Crypto custody faces regulatory death-roll

Banks stake their reputation on being able to keep your cash safe. But the custody of digital assets like bitcoin or tether is a riskier proposition.

So risky, in fact, that US regulators have issued guidelines that would force banks to hold punitive levels of capital against these digital assets—in effect “killing” crypto custody, say experts.

The accounting guidance is part of a wider squeeze on the crypto industry by US authorities who have been stung into action by last year’s failure of cryptocurrency exchange FTX and the implosion of algo stablecoin terraUSD, leading to losses of billions of dollars for investors.

Insiders say the regulatory measures are causing liquidity in digital markets to thin and assets to flee offshore. The action by authorities threatens to “pollute the pathway to the institutionalisation” of crypto, according to Jean-Marc Bonnefous, managing partner at digital investment firm Tellurian Capital.

Undeterred, some institutions such as Nasdaq and Fidelity are forging ahead with crypto custody offerings. Others, including State Street, are rethinking their custody plans.

Many digital devotees view the actions by US regulators as one prong of a campaign to deprive the crypto industry of access to traditional banking services. The de-banking thesis is spurred by a contention that Signature Bank—one of three US lenders with significant ties to crypto to bite the dust last month—was still “solvent” when it was closed by the New York State Department of Financial Services on Sunday March 12.

Former US congressman and ex-house financial services chair Barney Frank, who sat on Signature’s board, claims that the bank merely suffered “contagion” from the collapse of Silicon Valley Bank two days before, and that the Federal Reserve’s new banking backstop would have been enough to enable Signature to re-open for business as usual.

The SEC basically said that they don’t think a US adviser subject to the custody rule can keep client assets on a digital asset exchange

Gregory Rowland, Davis Polk & Wardwell

Whether the actions amount to regulatory “over-reach”, in Bonnefous’s words, or much-needed oversight of a risky and unproven area of finance, crypto custodians are nervous.

“A lot of the UK, European based players and on the Asian side as well are all taking a pause… to reflect on the best way of being able to serve the US [market],” says Anoosh Arevshatian, chief risk officer at Zodia Custody, a firm backed by Standard Chartered and Northern Trust.

Despite ructions in the crypto industry, the value of cryptocurrencies such as bitcoin and ether has soared. Bitcoin’s price stood at $30,400 at pixel time, up from $16,500 at the start of the year. Analysts attribute the rise, in part, to the recent woes of the banking sector. Cryptocurrencies are viewed as a hedge against inflation, and the closure of Signature, SVB and Silvergate and the forced sale of Credit Suisse were expected to act as a brake on central banks’ interest rate tightening.

However, crypto money is moving offshore. The operator of trueUSD, the fifth largest stablecoin, shifted $1 billion of funds into Capital Union Bank in the Bahamas last month. Research by blockchain data analytics company Chain Argos shows that the cash was originally held onshore with Signature and Silvergate.

Crypto liquidity, notably in bitcoin, has also ebbed away in recent weeks due to the difficulties in working within the US banking system, traders say.

Silvergate and Signature were two of the main providers of round-the-clock instant settlement through their respective platforms SEN and Signet. In the absence of those instant payment rails, market-makers say Customers Bank has been left as the sole significant US conduit offering instant settlement.

Thinner trading volumes may have contributed to the extent of bitcoin’s recent upside. But the drying up of liquidity is “obviously negative for professional funds that actively trade,” Bonnefous says.

He adds: “The window [to operate viably] is getting narrower.”

Where’s my wallet?

Crypto operators’ increasingly limited room for maneuver within the US banking system is only one facet of their woes. There are widespread concerns over a string of moves by the SEC to regulate custodianship.

Lawyers, market-makers and portfolio managers agree that provisions to segregate and protect client assets—a basic pre-requisite post-FTX—are much needed. But designing a regulatory regime to oversee custody of crypto assets is a challenge.

“The crypto world has digital bearer assets—they’re unique in the sense that they are both bearer and digital at the same time,” says Omer Suleman, founder of Haruko, an infrastructure provider for digital assets and blockchain. “In some ways we’re going back to the 1950s where someone can physically steal this bearer asset from you. What we need to invent collectively is a digital version of a Swiss bank safe.”

