With a new crypto-loving administration taking office on January 20, institutions are finally eager to invest and ready to face the serious operational and governance challenges posed by cryptocurrency investments.
A confusing patchwork of regulations and laws has long posed tricky legal obstacles for institutions looking to make large scale investments in the non-traditional space. But a fresh face in charge of the Securities and Exchange Commission may ring in necessary changes to induce more competition, transparency, and the clarity needed for full scale adoption.
The victory of Donald Trump at the polls in November propelled crypto into the limelight, pushing the price of one bitcoin — the bellwether of the industry’s success — temporarily over $100,000 for the first time. At the time of writing that number has fallen well below that milestone at around $94,500.
Trump’s courting of the industry, including the launch of an exchange, his relationship with lobbyists and pro-crypto enthusiast Elon Musk, and the recent nomination of crypto advocate Paul Atkins as chair of the SEC led to the resurgence.
Paul Grewal, chief legal officer at Coinbase, told II that Atkins is going to be a breath of fresh air for crypto, balancing protecting investors with promoting innovation for the first time in four years that will bring a lot more clarity up front for institutional customers.
The biggest issue for institutional investors that want to allocate funds to cryptocurrency is custody.
“For Coinbase, the issue has always been about making sure that custodians can provide their services under the supervision of either state or federal regulators,” said Grewal. “We think it’s very, very important that state-chartered institutions like Coinbase Custody, for example, have as much access to this market as custodians that are chartered at the federal level.
“But the main point is to provide clarity and certainty that these institutions can compete in the market. I have no doubt that we will see a much more competitive market, and if Coinbase were only self-interested in reducing competition we might have a different point of view, but we think having a much more competitive market is ultimately in our customers interests and advances the primary mission of the company — to bring a billion or more people into the crypto economy,” said Grewal.
Coinbase Custody obtained a license under New York State banking law to operate as an independent qualified custodian in 2018.
In addition to institutional investors, registered investment advisers also face ambiguous rules on whether they can provide access to digital assets with a custodian that’s chartered either at the state or federal level. In February 2023, the SEC proposed that RIAs use a limited list of regulated financial institutions for all assets, not just crypto. Grewal thinks a new regulatory regime will bring clear standards for what those custodians must adhere to in ways that will make it easier to comply, but at the same time give greater assurance to customers that their funds are always safe.
There are several rules and regulations that the industry has long campaigned to have removed or reconsidered. The Trump administration is likely to overturn the much-maligned — at least by the industry — Staff Accounting Bulletin 121 (SAB 121), for example, which was introduced in March 2022. This SEC directive stipulates that banks and exchanges should report customers’ crypto assets as a liability on their balance sheets, with full disclosure on what they are holding and potential vulnerabilities.
This has had the potential to cause significant capital reserve requirement issues for certain custodians, who tend to keep balance sheets small relative to the significant amounts they hold in custody.
“Asset managers have to put their assets with some sort of custodian, but with crypto they do not currently have the ability to put a large amount of assets in banks because of limitations like SAB 121,” according to a legal executive at a bank. “If these limitations go away, asset managers will have more diversity of custodian options, if they would like to use a non-bank custodian for crypto assets they could, but they could also use a chartered bank if they wanted to.
“It gives everyone more choice and it is better for the system because there’s no concentration risk, you don’t want all your assets at one entity — whether it’s a bank or not — because there should be diversity, there should be more options.”
The source suggested that greater choice will improve pricing, availability, and competition, but said that right now there are simply not enough players in the game.
A New World Order Beckons — But the Old One Is Still Here
Not surprisingly, necessary changes to how investors and their asset managers can hold cryptocurrencies securely can’t begin to be addressed until Trump takes office in January.
“People are anticipating a wide sweeping set of changes, and they’re skating to where the puck is going,” said Lewis Cohen, partner and co-chair of Cahill’s digital assets and emerging technology practice group, who suggested that initial wins for the sector will include a slowdown in “broken window enforcement cases.”
But Cohen reiterated that nothing has changed in the short term and there is still “an unprecedented level of scrutiny for the activities of anybody who has anything to do with crypto.” And all issues will take time to fix.
“There are still important guidelines that much crypto activity doesn’t clearly fit within and this is still going to have to be dealt with over time, particularly for institutional investors,” he added. “Custody and how custody is managed is a very tricky question. It can be managed, it will be managed, and we will figure it out, but it’s not like there is a day one, all of a sudden, snap your fingers solution.”
Both the custody rule for investor advisers, which is under the Investment Advisers Act of 1940, and the customer protection rule, which applies to broker-dealers that would hold assets on behalf of investors, and which sits under the Exchange Act, provide extra complications for institutional crypto investors.
Managers and others who hold crypto on behalf of clients are not in compliance with the custody rule, which requires them to use qualified custodians like a bank or broker-dealer. Meanwhile, the customer protection rule requires broker-dealers to keep assets safe, separate, and accessible even if there is an operational failure. However, there is little clarity after all this time whether cryptocurrencies are indeed securities, so the application of both of these rules is unclear and creating additional compliance hurdles.
