The SEC Is Still Working Out What ‘Qualified Custodian’ Means for Crypto

The U.S. Securities and Exchange Commission (SEC) is once again asking about qualified custodians and how crypto custody fits into this regulatory framework.

Last month, the Wyoming Division of Banking granted a no-action letter to Two Ocean, a wealth management firm hoping to offer custodial services for digital assets (which include virtual currencies) and call itself a qualified custodian. 

In the letter, the division said it “would not pursue enforcement action against Two Ocean for holding itself out to the public as a ‘qualified custodian’ if Two Ocean operates in conformity with applicable laws and rules surrounding the safekeeping of customer assets, including both Wyoming and federal law.”

In response, the SEC published a statement asking for public input on “qualified custodians,” noting that Wyoming’s letter touched on both state and federal law, and hinting the responses it gets may inform amendments to existing guidance to provide future clarity.

The statement’s very existence is a sign the SEC is still looking at cryptocurrency issues like custody, but confirms there is much work to be done in clarifying how digital assets fit into existing regulatory frameworks, industry experts said. 

“I think essentially the SEC is coming out here and saying, ‘Yes, it’s great that the Wyoming Division of Banking has issued this interpretation to you but we may have a different view and we are in the process of considering these issues,’” said Philip Angeloff, an attorney with Clifford Chance, a multinational law firm. 

The regulator isn’t directly saying its view differs from the Wyoming Division of Banking. Rather, it sounds more like the agency has yet to finalize its position, Angeloff told CoinDesk. Ensuring that it’s clear which companies fall into the definition of a “qualified custodian” remains under the SEC’s purview.

Still, the very fact the SEC is bothering to respond is a promising sign for the crypto industry, said Andrea Tinianow, an attorney who runs her own consulting firm. 

“This public statement reinforces the notion that digital assets are not going away, they are gaining in popularity,” she said. “Serious investors are paying attention to this asset class and they need to be protected, and that’s why the SEC is taking this up.”

The SEC move may benefit institutional investors and other parts of the investment community, she said.

Qualified custodians

The term “qualified custodians” is a legal one, defined by the SEC as a bank, broker-dealer, futures commission merchant or other entity that maintains client funds and securities in specific ways. The federal regulator can designate an entity as a qualified custodian, while state-level regulators typically cannot. 

That hasn’t stopped a number of crypto companies from trying to become qualified custodians, but by and large most have given up their bids and instead focus on becoming state-chartered trust companies, which still lets them offer custody services under regulatory oversight. 

While the Wyoming Division of Banking determined that Two Ocean could call itself a qualified custodian, other trust companies or entities cannot do so without receiving similar letters of their own, the letter warned.

“This is a fact-intensive analysis based on the assertions made in your letter of [July 27, 2020]. The guidance provided in this letter may no longer apply if these facts were to materially change,” the letter said.

This distinction is important. As the Wyoming letter notes, the law surrounding custody, especially for digital assets, “is not fully developed.” This means it may be difficult to ascertain which companies can provide custody for assets like virtual ones, or how these assets are treated under law. 

In response, the SEC published a statement telling the general public to send it comments on how the “Custody Rule,” a part of the Investment Advisers Act of 1940, should apply to issues like digital assets. 

Chris Land, general counsel at the Wyoming Division of Banking, told CoinDesk this question has hovered over the industry for a few years, noting that most crypto custodians in the U.S. currently operate as trust companies.

One of the main issues for a trust company is whether custody qualifies as a fiduciary activity, another important regulated activity that falls under the Advisers Act. 

Good sign

The SEC’s letter is encouraging, Land said. The SEC is highlighting that investment advisers must consider their fiduciary duties when acting as a qualified custodian, and in his view the federal agency is just laying out questions around this issue. 

“The SEC letter and our letter both agree we have shared power over this area, the custody area, but I don’t think that line has been drawn with the precision that the banking industry and the securities industry might like, and I think that’s one thing we’re both going to have to work together [on],” he said.

Tinianow agreed, saying trust companies and other entities are likely to provide “thoughtful input” in response. 

The move fits into a broader trend of recognizing that digital assets have value, something many states have already done by crafting laws around the space, she said. 

“The SEC staff would not invest its time, resources or expertise if this was going away,” she said.

What the letter does show is the SEC is maintaining its ground in terms of being able to declare whether or not an entity is a qualified custodian, Angeloff said. 

“In some cases, law firms and, as in this case, state regulatory agencies, could provide their interpretation of state and federal law, but the SEC has the final word on interpreting the Advisers Act,” he said. 

In other words, while the Wyoming Division of Banking can tell entities they look like qualified custodians, those entities should still be talking to the SEC, he said.

“From my perspective, this is a sign that the SEC staff is still grappling with the notion that digital securities can be held on a distributed ledger and is still in the process of forming a definitive view as to how intermediaries that provide digital securities custody services can provide such services in compliance with the securities law and SEC rules,” he said.

Not bitcoin

The question of how digital assets are relevant to qualified custodians only applies to securities, meaning assets like bitcoin are not affected, Land said. 

“I think providing further clarity around which virtual assets are securities is another issue,” he said. 

Land noted the question does not apply to Wyoming’s Special Purpose Depository Institution license. So far only two entities have received this license – Kraken and Avanti – and both are operating as banks under the state law. 

“I think it’s reflective of the SEC’s willingness to continue to look hard at digital assets and I’m fairly encouraged by the SEC putting that statement out. It was quite good, in my opinion. It was thoughtful and highlighted the issues well, in my opinion,” Land said.

The SEC’s statement asks whether state-chartered companies resemble qualified custodians, how their services compare, what advisers might look at when assessing custodians and if there are any qualified custodians that do not match the policy goals. Members of the public interested in commenting to the SEC can email the agency, and the SEC will make all responses publicly available, it said.