Safeguarding Rule | Blog Series: Part 1New Custody Rules to Reshape the Digital Asset Market

Patrick Clancy, Head of Digital Asset Strategy, PolySign

On February 15, 2023, SEC Chair Gary Gensler issued new SEC ‘Proposed Rules Regarding Investment Adviser Custody’ that will vastly expand the role and remit of Qualified Custodians (QCs) in digital asset capital markets, as well as other asset classes.

In the first of our multi-part blog series on the SEC enhanced safeguarding rule, Patrick Clancy, Head of Digital Asset Strategy at PolySign, highlights the essential provisions of the new rules to help advisers, funds and institutions in the crypto space ensure that their businesses are ready for the future.

The last 18 months have shone a spotlight on the many weaknesses in the digital asset industry. In the wake of collapsed centralized crypto platforms, depegged stablecoins, code-exploited hacks, instances of fraud and the bankruptcy of a prominent offshore crypto exchange, we heard a loud call for reform from investors and policymakers.

Seemingly overnight, we saw the downfall of several Tier 2 banks deeply embedded in the start-up, technology, and VC markets. These incidents have shifted the conversation. Now, the discussion is less about the hype and potential of crypto and distributed ledger technologies and more about balancing centralized risks with equitable regulation in a way that does not hinder innovation. To date, regulators have dug into specific policy issues, specifically around improving risk management practices, separating, and segregating business functions such as custody from the day-to-day operations at the exchanges, and implementing better internal controls to mitigate malfeasance and augment investor protections.

Many policymakers have looked to pull existing practices from traditional capital markets into this nascent industry. On February 15, SEC Chair Gary Gensler released a statement proposing to expand the role of QCs in securing assets on behalf of investors. If enacted, this legislation would reign in the activities of fiduciaries, who have a legal responsibility to ensure that “advisers don’t inappropriately use, lose, or abuse investors’ assets.” These new proposed SEC rules would represent the most significant change to the custodial function since 2009. In summary, regulators would move digital assets into a framework requiring Registered Investment Advisers (RIAs) to direct capital from QCs and implement a series of controls to safeguard digital assets.

Gensler’s proposal presents significant changes to digital asset fund managers (and how they deploy capital for investment management) as well as institutions and fiduciaries. This would include the segregation of duties, the roles between counterparties and the intermediaries used to facilitate such trades. Understanding the impact and taking the appropriate action will be vital for the investment management community. Specifically, for some exchanges, the proposal is expected to require compliance by as soon as mid-2024.

Below we highlight essential provisions in the new proposed legislation, referred to as the “Safeguarding Rule,” to help institutions, fund managers, and advisers better understand how to prepare for this ruling that could be enacted within a year of the proposal being approved.

1) Expanded scope of the custody rule
The scope of the current custody rules will broaden to apply to client funds, securities, and any client assets, including cryptocurrencies and tokenized physical assets such as real estate, commodities, private equity, private debt, artwork, and financial contracts held for investment purposes.[1] Notably, the rules extend and strengthen the role of QCs[2] to support a wider array of assets.

2) Segregation and protection of assets
The new rule will also compel advisers to properly segregate investors’ assets[3] and obtain reasonable assurances (e.g., contractual agreements) from QCs that investor assets are protected in the event of insolvency and bankruptcy.[4]

3) Use of Qualified Custodians
RIAs and fund managers will be required to use QCs[5] and not self-manage the custody of clients’ crypto or digital assets. For many institutions, using QCs under the new rules will require a significant change to their operations in order to comply with U.S. law.

4) Discretionary authority to trade
The proposed rules also widen the definition of custody to include discretionary authority or “the authority to decide which assets to purchase and sell for the client.”[6] Under the existing rules, a RIA is deemed to have “custody” of client assets in scenarios such as an adviser being “authorized or permitted to withdraw or transfer beneficial ownership of [the] client assets.”

