SEC Grapples With Crypto Custody Quandary

If possession were actually nine-tenths of the law, that would be a big issue for custodying crypto assets, an area that already has enough problems. 

During its latest crypto roundtable last Friday, the SEC questioned broker-dealers on whether physical possession and control of assets is the right standard for custody. By all accounts, the space needs clarity to account for the differences between crypto and more traditional assets. There was no shortage of finger-pointing at the prior Securities and Exchange Commission for being slow to act on crypto. Commissioner Hester Peirce, who heads the agency’s new crypto task force, said that companies are playing “the floor is lava” but with the extra obstacle of the lights being off. 

“To engage in crypto-related activities, SEC registrants have had to hop from one poorly illuminated regulatory space to the next, all while ensuring that they never touch any crypto asset,” Peirce said at the roundtable. “A broker or [alternative trading system] that cannot custody or otherwise handle an asset will find it difficult to facilitate trading in the asset, and a robust market is unlikely to develop.”

Getting a Handle on Crypto

In one of his first public appearances as SEC chairman, Paul Atkins made clear that he wants the regulator to provide clarity to “long-festering issues, such as regulatory treatment of digital assets and distributed ledger technologies.” That could mean changes to custody rules under the Exchange Act, Advisers Act, or Investment Company Act, he noted. So-called “special purpose broker dealers” can custody crypto assets, under guidance from the SEC and FINRA, but only a couple of firms have obtained approval to do so. Further, there are questions of whether investment advisors should be able to self-custody digital assets and what happens when crypto assets are or aren’t securities.

Commissioner Caroline Crenshaw, the lone Democrat at the head of the SEC, cited concerns about risks to consumer protections in changing custody rules on either the broker-dealer or investment advisor side. For investment advisers, she raised several questions, including:

• What are the risks of self-custody generally, and is that heightened with crypto? 
• Would an exemption from the custody rule for crypto invite fraud?
• Are most investment advisers capable of safe self-custody of crypto?

Advice from a Crypto Exchange. The best way to custody crypto is to keep it from moving around, said Mark Greenberg, Kraken’s vice president of consumer business and product. “Crypto assets are best held at rest,” he said, of storing them in fewer locations. Having crypto segregated into many small wallets means having to move it more often, so “the more likely it is to get stolen,” he said.