On February 15, the US Securities and Exchange Commission put forward a new custody rule—233-1, replacing 206(4)-2 and covering custody frameworks across both traditional and digital assets.

The SEC proposal aims to clarify the regulatory scope of financial securities and redefine the “possession or control” of assets—which can be a fuzzy area for digital assets whose ownership is transferred through cryptographic keys.

In particular, the new rule takes aim at crypto exchanges or platforms where most trades are executed and settled. Because the platforms are not qualified custodians, “this practice would generally result in an adviser with custody of a crypto asset security being in violation of the current custody rule,” the SEC wording states.

Gregory Rowland, a partner at Davis Polk & Wardwell says: “The SEC basically said that they don’t think a US adviser subject to the custody rule can keep client assets on a digital asset exchange.”

He adds that trading over a crypto exchange requires moving assets out of a custody wallet and into an exchange account wallet. “The SEC seems to be saying that that alone is not… allowed even today.”

Rowland expects that the proposed custody rule will “spur” crypto settlement solutions that obviate any need for client assets to pass through an exchange.

Several US custodians have developed off-exchange custody operations, including Anchorage Digital. The process involves trades taking place on an exchange but settlement occurring off-exchange, via the custodian for the two counterparties. Uptake for the service has been limited, though.

“The only firm that is placed to meet all [US regulatory] requirements and meet them without attracting any further scrutiny is Anchorage,” says Arevshatian at Zodia Custody, adding that Anchorage is a federally regulated and OCC-chartered bank.

Georgia Quinn, general counsel at Anchorage Digital, explains that the firm’s off-exchange settlement model works only when “we’re the custodian for both parties… the exchange provides us the settlement instructions, and we transmit the assets on behalf of the exchange participants.” The firm announced in March that it was cutting its workforce by 20%, citing regulatory headwinds.

UK-registered digital assets firm Copper also operates an institutional custody service, offering clients the ability to “trade without moving assets to exchanges, mitigating the risk of appropriated assets”.

Copper teamed up last year with US custody giant State Street, which services more than $40 trillion in assets. But State Street announced in March that the two companies were terminating their joint licensing agreement. Copper did not respond to a request for comment.

Off-exchange crypto solutions also face strong headwinds due to the balance of power within the marketplace, according to Anton Golub, founder of Flovtec, a crypto market-maker based in Switzerland.

“It will take a long time” for off-exchange custody and settlement to gain traction,” he says. “The exchanges don’t want to give up the assets; the whole game is that you have the assets.”

That hasn’t stopped other firms from forging ahead with their custody projects. US exchange Nasdaq, which currently does not run a trading platform for digital assets, announced in March that it was planning to launch a crypto custody service by the end of the second quarter. Also in March, Fidelity extended its crypto custody and trading services from institutional to retail clients in most US states.

‘Good way to kill an industry’

The SEC’s Staff Accounting Bulletin 121, issued last year, is custodians’ biggest bone of contention. The guidance has also attracted the ire of members of two influential congressional committees.

SAB 121 states that banks and broker-dealers that act as crypto custodians must record digital assets as a liability on the balance sheet. Financial regulation requires custodians to hold corresponding assets against these liabilities. The assets could take the form of reserves held at the US central bank or Treasuries, which wouldn’t require any risk-based capital. But the assets would still show up in the leverage ratio, thereby inflating capital requirements.

Quinn at Anchorage Digital says the guidance means that “a prudentially regulated institution would have to put a counter-asset on its balance sheet with respect to any assets that it holds in custody.”

This would make it “economically untenable for any SEC regulated, prudential institution—so any public bank—to engage in custody of digital assets on behalf of their clients, and that’s frustrating,” she adds.

American competitiveness and national security are huge issues in the US right now that are re-energising the debate about crypto and digital assets

Source at custody firm

Meanwhile, the SEC’s custody rule 233-1 restricts the custody of digital assets to “banks and broker-dealers,” but since no broker-dealers have been approved to custody digital assets in the US, that leaves only the banks—many of which can’t turn a profit due to the onerous capital requirements of SAB 121.

“If you want to kill an industry, this is a pretty good way,” Quinn laments.

