Is SEC staff accounting bulletin 121 (SAB 121) dead or alive?

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SEC Staff Accounting Bulletin 121 (SAB 121) is sometimes described as making it impossible for public regulated banks to provide custody for digital assets, at least at scale. That is because the advice, published on 31 March 2022, requires public companies that are custodians of cryptocurrencies and digital assets on behalf of investors to recognise the fair value of the custodied assets as both a liability and an asset on their balance sheets.

As State Street, a major global custodian bank, pointed out in the autumn of 2022: “The SAB 121 position represents a marked departure from the historical treatment of custodied assets as off-balance sheet items, and disproportionately impacts those crypto asset custodians that are subject to prudential capital requirements, such as banks, that are required to maintain capital based on assets included on their balance sheet.” (1)

The SEC justified such a dramatic change on the grounds that digital assets pose new risks, and that those risks had yet to be tested in the courts – a gap now being filled by a variety of legal actions taken by regulators and others against the failed cryptocurrency lenders BlockFi, Celsius and Voyager Digital - but the potential impact on public, regulated global custodian banks under pressure to support end-investor clients investing in cryptocurrency was large enough to make it extremely difficult for them to offer institutional clients a digital asset custody service. Indeed, SAB 121 is seen as a factor behind the decision by State Street to curtail its push into digital asset custody.

It is a plausible argument. The five largest global custodian banks, all of them American, are all public companies. They have between them collective AuC of US$154.1 trillion and total balance sheet footings of less than a twentieth of that figure (US$6.9 trillion). Unaltered, SAB 121 would make it impossible for them to custody digital assets at scale. This would have the perverse effect of leaving the field open to foreign banks, non-bank custodians and privately held companies. That is scarcely an outcome that regulators such as the SEC, whose primary concern is investor protection, were seeking.

As State Street and the other major global custodian banks acknowledged at the time, the threat of catastrophic balance sheet consequences lay in the future rather than the present. More than a year later, the exposure of the major global custodian banks to cryptocurrencies and digital assets remains trivial. BNY Mellon, for example, is compliant with SAB 121 for the Bitcoin and Ether it holds on behalf of clients but the bank is not even disclosing the value of the assets and the liabilities because they are not material.

This would change, especially if tokenised versions of existing and future (“native” only) regulated securities and funds took off and became a deca-trillion-dollar asset class around the world. An unaltered SAB 121 would make it impossible for the largest global custodian banks in the world to custody digital assets. It would concede a massive volume and value of digital assets to non-American and non-bank custodians.

While the United States is not immune to self-inflicted wounds - the €13 trillion Eurobond market was initially a creation of the American tax system and deficit spending – this consideration alone makes it likely that SAB 121 will be modified or overturned.

The uncertain status of SAB 121 itself certainly makes it vulnerable. The rule was announced with no comment period, violating Congressional rules. It was aimed at public companies, rather than the private ones that are the main source of risk.

The text contains contradictions. The heading to the document declares both that “this staff accounting bulletin expresses the views of the staff regarding the accounting for obligations to safeguard crypto-assets an entity holds for platform users” and that “statements in staff accounting bulletins are not rules or interpretations of the Commission, nor are they published as bearing the Commission’s official approval. They represent staff interpretations and practices followed by the staff in the Division of Corporation Finance and the Office of the Chief Accountant in administering the disclosure requirements of the federal securities laws.” (2)

This formulation allowed SAB 121 to be issued with no consultation, as would be required of a ruling issued under prevailing regulations. It also implies that moving customer assets onto the balance sheet of the custodian is simply a good idea for public companies, at least in the view of the SEC accounting staff, but that it is also not a directive custodians must comply with.

Yet the body of the text of SAB 121 makes clear that compliance with its provisions is not optional but mandatory:

The staff would expect an entity that files reports … to apply the guidance … no later than its financial statements covering the first interim or annual period ending after June 15, 2022, with retrospective application as of the beginning of the fiscal year to which the interim or annual period relates.

Such contradictions open SAB 121 to challenge in the courts. Certainly, the text and the irregularities in the process by which SAB 121 was introduced are open to different legal interpretations.

