Where the SEC’s Proposed Custody Rule Comes Up Short for Crypto

In February, the SEC proposed dramatic changes to a bedrock law governing the custody of assets. The original rule, Custody Rule 206(4)-2, was adopted by the SEC in 1962 which mainly focused on physical custody of client assets – stock and bond certificates – saying they were to be kept in a bank, segregated from advisor assets, and held in a “reasonably safe” place.

In 2003, the SEC amended the rule to keep up with technological advances in capital markets infrastructure, which have made virtually every aspect of the advisory industry more efficient. The modernized rule, which better defined custody and essentially removed any assumption of paper assets, has been serving advisors and clients well, allowing trusted, qualified custodians to provide custody and many other services to the industry.

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Digital assets, most notably cryptocurrency, came just a few years later. The seeds of the digital asset industry were planted with the bitcoin whitepaper nearly 15 years ago as a novel way to send value natively across the internet without the need for a trusted third party. Five years after that, the Ethereum whitepaper was published. In the years since, an entirely new asset class has emerged, and advisors are now being asked to guide investors engaged with it.

The proposed rule (you can read the whole 432-page document here) would expand the definition of assets in the advisor/client relationship to specifically include digital and crypto assets (from page 28 of the proposed rule): “…the proposed rule’s definition of assets would include investments such as all crypto assets, even in instances where such assets are neither funds nor securities.”

Most advisors are already applying their fiduciary obligation to the entire relationship with their clients, so at first glance this doesn’t seem like a big step. However, the new rule also narrows the scope of what an advisor could use as a “qualified custodian” of digital assets. This passage is from page 33-34:

“We believe it is important to extend the protections of the rule by explicitly including “discretionary authority” within the definition of custody. However, because we continue to believe more limited risk of loss exists when a qualified custodian participates in transactions, we are also proposing a limited exception to the surprise examination requirement of the rule. The exception would generally apply to client assets that are maintained with a qualified custodian when the sole basis for the application of the rule is an adviser’s (sic) discretionary authority that is limited to instructing the client’s qualified custodian to transact in assets that settle only on a delivery versus payment (DVP) basis.”

Most advisors providing discretionary trading use the current exception to the surprise examination, but it wouldn’t be clear based on how crypto asset trades settle – either on an exchange order book, to even on-chain settlement, that the SEC will allow this exception to apply. This will cast more doubt on an already skeptical advisor population.

Some advisors assist clients manage their digital or crypto assets on-chain, including the increasing supply of real-world-assets, through various forms of wallet architecture. But this group doesn’t get any relief or clarity from the proposal either, despite a goal that “allows the rule to remain ‘evergreen’ as the types of assets held by custodians evolve” (page 78).

The proposed new rule will make it far more difficult for advisors to meet this rapidly growing demand for responsible advice and management of digital/crypto assets. This asset class trades 24/7/365, has unique characteristics, and doesn’t fit nicely with current regulatory or even product wrappers designed in the 1990s (e.g. ETFs).

However, many of the current products available through a traditional custodian such as the various trusts and few ETFs that provide a type of exposure to digital assets for clients won’t be impacted greatly by this proposal.

One effect the new rule could have: Since it doesn’t greatly impact advisors that use an assets under advisement (AUA) model – as opposed to an assets under management (AUM) with discretion model – it might push the industry more towards the former, particularly those advisors offering services and advice for digital assets. That shifts the burden of custody, and it’s an open question how many clients have the tolerance for such a future.