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 assets.