In short, SAB 121 is an inept measure, introduced from a narrow accounting perspective, aimed at the wrong target, beset by contradictions, open to legal challenge and implemented in a manner whose process cannot be understood unless it was designed deliberately to bypass the normal consultation process.

These shortcomings mean SAB 121 is acutely vulnerable to a change of Presidential administration and/or chairmanship of the SEC - the current five-year term of Gary Gensler ends in 2026 - at some point soon, and perhaps as soon as the years between 2024 and 2026. It is already the target of energetic lobbying by the custodian banks and has come up regularly when Gensler appears before any Congressional committee.

Senator Cynthia Lummis of Wyoming, who serves on the Senate Committee on Banking, Housing, and Urban Affairs, has certainly never missed an opportunity to raise it. It is a particular interest of hers because the State of Wyoming passed laws exempting cryptocurrencies from securities laws in 2018. It also chartered Custodia, a digital asset custodian bank that opened for business in the State in 2020 but was denied an application to be supervised by the Federal Reserve in March 2023 because of concerns about its ability to fund its activities and manage the risks of its focus on the “crypto-asset sector”. (3)

It was a question by Senator Lummis, arguing that placing custodial assets on the balance sheet reduced them to ordinary creditors in the event of bankruptcy, that prompted Gary Gensler, in his 12 September 2023 testimony to the Senate Banking Committee, to argue that SAB 121 was purely about accounting for “crypto” in public companies because “crypto” assets cannot be segregated from bankruptcy proceedings in the same way as traditional equities and bonds – as the bankruptcies of Celsius, Voyager and FTX proved.

Importantly, Gensler disowned the idea that SAB 121 was responsible for the capital implications of putting custody assets on the balance sheet:

Staff Accounting Bulletin [121] is just about public companies and how to properly show that to investors in those banks. And it’s [about] investors, not the people getting custody. The bank regulators are free to address how they treat capital however they wish to treat capital. But this is just about is the balance sheet … [they] have those custody crypto as a liability, but they also have the crypto as an asset. We don’t speak to how it’s backed - that’s up to the bank regulators. (4)

This was an invitation to the highly paid analysts that follow the Big Five publicly listed global custodian banks - BNY Mellon, State Street, Citi, J.P. Morgan and Northern Trust – to treat SAB 121 not as a regulatory capital catastrophe but as a technical accounting fix to the segregation problems occasioned by an ill-defined set of “crypto” assets, though the term probably refers in this context to cryptocurrencies only.

However, Gensler did not dispose of the capital question; he merely passed it to the bank regulators. Unfortunately, the banking regulators have not formally clarified their position on SAB 121. Although Federal Reserve Chairman Jerome Powell, again in response to Senator Lummis while testifying to the Senate Banking Committee on 22 June 2022, stated plainly that “custody assets are off balance sheet, have always been,” he also said, “the SEC made a different decision as it relates to digital assets for reasons it explained, and now we have to consider those.” (5)

Bank regulators are certainly considering what to do. Call reports of meetings of the Federal Financial Institutions Examination Council (FFIEC) - a body where the Federal Reserve, the FDIC, the National Credit Union Administration (NCUA), the OCC and CFPB meet, as regulators of the banking system, to promote uniformity in the supervision of financial institutions – show that invitations to banks to include “crypto-assets” on their balance sheet in their call reports have featured in FFIEC Supplemental Instructions in June 2022, September 2022, December 2022, March 2023, June 2023 and September 2023. (6) Yet SAB 121 still remains under consideration by banking regulators in the United States.

As Senator Lummis pointed out to Chairman Powell on 22 June 2022, the Bank for International Settlements (BIS) - the central bank for central banks - has confirmed that in the opinion of the Basel Committee “crypto-assets” held in custody do not need to be held on the balance sheet of the custodian. In an otherwise conservative standard, which imposes heavy capital requirements on banks exposed to “crypto-assets,” the BIS confirmed that the SAB 121 perspective on custodial assets is an outlier.