The custody requirements generally apply to ’funds’ and ’securities.’ Until now the SEC had been reluctant to state whether they felt some crypto assets were ’funds,’ ’securities,’ ‘commodities,’ or something else entirely. Managers and investors need clarity on how both rules apply to digital assets, and changes need to be made to ensure that institutions can make compliant crypto investments.
Teresa Goody Guillén, partner and co-leader of BakerHostetler’s blockchain team, and one of those touted as a potential SEC chair, said that under Atkins creating order in the market and providing regulatory clarity will likely be a Commission priority.
“Cryptocurrency is a type of digital asset, some of those assets implicate the federal securities laws but some of them do not,” she said. “So, we’ll hopefully see order and clarity as to which to regulate, which fall under the SEC jurisdiction and which fall under other regulators’ jurisdictions, or maybe are not regulated by a regulator at all.”
Similarly, with crypto exchange-traded funds, the SEC needs surveillance-sharing agreements with futures markets. A surveillance-sharing agreement is a collaboration between the exchange offering the crypto ETF and a regular regulated futures market, allowing for irregularities or insider trading to be monitored to avoid fraud or insider trading. This is to ensure that the price of crypto ETFs is not swayed by the manipulative activities of large traders or pump-and-dump ventures and to secure market integrity.
“There’s tons of enthusiasm, but if you don’t start as an investor now then you’re going to have a lot of work to do later,” said Cohen, who added that there has been a dramatic increase in institutional interest in the industry in recent weeks. “If you’re assuming that by the start of the second quarter of next year there’s going to be a very different environment, you have got to start working on that now. You can’t wait till then.”
More Competition Will Spur New and Creative Options
Of course, there have been plenty of crypto-centric custody solutions brought to the market in recent years, and many have been the foundation of secure deposits for institutional crypto investors. Coinbase, Gemini, and BitGo were start-ups built specifically for the crypto ecosystem and are the current market leaders.
Cryptocurrency custody solutions are third-party securities service providers aimed at institutional investors that either do or want to hold large amounts of cryptocurrency. The solutions use both “hot” — meaning online — and real world “cold storage.” Storing digital assets for clients in a way that is both compliant to the patchwork of U.S. securities rules is difficult enough and made harder still when done in a more vulnerable and volatile environment that is more at risk of cyber-attacks.
Once the rules for crypto custody are clarified it may well open the door to greater competition in the industry, allowing more entrants to the market and potentially even paving the way for self-custody for asset managers.
“We welcome competition. We think it will lead to a better product and set of services for our customers,” Grewal stressed.
On top of custodians built for crypto, more traditional custody banks have gotten involved in recent years, citing increased interest from institutions. BNY Mellon, for example, launched a Digital Asset Custody platform that allows clients to hold and transfer bitcoin and ether. A survey at the time led by BNY Mellon highlighted the significant institutional demand for a financial infrastructure that could incorporate both traditional and digital assets. A vast majority of institutional investors (91 percent) expressed interest in investing in tokenized crypto products, while 41 percent already held cryptocurrency in their portfolios.
Other firms have arisen as specialists, including Anchorage Digital, for example, which has positioned itself as a national crypto bank for institutions. The company uses a combination of hardware devices to store sensitive key material and software to ensure secure and usable crypto asset storage, and their national charter offers a benefit to users.
“The fact that we are chartered and operate as a national bank allows more clients to satisfy their regulatory obligations, many of our clients have SEC requirements that mean they must not custody assets themselves but must use a third party,” said Nathan McCauley, co-founder and CEO of Anchorage. “It is quite difficult to do the cold storage yourself. In terms of operationally, getting it right and making sure you don’t lose access to the keys, because what if you lose them?” (Unlike any other security, crypto requires that holders have a unique key to access the currency.)
Anchorage has set out to provide a safe place to hold crypto that is compliant with existing securities rules. However a pro-crypto SEC may look to amend these rules so asset managers are able to more securely hold their own assets while remaining compliant with existing laws.
The concept of self-custody may not be appealing for asset managers, however, even if it is possible under a new regime. It all boils down to technical competence and institutional priorities.
“Self-custody, in theory, has a lot of benefits, but it also requires work by the institution to know how to do it and where to do it,” said the legal executive. “Most asset managers would want to use and leverage a bank or a bank-type entity that has certain supervisory capital requirements just to ensure there’s more confidence that the assets are not going to be lost.
“There’s no, ‘let me go reset my password’ with crypto, if you lose the keys you’ve lost the assets and you’re done.”
McCauley said that handing off that responsibility to an organization that is purpose-built for security and overseen by a federal regulator gives a lot of people comfort that there is longevity and organizational rigor.
He does not envision this situation, expecting clients to appreciate the security and safety recognized services offer.
Growing demand for cryptocurrency has led to some unusual activity, with the Federal Reserve now even contemplating holding some as an asset.
As institutional interest grows, there will be greater demand to meet the challenges facing the industry and custody is just one of those.
