SEC’s Proposed Crypto Custody Rule Faces Pushback from States

An SEC effort to impose a uniform standard on investment funds for storing clients’ assets, including cryptocurrencies, has set up a potential clash with state regulators with their own rules for providing custodial services.

The US Securities and Exchange Commission on Feb. 15 proposed establishing a standard for banks and other firms looking to safely store client assets entrusted to hedge funds, private equity funds, pension funds, and other investment firms.

The proposal comes in the wake of several high-profile crypto firm collapses and raises concerns about the ability of state-chartered banks to meet a singular federal standard.

“Some state regulators may push back for a few reasons, one of which is that they probably don’t want the SEC to limit their authority over state-chartered banks,” said Jiaying Jiang, a professor at the University of Florida’s Levin College of Law.

Some states, including New York and Wyoming, have their own trust bank charters that allow banks to provide custody services without federal deposit insurance or being a member of the Federal Reserve System.

‘Common Denominator’

The SEC’s proposed custodial services update follows the implosion of crypto firms such as FTX that advertised that customers’ crypto tokens were stored separately from company assets. When those promises turned out to be false, customers lost their money as the companies fell into bankruptcy.

The SEC would require all custodians to have written agreements with investment advisers that client assets would be properly segregated and protected in the event of a bankruptcy or insolvency. It pointedly, in the rule’s preamble, states its concern that “new entrants” into the custodial marketplace, including banks operating under state charters, “offer, and are regulated to provide, the types of protections we believe a qualified custodian should provide under the rule.”

The proposal also includes a series of questions about how to deal with state-chartered banks, ranging from cutting them out from the ranks of qualified custodians entirely to imposing SEC rules on them. Banks can operate under federal or state charters, with the latter encompassing banks at virtually every level from smaller community institutions to huge commercial enterprises.

“By changing the definition, the SEC seeks to establish a common denominator across the states, create more uniformity, and reduce regulatory arbitrage,” said Yuliya Guseva, the head of the Blockchain and Fintech Program at Rutgers University Law School.

The SEC concerns followed recent statements from the Federal Reserve, the Federal Deposit Insurance Corp., and the Office of the Comptroller of the Currency that cryptocurrency activities may not be compatible with safety and soundness standards for banks—and specific concerns raised about state cryptocurrency rules.

SEC Commissioner Mark Uyeda, a Republican, approved the proposal but, in a statement, noted that the actions from federal regulators “suggest that state-regulated banking entities are less trustworthy than federally-chartered ones.”

Expanding Reach

The SEC’s proposal is an extension of existing qualified custodian rules to asset classes where they previously didn’t apply, said Mellissa Campbell Duru, special counsel at Covington & Burling LLP and a former SEC attorney.

Coinbase Global Inc., which operates a crypto exchange platform, says its custody services already comply with the SEC’s proposed new requirements. Likewise, big custody banks such as the Bank of New York Mellon Corp., which has a New York charter but carries federal deposit insurance and is a member of the Federal Reserve System, would meet the new standard.

“That definition still ties to the prior or existing definition of a qualified custodian,” Campbell Duru said.

But state regulators such as the Wyoming Division of Banking issue trust company charters that don’t require banks to have deposit insurance or be Fed member banks. The Fed has already raised objections to those types of institutions having access to the federal banking system.

The New York Department of Financial Services has had a special charter for crypto custodial services since 2015. Coinbase is among the companies to be chartered with New York state. An agency spokesperson said the department was reviewing the SEC plan.

“DFS has and continues to provide the technical expertise gained from seven years of regulating virtual currency to our federal and global counterparts,” the spokesperson said in an statement.

A spokesperson for the Conference of State Bank Supervisors said that group was reviewing the proposal. The Wyoming Division of Banking didn’t immediately respond to a request for comment.

Those, and potentially other, state agencies are expected to push back hard on the SEC’s presumption that state-regulated banks provide less safe custody services than those with federal charters and will likely not welcome having additional requirements imposed on their banks.

“Any time it appears to state regulators that institutions that they supervise may be disadvantaged by a federal regulation, state regulators are going to have a concern,” said Karen Solomon, senior of counsel at Covington and a former top OCC official.