Impact of the "safeguarding" rule on digital asset custody
- Future of Finance
- Dec 15, 2023
- 3 min read
Clearly, digital assets, being neither securities nor funds (under the old “custody rule” definition) but certainly client “positions” (under the proposed new “safeguarding” rule) must be held by a “qualified custodian.” But digital assets also present even the best “qualified custodians” with novel challenges.
In the text of its proposed rule change, the SEC expects custodians to have “possession and control” of assets to provide custody. This is hard to demonstrate with digital assets. Indeed, the SEC acknowledges that “it may be difficult actually to demonstrate exclusive possession or control of crypto assets due to their specific characteristics (e.g., being transferable by anyone in possession of a private key)” and that “an advisory client and a qualified custodian might simultaneously hold copies of the advisory client’s private key material to access the associated wallet with the client’s crypto assets, and thus both have authority to change beneficial ownership of those assets.” (1)
Nevertheless, the SEC expects RIAs to place digital assets with “qualified custodians” and expects the “qualified custodians” to hold the private keys both “in a manner such that an adviser is unable to change beneficial ownership of the crypto asset without the custodian’s involvement” and in such a way that that it “has possession or control of the assets at all times in which the adviser has custody.” (2)
In short, the SEC is demanding that custody be structured in such a way that the custodian can exercise control over the assets at all times.
Such a demanding criterion is likely to further reduce the number and quality of custodians willing to take on digital assets belonging to clients of RIAs. It may force some RIAs to decline to offer cryptocurrencies and digital assets as products, limiting investor choice. There are already many forms of digital asset – tokens issued by providers of DeFi apps are an obvious case in point – where no “qualified custodian” is willing to offer a service. Obviously, this is a problem for any RIA client that owns or wants to own such assets.
True, the “safeguarding” rule does permit RIAs to self-custody assets, including digital assets. (3) However, the requirements for self-custody are demanding and in practice few RIAs are likely to take advantage of the opportunity.
Another challenge RIAs will face is the fact that cryptocurrencies trade on exchanges, almost all of which insist users trade, settle and safekeep assets with the exchange but almost none of which rank as “qualified custodians.” Since the proposed new safeguarding rule will require even self-custodying RIAs to “maintain possession and control of client assets at all times,” any using the custody services supplied by cryptocurrency exchanges are likely to be in violation of the safeguarding rule.
Fortunately, models have emerged in the cryptocurrency markets that enable investors to trade on exchanges without placing assets in custody with the exchanges. Both the ClearLoop service provided by Copper and BitGo Prime Trading allow bi-lateral off-exchange delivery-versus-payment or delivery-versus-delivery settlement models. This ensures digital assets never leave the “possession and control” of a custodian even for settlement purposes since settlement entails simultaneous exchange.
If the new “safeguarding” rule does eventually come into force, digital asset exchanges will have to adapt to the needs of RIAs that originate buy or sell orders. The size of the challenge is unknown, since it is not known what proportion of transactions originate with RIAs.
Most exchanges require buy/sell orders and settlement through accounts on the exchange. Where the exchange is not a “qualified custodian” – which is true of all bar a handful – placing custody assets on such an exchange would be a violation of rule 223-1. This would limit compliant models for trade execution for RIAs to transactions involving settlement directly into and out of a “qualified custodian.”
(1) See Securities and Exchange Commission, 17 CFR Parts 275 and 279, Release No. IA-6240; File No. S7-04-23, RIN 3235-AM32, Safeguarding Advisory Client Assets page 82.