Zodia’s Arevshatian likewise takes aim at SAB 121: “You have to have massive amounts of capital on hand in order to actually be able to provide those [custody] services” in the US, she says.

US Bancorp, which acts as custodian or administrator for nearly $9 trillion in assets, told Reuters in January that it was “pausing intake” of clients into its bitcoin custody service—launched in October 2021—as it evaluated the “evolving regulatory environment”. US Bancorp did not respond to requests for comment.

A spokesperson for Fidelity says: “We are aware of the SEC’s staff accounting bulletin and are reviewing it to understand what impacts it may have.”

An SEC official says: “SAB 121 addresses financial reporting that provides useful information for investors in entities that safeguard crypto for others.”

Turf war

The regulatory clampdown comes amid confusion over which agencies are responsible for the supervision of digital assets in the US. While the Biden administration has been accused of dragging its heels on crypto regulation, the SEC and the Commodity Futures Trading Commission have also struggled to set out a coherent strategy on digital assets.

The SEC sees almost all crypto assets as securities, apparently contradicting the CFTC, which views stablecoins as commodities.

Changpeng Zhao, CEO of Binance, an offshore exchange that boasts the majority of global crypto trading, was hit by an CFTC civil enforcement action on March 27 for “numerous violations” of the Commodity Exchange Act, generating further uncertainty.

Industry players complain that amid the competing jurisdictional claims—and despite the SEC pursuing cases based on failures to register crypto assets as securities—there is no established designation of crypto assets as a specific asset category.

US authorities “should say, ‘okay, these are the top 10 coins: tether, ethereum, bitcoin’ … start there and say, ‘we think such and such is as a security,’” says Suleman at Haruko.

There “needs to be much more clarity in terms of what crypto assets are considered securities versus commodities”, says Arevshatian.

“We need some clarity,” echoes Quinn. “To know what is and is not a security; that will be super-helpful.”

But Quinn also notes that when an asset is classified as a security in the US, “it can only be traded on a national securities exchange. And I don’t see the NYSE or Nasdaq listing these assets any time soon.”

Rowland meanwhile believes that any crypto business starting “from scratch today… wouldn’t choose to start in the United States, given all the regulatory hostility and uncertainty.”

Suleman estimates that US authorities have between “12 and 24 months” to create a viable regulatory regime for crypto assets before many companies that have invested onshore either pull the plug entirely or move their operations elsewhere.

Moving abroad

If the US continues on its current path, it will push the industry “outside the regulatory rails to Europe, Asia and elsewhere” over the short to medium term, says Bonnefous at Tellurian.

“The ultimate prize for people like us is to get the pension funds to allocate assets.”

Since the biggest pension funds are in the US, the ongoing uncertainty will certainly “slow down… upper tier, real money investment into crypto, because they want to see the dust settle”, he says.

But Bonnefous, Golub and Suleman all see a future for institutional crypto, whether the US is substantively involved or not.

The latter identifies “Zurich, Geneva, Singapore, Hong Kong and Dubai” as the prime beneficiaries of aversion to the US and even believes that the salience of dollar denominated stablecoins will fade over time.

“If US regulators become really antagonistic… the ecosystem will move not only offshore, but it will actually move off dollars in my view,” he predicts. “You’ll end up finding stablecoins backed by local currencies in the Middle East and the Far East.”

Bonnefous, however, believes that the development of stablecoins outside the major currencies will be marginal.

Golub, the founder of a Swiss market-maker, also notes that while the Swiss market offers banking and custodianship options for crypto, the “money is just not there” to achieve scale, while the UAE is limited by underdeveloped digital infrastructure.

However, Rowland and Bonnefous are keen to emphasise that the US arena should not be written off.

They argue that political lobbying and legal pushback—respectively against the custody proposals, or the ability of crypto exchanges and asset issuers to better access banking onshore—could yield fruit.

An expert at an established custodian cites another factor that could force US authorities into a rethink on digital assets.

“What happens if China has its digital currency and starts using it for transactions in Africa and other emerging economies?” the custodian says. “American competitiveness and national security are huge issues in the US right now that are re-energising the debate about crypto and digital assets.”