Going forward, advisers would need to ensure that the QC has “possession or control” over client assets, including instances where the adviser is applying “discretionary authority.”[7]

5) Timeline
The legislation is generally expected to include the provisions highlighted above.

Depending on the threshold of the adviser’s assets under management, the proposed compliance date comes into effect:

● More than $1b under management, 12 months after the effective date
● Up to $1b under management, 18 months after the effective date.

If enacted, private fund managers should note that compliance with the proposed rules will not be required until mid-2024 at the earliest.

Key terminology and resources

What is a Qualified Custodian (QC)?
A QC is a legal term defined by the SEC as a bank, registered broker-dealer, futures commission merchant or certain foreign entity that maintains client funds and securities in a particular manner. A QC either manages client funds and securities in a separate account for each client under that client’s name or in accounts that contain only that client’s funds and securities under the name of the investment adviser as agent or trustee.

Requirements of Qualified Custodians
At least annually, the QC will obtain and provide a written internal control report with the opinion of an independent public accountant on the effectiveness of the QC’s internal controls.

● Recordkeeping: QCs must notify and maintain records of how funds are held and share this with clients on a regular basis. Furthermore, they must issue quarterly accounting statements to clients.
● Discretionary authority: The new rule updates the definition of “custody” to include discretionary authority: “the authority to decide which assets to purchase and sell for the client.”[8] Under this proposed ruling, an investment adviser would have “custody” of client assets including any instances when the adviser is “authorized or permitted to withdraw or transfer beneficial ownership of [the] client assets.”[9] This provision means that the adviser will now need to ensure that a QC has “possession or control” over client assets when deploying capital, including instances where the adviser executes “discretionary authority.”
● Internal controls: At least annually, the QC will obtain and provide a written internal control report with the opinion of an independent public accountant on the effectiveness of the QC’s internal controls.
● Written agreement: The QC must have a written agreement[10] in place between the QC and the investment adviser. The advisers need to enter the arrangement with the reasonable belief that the QC is capable and able to meet its contractual obligations. The agreement must also refer to the provision of records, where the QC can provide records of the client’s assets to the SEC or a qualified accountant upon request.
● Indemnification and insurance: The QC will indemnify an advisory client when its negligence, recklessness, or willful misconduct results in the loss of client assets. QCs must have adequate insurance arrangements in place to protect the client.
● Sub-custodial agreements: An adviser or custodian isn’t exempted from its duties to the client as a result of any sub-custodial or another similar arrangement.
● Liens or collateralized asset reporting: Client assets must not be subject to any right, charge, security interest, lien or claim in favor of the QC, its related persons or creditors. An exception to this provision is possible when authorized by the client in writing.[11]

As you can see above, the new rules will impact how all registered investment advisers deploy capital, segregate assets, and interact with intermediaries. We expect to see many parties opine on these changes (including traditional and digital asset managers and counterparties). Overall, these proposed rules mark a significant step forward in the effort to balance centralized risks with equitable regulation to protect investors in the digital asset industry.

In our next blog, we will compare the new rules, address the potential impacts, and provide guidance on what you need to do to be in compliance with the proposed changes.

[1] Release at 18

[2] Rule 206(4)-2(d)(6).

[3] Release at 63–66.

[4] In the Release, the SEC stated that, “the account terms should clearly identify that the account is distinguishable from a general deposit account and clarify the nature of the relationship between the account holder and the QC as a relationship account that protects the client assets from credits of the bank or savings association in the event of the insolvency or failure of the bank or savings association.” Although the Proposed Rule does not contain any requirements in respect of these terms, the SEC did request comments on these terms.

[5] Rule 206(4)-2(d)(6

[6] Proposed Rule 223–1(d)(4).

[7] Release at 67.

[8] Proposed Rule 223–1(d)(4).

[9] Proposed Rule 223–1(d)(3)(ii).

[10] Proposed Rule 223–1(a)(i).

[11] Release at 177.