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Coinbase says SEC’s proposed tweak to custody rule ‘unnecessarily singles out crypto’

Coinbase says SEC’s proposed tweak to custody rule ‘unnecessarily singles out crypto’
Coinbase CEO Brian Armstrong says the SEC 'makes inappropriate assumptions about custodial practices' in crypto

The Securities and Exchange Commission wants to toughen up rules about where investment firms can store their clients’ assets. Coinbase is pushing back.

Chief Legal Officer Paul Grewal said the exchange agreed with the spirit of the SEC’s proposed overhaul — part of a set of laws that were last updated more than a decade ago in the wake of Bernie Madoff’s Ponzi scheme.

But Grewal said that many details of the proposal were “misguided.”

”This proposal unnecessarily singles out crypto and makes inappropriate assumptions about custodial practices based on securities markets,” he wrote on Twitter.

At stake is the fate of crypto custody. The SEC rules currently require investment advisers to keep client assets with “qualified custodians” — companies like banks and savings trusts that fulfil certain SEC requirements.

After the FTX scandal, the SEC wants to modernise them again, this time partly by bringing crypto into the fold of assets that must be held with such qualified custodians, or QCs.

Grewal said the SEC should continue allowing state-licensed banks to custody crypto assets on behalf of investors.

Coinbase has recently come out swinging against the regulator, serving the agency with a lawsuit after the SEC gave the exchange a notice of intent to bring legal action. Meanwhile, a banking crisis has been upending US markets as investors question the trustworthiness of financial institutions.

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The qualified custodian, or QC, rules were beefed up in the early 2010s amid the fallout from the Madoff scandal, which fleeced investors of billions. The recent overhaul is a response to the many scandals that have beset crypto recently, especially the collapse of Sam Bankman-Fried’s FTX exchange.

Many crypto exchanges lend to and borrow from customers while also offering custody services. In the case of FTX, investors thought their money was being carefully shepherded in segregated accounts, only to discover after the exchange collapsed that their funds were being commingled with FTX’s.

With the exchange in bankruptcy court, investors now have to line up and wait for their money back.

Among other questions in the QC proposal, the SEC asked whether it should limit the kinds of firms allowed to serve as QCs to just those banks with a federal licence.

Coinbase operates a state-chartered QC, Coinbase Custody. This would remain a QC under the new proposal, Grewal noted. But he said it was dangerous to limit the types of firms that can be counted as custodians.

State banks are no less steady than federal banks, he said, and in many cases federal regulators respond quicker to crises.

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“State financial regulators are often more nimble than their federal counterparts in response to technological and economic changes,” Grewal said.

For instance, he said, Coinbase Custody is strictly regulated by the New York Department of Financial Services under its crypto-specific framework.

Grewal warned that narrowing the definition of QC to only federal entities would force investors to find a home for billions of dollars’ worth of assets, and reduce competition in the space, weakening existing custody services.

Coinbase Custody and its competitors develop “cutting-edge technology to safeguard and segregate those assets,” Grewal wrote. Without those, investment clients “would be left to fend for themselves, unnecessarily exposing them to cyber threats, fraud, and other risks institutional custodians solve for.”

He estimated that if the SEC went ahead and excluded state-licensed banks from holding investor assets, the number of QCs could drop by as much as 77%.

Custody in crisis

Custody of crypto assets has become a pivotal issue amid what many crypto proponents see as the systematic de-banking of the industry, amid an ongoing banking crisis.

Some believe the federal government is engaged in a deliberate campaign to choke crypto off from its access to fiat dollars — so-called Operation Chokepoint 2.0.

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The failure of three crypto-friendly banks this year included Silicon Valley Bank, which offered crypto custody to clients.

And in January, the Fed declined an application by crypto-focused Custodia Bank to join the Federal Reserve system. The Wyoming-based bank is currently suing the regulator over the process.

In parallel, the SEC has cracked down on crypto businesses, including custody.

SEC chair Gary Gensler made it clear that FTX and similar scandals were on his mind when the SEC published the QC proposal in February.

“Make no mistake,” he said then. “Based upon how crypto platforms generally operate, investment advisers cannot rely on them as qualified custodians.”

The proposal followed SEC staff guidance issued in May 2022, known as staff accounting bulletin 121.

Critics of SAB 121 — including Republican lawmakers — said it effectively financially punishes custodians of crypto assets, making providing these services unattractive.

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