Crypto platforms’ ties to hedge funds under fire in SEC rule

The Securities and Exchange Commission on Wednesday proposed expanding its “qualified custodian” requirements to cover a range of assets, including virtual currencies. The broad changes to those long-standing rules might hit the crypto industry particularly hard as it continues to reel from a regulatory crackdown.

Watchdog concerns over the safety of investors’ tokens held by crypto platforms was heightened after a series of meltdowns last year, including FTX’s wipeout in November. The SEC’s plan would require that custodians give assurances that money-manager client assets are properly segregated and protected in the event of bankruptcy, or insolvency, as a condition of being able to hold them.

“Make no mistake: Based upon how crypto platforms generally operate, investment advisers cannot rely on them as qualified custodians,” SEC Chair Gary Gensler said in a statement. He added that crypto exchanges that co-mingle custodial services with other business activities already prevents them from qualifying as custodians for investment advisers under existing rules.

In practice, money managers would have to enter into a written agreement with qualified custodians under the SEC plan. The intermediaries, including crypto companies, would face annual evaluations from public accountants, as well as have to provide account statements and turn over records upon request.

According to the SEC, the proposed changes are asset- and technology-neutral. They would also apply to physical assets such as art and real estate, and all custodians — regardless of industry — would have to abide by the new standards.

Still, the plan is expected to affect the crypto sector particularly because it historically had far less formalized processes for dealing with client funds.

It’s unclear who would take on custodial services for digital assets if crypto platforms can’t meet the new requirements. The question is a major concern for the industry after some banks said SEC guidance released last March made holding cryptoassets on behalf of clients too costly.

Republican Commissioner Hester Peirce opposed the proposal, and questioned whether, if implemented, it would put crypto investors at greater risk of fraud or loss by restricting the number of firms who can safely hold their assets.

Gensler has repeatedly said crypto exchanges skirt SEC rules. He’s urged digital-asset firms to come into compliance and last week said that they don’t properly safeguard their customers’ assets and often mix them with their own funds.

Now that a majority of the SEC commissioners voted to propose the rule, it will be put out for public comment and then would be subject to another vote before it could be finalized months later.