Asset custody and its application to cryptocurrency
The U.S. Securities and Exchange Commission (SEC), in concert with a private industry organization known as the Financial Industry Regulatory Authority (FINRA), issued a joint statement in early July 2019 that could spell trouble for the cryptocurrency industry in the United States. This post will detail that announcement as part of a discussion of asset custody and its application to cryptocurrency.
Custodial issues are always a consideration whenever you are talking investments. Regardless of whether an investment is made in stocks, commodities, or any other kind of asset, the individual or organization that maintains custody over those assets is critical. That is why most developed nations have strict custodial laws in place.
Those laws bring us to the problem in the US. According to the SEC and FINRA, there is no way for a cryptocurrency custodian to satisfy the current rules as set forth by the SEC. The two organizations' joint statement said, among other things:
"Put simply, the Customer Protection Rule requires broker-dealers to safeguard customer assets and to keep customer assets separate from the firm's assets, thus increasing the likelihood that customers' securities and cash can be returned to them in the event of the broker-dealer's failure."
More about the custodian
Certain players in the cryptocurrency space might argue that the SEC/FINRA position is not accurate. It turns out that the whole question rests on how you define 'custodian'. Investopedia defines a custodian as "a financial institution that holds customers' securities for safekeeping in order to minimize the risk of their theft or loss."
Custodians can hold assets in either electronic or tangible form. They can hold as little as a few hundred U.S. dollars or as much as billions. The difficulty in the cryptocurrency space is found in the reality that some custodians are not legally recognized as financial institutions.
As such, can they legally act as custodians? And if so, are they required to follow the same rules and regulations as banks, stockbrokers, etc.? These are questions that have not yet been answered.
The issue at hand
U.S. law requires asset custodians do a couple of things. First and foremost, they must protect the assets they hold against theft or any other kind of loss. They are responsible for ensuring that assets can be recovered and/or liquidated on demand. That is a pretty tall order.
Next, custodians must keep assets separate. They are not allowed to mix customer assets with their own under any circumstances. There is some debate as to whether or not they are allowed to mix the assets of multiple customers together. Common sense seems to suggest they can, or it would be impossible to invest in things like mutual funds.
The issue at hand is whether or not certain kinds of cryptocurrency custodians can meet those two obligations. A crypto exchange is a good example. Coinbase, one of the biggest exchanges in the world, protects customer assets by storing 98% of its holdings in off-site cold storage.
In that regard, Coinbase is meeting its obligation to protect customer assets. However, the 2% that remains hot is still subject to theft and other potential hazards. For the record, that remaining 2% must remain in hot storage so that the organization has the funds to complete trades.
In terms of mixing funds, it is hard to see how some exchanges could avoid doing so. Cryptocurrency is incredibly fluid, a characteristic that requires organizations like Coinbase have quick access to cash. Perhaps some of your bigger exchanges can get away with keeping funds separate and still maintaining a strong position of liquidity, but smaller exchanges would have a more difficult time.
Exchanges are largely unregulated
We should point out that the SEC and FINRA did not issue their statement haphazardly. They have been working on possible cryptocurrency regulations for quite some time now. Unregulated exchanges have been the impetus behind their efforts. Regulators in the U.S. and elsewhere are very concerned that investors are risking too much by allowing exchanges to be custodians of their assets.
Perhaps you remember the passing of QuadrigaCX 's Gerry Cotten in December 2019. Being the owner and operator of an exchange with custody of hundreds of millions of dollars in assets, Cotten had a responsibility to protect his customers against loss. His biggest mistake was that he kept all of the keys to customer assets on a secure laptop that could not be accessed after his death.
It was estimated earlier in 2019 that not having access to the laptop put some CAD $190 million worth of assets in jeopardy. QuadrigaCX faced obvious liquidity issues that led to its filing for bankruptcy in February 2019.
Cotten did the right thing by storing assets in cold storage facilities. But by not making backup copies of customer keys and storing them in such a way as to give others access to them in the event of an emergency, Cotten failed in his responsibilities as a custodian.
Regulators say this all could have been avoided if QuadrigaCX had been forced to follow more stringent rules. The problem is that those rules do not exist. Nor does anyone know how to fashion a set of rules that would protect customers without harming exchanges.
Safeguarding cryptocurrency funds
Cryptocurrency exchanges are challenging because they provide custody for individual asset owners. But they are not the only institutions regulators are worried about. Regulators are also concerned about a growing number of investment groups attempting to launch cryptocurrency funds that would operate in a way similar to exchange traded funds (ETFs) and mutual funds.
If we had to make a wager, we would bet that any approval of such funds would be subject to the same rules that apply to their more traditional counterparts. We would be hard-pressed to believe the SEC would grant permission for a cryptocurrency fund to operate independent of the same rules that apply to ETFs and mutual funds.
The significant difference here is that fund managers assume most of the liability for their activities. As asset custodians, they have a fiduciary responsibility to protect their customers even in the midst of their own failure. There are regulatory controls in place to guarantee that happens.
Be your own custodian
Whether or not regulators ever come up with a rock-solid set of rules to protect customers, cryptocurrency is different in one respect: investors can be their own custodians if they so choose. That is not the case with traditional securities.
If you want to purchase your favorite stock from any of the world's major stock exchanges, you cannot simply go to a store and pick something off the shelf. You cannot directly purchase stocks and shares yourself. You must go through a broker. That broker acts as a custodian of your assets.
Cryptocurrency doesn't work that way. For starters, you can purchase cryptocurrency directly from another coin owner without any middleman. You give that person fiat and he or she pushes coins to your wallet. You can then move those coins directly into whatever cold storage option you utilize.
Should you buy coins on an exchange, you do not have to leave them there. You are free to withdraw all of your assets and put them in cold storage. You could withdraw them and leave them online as well, but what would be the point? Withdrawing from an exchange is something you do to protect your assets, and the best way to protect them is to get them off-line.
Regulators can put all sorts of rules in place to force asset custodians to do what they should be doing anyway. Those rules will not apply to you if you act as your own custodian. When you look at it that way, it is easy to see that you are your best choice as custodian of your assets.
None of this may matter to you if your only experience with cryptocurrency is using your favorite coin for day-to-day purchases. Maybe you own only a few hundred dollars in Bitcoin that you use to make online purchases or do a bit of gambling. Custody of your assets is something you rarely think about.
Your lack of concern is understandable albeit unwise. Even a couple of hundred dollars in assets could be lost by a custodian that doesn't take his/her responsibility seriously. So if you are intent on leaving your assets with a custodian, please do your homework. Make sure you are working with an entity that has a stellar reputation and a long history.
In the meantime, cryptocurrency custodians in the U.S. now have a problem on their hands. The SEC and FINRA apparently cannot find a single instance in which a custodian could meet its obligations under the law. That can only mean bad news for custodians in the future.
Expect U.S. regulators to come up with a stringent set of rules that will change how custodians in the U.S. operate. Should those rules prove effective, they may catch on in other parts of the world. It is likely that being a custodian is going to get more difficult in the very near future.