On October 1, the U.S. Securities and Exchange Commission (SEC) unveiled a set of proposed regulations regarding the custody of crypto assets by investment advisers and funds. Under specific conditions, these entities would be permitted to hold clients' funds directly or entrust them to state-licensed trust organizations.

The proposed changes affect two laws from 1940: the Investment Advisers Act and the Investment Company Act. The former governs investment advisers, while the latter pertains to registered investment companies and business development structures, referred to as regulated funds by the SEC.

“Since the emergence of Bitcoin in 2008, the crypto asset market has evolved from a niche phenomenon into a multi-trillion dollar asset class that investors are eager to access,” stated SEC Chairman Paul Atkins.

Atkins noted that existing regulations have not kept pace with industry developments, many of which were established prior to the internet and focus on traditional financial instruments.

He also highlighted the inadequate custodial infrastructure, pointing out that new tokens can go months without a suitable custodian.

The proposed framework does not encompass all digital assets; it is limited to those classified as securities or monetary equivalents, such as stablecoins. For regulated funds, the scope is broader: if an adviser stores their assets, the requirements apply to Bitcoin, Ethereum, and other native blockchain coins.

Self-Custody

An adviser can hold a client's crypto asset themselves only if there is no acceptable custodian available. This must be confirmed in writing beforehand and reviewed quarterly.

When a suitable custodian becomes available, assets must be transferred to them "as soon as reasonably practicable.”

The term “self-custody” in this context does not imply that the owner personally manages the coins. SEC Commissioner Hester Peirce clarified this point:

“The proposal uses this term not in the sense of true self-custody by the investor.”

In effect, the adviser acts as the custodian.

The SEC has established protective measures for this model. Expertise and security systems will be required, including private key management. Each transaction must receive approval from at least two individuals.

Clients’ coins must be stored on separate addresses that do not contain any third-party funds.

Additionally, cybersecurity measures are mandatory, with annual assessments required. The first report from an independent auditor on internal controls must be obtained within six months of starting custody, followed by annual assessments.

Investors will receive quarterly statements detailing the address and network, balance at the end of the period, and all transactions during that timeframe.

If an adviser holds assets for a regulated fund, the board of directors will provide additional oversight.

Commissioner Mark Uyeda pointed out that the SEC is aware of the "inherent conflict of interest" in this arrangement, yet the fiduciary responsibilities of advisers to their clients remain intact.

Separate Regulations for Trust Companies

An adviser or fund can only transfer tokens to a trust company after conducting a thorough examination. This must occur before signing a contract and repeated annually thereafter.

The custodian must have the approval of their state’s banking regulator for holding crypto assets. Furthermore, they must have documented procedures in place to protect against theft, loss, and misappropriation of funds.

It is also essential to review the audited financial statements of the organization and reports on internal controls. Client assets must be segregated from the custodian’s own funds.

In addition to crypto regulations, the SEC proposed updates to general rules affecting broker-dealers servicing funds, as well as those related to auditing, accounting, and disclosures.

The rules have not yet been finalized. A public commentary period will last 60 days following the document's publication in the federal register.

Notably, in September, the SEC permitted limited trading of tokenized stocks on certain on-chain platforms for a five-year period.

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