Thursday, May 11, 2023

Forcing crypto assets into qualified custodians would ‘destroy’ crypto, industry association says

By Lene Powell, J.D.

The SEC is seeking to destroy the crypto industry, an industry association said in a strongly worded comment letter on the SEC’s recent proposal on safeguarding advisory client assets. The Global Digital Asset & Cryptocurrency Association (GDCA) found fault with specific aspects of the proposal, but also more generally with the overall requirement for investment advisers to hold crypto assets with a qualified custodian.

“For the SEC to try to force crypto assets into qualified custodians when it knows that the banking agencies are refusing to let banks custody those assets, is for the SEC—without Congressional imprimatur—to seek to destroy the trillion-dollar asset class that is crypto,” the association wrote.

In contrast, the watchdog group Better Markets praised the proposal, saying the reforms would help promote investor confidence in advisory services and benefit capital markets.

SEC proposal. The SEC issued a proposal in February to enhance protections of customer assets managed by registered investment advisers. According to a fact sheet, the proposed rule changes would expand the current custody rule to protect a broader array of client assets and advisory activities to the rule’s protections; enhance the custodial protections that client assets receive under the rule; and update related recordkeeping and reporting requirements for advisers. The comment period closed May 8.

Global Digital Asset & Cryptocurrency Association (GDCA). According to the comment letter, GDCA is a “global, voluntary Self-Regulatory Association for the digital asset and cryptocurrency industry.”

GDCA takes issue with the SEC’s position that the current custody rule and proposed safeguarding rule apply to crypto assets. The proposal raises hurdles to compliance with both the current and proposed rule and is “short on solutions” on how investment advisers and qualified custodians can demonstrate compliance with the current and proposed rules, the association said.

“A ‘rule’ that cannot be complied with is hardly a ‘rule’ at all. It’s a ban,” the association wrote.

This is particularly so in the current moment, in which the GDCA says federal banking regulators are “actively discouraging banks from engaging in custody and other crypto asset activities” and only one bank with a federal charter is empowered at present to custody crypto assets.

In this context, requiring crypto assets to be held by qualified custodians would “raise serious issues of statutory authority, administrative due process and deprivation of constitutional rights,” said GDCA.

GDCA also objected that the proposing release inappropriately assumes application of and non-compliance with the current custody rule, and that minimum custodial standards provisions ignore the important role of state regulation. In GDCA’s view, the Commission should adopt flexible standards for demonstrating “possession or control” and should not discourage use of crypto trading platforms.

Objections from finance industry. Some of GDCA’s objections echo criticisms by major finance industry groups like SIFMA and the Investment Company Institute, including opposition to expanding the definition of assets beyond just funds and securities. The alignment reflects that although crypto assets were originally envisioned as an alternative to traditional finance, they have become increasingly ensconced in mainstream financial systems.

Better Markets. Expressing support for the SEC proposal, Better Markets said expanding the scope of assets subject to the safeguarding rule is consistent with the need to modernize custodial practices, and aligns with congressional intent.

The watchdog zeroed in on crypto assets, pointing to the “recent cryptocurrency carnage” including the failure of FTX and other major crypto entities.

“The short history of cryptocurrencies is marked by extremely volatile markets; brazenly fraudulent schemes, hacks, and scams; and innumerable failures and bankruptcies leading to billions of dollars of investor losses,” the group wrote.

Better Markets agreed with SEC Chair Gary Gensler’s view that most crypto assets are securities, but argued that is not a requirement for bringing crypto assets within the custody rule.

“[F]or purposes of the Proposal’s new safeguarding rule, the question of whether or not a given cryptocurrency token is a security is not at issue,” the group wrote. “By expanding the scope of assets subject to the safeguarding rule, as this Proposal does, a determination of whether or not an asset is a security is irrelevant. All assets, including all cryptocurrency assets, would fall under the safeguarding rule as they should.”

The group noted that the custody rule was updated in 2003 and 2009 to reflect technology advances and close loopholes that allowed the massive Bernie Madoff Ponzi scheme to succeed. The group added that the SEC’s economic analysis “amply” satisfies the Commission’s legal obligation to assess the impact of the proposal.