“Respondents to the second consultation raised concerns about the application of the standard in relation to customer assets where a bank is acting as a custodian,” read the BIS paper Prudential treatment of cryptoasset exposures. “Respondents were concerned that the standard may imply the application of credit, market and liquidity risk requirements to those customer assets. This was not the intention of the standard. The standard has therefore been revised to clarify which elements are applicable to custodial services provided by banks.” (7)

The efforts of Senator Lummis have not gone totally unrewarded. On 31 October 2023, the Government Accountability Office (GAO) a non-partisan body that aims to supply Congress, executive agencies and the public with information to improve decision-making, responded to a request by Senator Lummis to review SAB 121 in the light of the Congressional Review Act (CRA). Under the CRA, government agencies must submit rules to Congress for approval.

The GAO concluded that there was a risk “companies may change their behaviour to comply with the staff interpretations found in the Bulletin” yet the “the Bulletin is a rule under CRA and thus subject to CRA’s submission requirement … The Bulletin is a rule for purposes of CRA because it meets the APA [Administrative Procedure Act] definition of a rule and none of the three CRA exceptions apply. Accordingly, the Bulletin is subject to the CRA’s submission requirement.” (8) In theory, this means the SEC should submit SAB 121 for review under the CRA and until it does so, SAB 121 is not a live regulation.

On 15 November 2023 a group of Congressmen led by Senator Lummis and the Chairman of the House of Representatives Financial Services Committee, Patrick McHenry, submitted a letter to the OCC, the Federal Reserve, the FDIC, and the NCUA urging them to clarify that SAB 121 is not enforceable following the finding of the GAO that it is not a rule under the CRA. They argued in the letter that “SAB 121 should have no legal effect and the Federal banking agencies and National Credit Union Administration should not require banks, credit unions and other financial institutions that provide custody services for digital assets to comply. This means that such entities need not recognize a liability and a corresponding asset offset on their balance sheets.” (9)

However, in reality the banking industry will continue to work as if SAB 121 is in force, whether or not the SEC submits it for CRA review or not - simply because regulated banks prefer not to antagonise regulators – at least until the banking regulators make clear that they do not expect regulated financial institutions to put “crypto-assets” on their balance sheets. Which means that, although the impact of SAB 121 on the digital asset custody market today is minimal, its growth will be hampered until such time as the banking regulators reach a verdict.

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(1) State Street Digital, Fall 2022 Digital Digest, Volatility and the Digital Transformation, page 20.

(2) Securities and Exchange Commission, Staff Accounting Bulletin No. 121, 17 CFR Part 211, Release No. SAB 121, 31 March 2022.

(3) See March 24, 2023: Federal Reserve Board publishes its order denying the application by Custodia Bank, Inc., to be supervised by the Feder-al Reserve at https://www.federalreserve.gov/newsevents/pressreleases/orders20230324a.htm

(4) See the Gensler testimony to Congress at https://www.youtube.com/watchv=qVvizbAMLA4, between 1:30:42 and 1:34:38. The quotation is taken from a transcript of this recording.

(5) See the Powell testimony to Congress at https://www.youtube.com/watch?v=odBHvbmNoE, between 1:26:00 and 1:28:18. The quotation is taken from a transcript of this recording.

(6) See, for example, Federal Financial Institutions Examination Council (FFIEC), Supplemental Instructions, 30 September 2023, at https://www.ffiec.gov/pdf/FFIEC_forms/FFIEC031_FFIEC041_FFIEC051_suppinst_202209.pdf

(7) Basel Committee on Banking Supervision, Prudential treatment of cryptoasset exposures, December 2022, pages 3-4.

(8) US Government Accountability Office (GAO), Securities and Exchange Commission—Applicability of the Congressional Review Act to Staff Accounting Bulletin No. 121, B-334540, 31 October 2023.

(9) Financial Services Committee, Press Releases, McHenry, Lummis, Colleagues Urge Prudential Regulators Not to Enforce SAB 121, Letter follows GAO finding SAB 121 constitutes a “rule” for purposes of the CRA, Washington, 15 November 2023.