Madoff scandal and other events related to the financial crisis, the SEC was accused of failing to keep private sector businesses and executives accountable. Among other things, it encouraged registered investment advisers to place client assets in custody with an independent firm or otherwise subject advisers to "surprise exams" and third-party reviews.

In a crypto-focused Senate Banking Committee hearing held Tuesday, Republican members of the Committee laid into the SEC, asking for Chair Gensler to testify.

Already in 2023, the SEC has delivered four enforcement actions against crypto firms. On Monday, stablecoin issuer and trust company Paxos stated it had received a Wells notice from the agency informing the firm of a potential enforcement action related to the Binance USD stablecoin.

During Wednesday's meeting, SEC Commissioner Hester Pierce called the rule part of "a broader strategy of wishing complete jurisdiction over crypto into existence." Though saying it had good intent, Pierce raised the issue that the proposal's amended result might impose costs on investors which ultimately outweigh the benefits to them.

Crypto firms that custody assets for institutional clients, such as exchanges, may not have an easy or viable path to become a qualified custodian for crypto assets.

Under the SEC's rules, a qualified crypto custodian would generally mean chartered state and federal banks or trust companies, SEC registered broker-dealers, or a futures commission merchant, Gensler said in a press briefing following the hearing.

Gensler added there are a number of state chartered trust companies, federally chartered or state chartered banks, and other business models that may meet the qualified custodian standard with proper asset segregation, bankruptcy remoteness, and documentation.

Open for public comment, the proposal stands out as a different approach to regulating crypto after the agency has levied a series of enforcement actions on crypto firms in recent weeks.

Gensler underscored with reporters that most of crypto is already covered under the custody rule updated in 2009 and that this is a priority for enforcement action and examination by the SEC.

"Crypto exchanges today generally how they're modeled do not meet the qualified custodian standards of the current rule," said Gensler. "So investment advisors investing in crypto assets should be considering that and how they would come into compliance."

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