SEC Wants Enhanced Protections on Crypto, Other Adviser-Managed Investments

The proposed changes would amend a custodial rule requiring cryptocurrency exchanges to be run by qualified custodians.

The Securities and Exchange Commission on Wednesday proposed rule changes to enhance protections of customer assets managed by registered investment advisers, including cryptocurrency investments.

The changes seek to amend the so-called “custody rule” under the Investment Advisers Act of 1940 to safeguard against what the SEC identifies as a “general reduction in the level of protections offered by custodians,” according to the proposed rule. The SEC also cited “significant developments” in crypto-asset trading through blockchain technology that, while efficient, creates regulatory risks to investors.

“Unlike mechanisms used to transact in more traditional assets, this technology generally requires the use of public and private cryptographic key pairings, resulting in the inability to restore or recover many crypto assets in the event the keys are lost, forgotten, misappropriated, or destroyed,” the SEC proposal states. “These specific characteristics could leave advisory clients without meaningful recourse to reverse erroneous or fraudulent transactions.”

Although the 434-page document does not name the failed cryptocurrency exchange FTX by name, regulators such as the SEC and Commodity Futures Trading Commission have called for regulatory action to safeguard investors and the markets from another multi-billion-dollar collapse.

“The proposed changes are intended to help ensure that qualified custodians provide certain standard custodial protections when maintaining an advisory client’s assets,” the SEC proposal states. “These protections are designed, among other things, to ensure client assets are properly segregated and held in accounts to protect the assets in the event of a qualified custodian bankruptcy or other insolvency.”

Alternative Investments

Before the FTX collapse that led to a Chapter 11 bankruptcy filing in November 2022, retirement industry recordkeepers Fidelity Investments and ForUsAll had started offering retirement savers access to cryptocurrency investments in their defined contribution retirement plans. Fidelity offers investment in bitcoin through the core retirement plan lineup. ForUsAll offers access through the self-directed brokerage window to an exchange called Coinbase Institutional.

According to the proposal, cryptocurrency and other RIA-led investments would need to be managed by qualified custodians such as banks or savings associations, registered broker/dealers or foreign financial institutions. Coinbase, which runs Coinbase Institutional, announced that the SEC has recognized Coinbase Custody Trust Co. as a qualified custodian and that the proposed rulemaking will not change that designation.

“We fully agree investors deserve to feel confident their assets are safe—as a reminder, our clients’ assets are segregated and secured,” Paul Grewal, Coinbase’s chief legal officer, said in a statement. “We support the Commission’s efforts to provide all investors with the protections already available to CCTC clients.”

ForUsAll did not immediately respond to a request for comment.

Early Response

The general counsel for the Investment Adviser Association, Gail Bernstein, says her organization is still delving into the proposal. Bernstein’s initial response was that the rule would be a “major departure from how the rule” discretionary advice is currently treated from advisers and will encompass all authorized adviser trading on behalf of a client.

The IAA, which represents fiduciary investment advisers, noted that safeguarding client assets is of paramount importance and in need of modernization, but Bernstein said care must be taken on how to get there.

“The proposal expands the reach of the rule well beyond what it is today,” Bernstein writes via email. “It will expand from covering a client’s funds and securities to include all assets in a client’s portfolio with an adviser, like crypto, derivatives, real estate and more.” 

The SEC’s comment period on the proposal will remain open for 60 days following publication of the proposal in the Federal Register.