Background

On Wednesday, February 15, 2023, the U.S. Securities and Exchange Commission (SEC) released proposed amendments to Section 206(4)-2 of the Investment Advisers Act of 1940, which sets out the custody requirements applicable to registered investment advisers. The current rule requires investment advisers to deposit customers’ “funds and securities” with a qualified custodian. The rule is aimed at protecting customer assets from a variety of risks, including loss through misuse by the investment adviser or entanglement in the adviser’s estate in the event of bankruptcy.

According to SEC Chair Gary Gensler, “[the] current rule … covers a significant amount of crypto assets.” As stated in the SEC’s press release, Chair Gensler asserted that “most crypto assets are likely to be funds or crypto asset securities covered by the current rule.” Chair Gensler’s statement concedes that some crypto assets may not be securities and thus, to the extent the SEC seeks to charge an investment adviser with a violation of the current rule based on the adviser’s depositing crypto assets with a non-qualified custodian, the SEC would need to prove the assets were “crypto securities” on an asset-by-asset basis.

Implication of the New Rule

The proposed amendments to the rule would relieve the SEC of having to prove the assets were crypto securities by extending the scope of the custody requirements beyond client “funds and securities” to apply more generally to client “assets.” The SEC announced that this change is intended to “broaden[] the application of the current investment advisor custody rule beyond client funds and securities to include any client assets[.]” Chair Gensler confirmed in a statement the same day that “today’s proposal, in covering all asset classes, would cover all crypto assets[.]”

Whether intended or not, if codified into law, the proposed amendments could shut investors trading through investment advisors out of the crypto markets unless and until the model for centralized crypto exchanges evolves to allow off-exchange settlement through third-party intermediaries.[1]

Traditional Securities vs. Centralized Crypto Exchanges

For purposes of the 1940 Act’s custody rules, the critical, and related, differences between traditional securities exchanges and centralized crypto exchanges are who holds the securities traded on the exchange and where trades are settled. In the case of traditional securities exchanges, a qualified custodian holds the traded securities and helps settle the trades. This process allows the investment advisor to stay in compliance with the custody rules because it never causes customer assets to be transferred outside the custody of a qualified custodian.

By contrast, an investor trading on a centralized crypto exchange must typically transfer assets to a wallet controlled by the exchange so that the exchange can settle the investor’s trades. Once the trade is complete, the investor has the option of either leaving its assets in the exchange-controlled wallet or transferring its assets to an off-exchange wallet. As a result, the centralized crypto exchange model would require an investment adviser to transfer customer assets to the exchange-controlled wallet to complete a trade. As Chair Gensler made clear on the day of the release, “[t]he current business model in crypto exchanges does not meet the qualified custodial standard,” and thus, “investment advisers cannot rely on them as qualified custodians.” For this reason, the current centralized crypto exchange model would require an investment adviser to violate the amended rule with every transfer of customer assets to an exchange-controlled wallet. This violation would literally be unavoidable and would act as a de facto ban on investment advisors trading customer crypto assets on centralized crypto exchanges as they exist today. Moreover, even if the proposed amendments do not become law, the SEC’s statement that “most crypto assets are likely to be funds or crypto asset securities covered by the current rule” may have the same practical effect on investment advisors.

Looking Ahead

What remains to be seen is whether centralized crypto exchanges will evolve to allow off-exchange settlement through a third-party intermediary in the nature of Depository Trust Company so that investment advisors may trade crypto assets without fear of SEC action.

The full text of the proposed amendments is available at https://www.sec.gov/rules/proposed/2023/ia-6240.pdf. Comments to the proposal may be submitted to the SEC in the manner described therein on or before 60 days after the date of publication in the Federal Register.

[1] It seems unlikely that the decentralized crypto exchange model would provide a viable alternative through which investment advisors could trade customer assets given that such exchanges are designed specifically for peer-to-peer transactions without intermediaries such as custodians and investment advisors.

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