US bill aims to ban SEC rule that makes crypto custody ‘completely non-viable as a business model’

A new bipartisan bill aims to tear up rules that make crypto custody “completely non-viable as a business model” due to high costs, according to market stakeholders.

While Wall Street has dipped its toes into cryptocurrencies, trading firms have held back from going all in due to a lack of places to keep their digital assets safe.

Banks and other financial firms want to offer such services, but have rolled back or halted them due to US Securities and Exchange Commission guidelines that make crypto custody at scale too costly.

A bipartisan group of lawmakers in the House of Representatives — Republicans Mike Flood and French Hill, and Democrats Ritchie Torres and Wiley Nickel — is fighting back.

They have drafted a law that aims to block SEC guidelines that force banks to account for custodied crypto assets differently than they do other assets.

The Uniform Treatment of Custodial Assets Act would rescind “the SEC’s disastrous” guidelines to “ensure that assets custodied by banks, credit unions, and trusts are kept off-balance sheet in line with longstanding practice,” Flood said in a statement.

The bill would “prohibit certain federal agencies from requiring certain institutions to include assets held in custody as a liability.”

By doing so, it would “help to keep the digital assets industry in the United States, bolster American competitiveness, and put proper protections in place for investors,” Nickel said, alluding to oft-cited fears that the harsh legal environment Stateside may force the industry to go to places with more welcoming regulations.

Crypto custodian businesses have welcomed the proposal.

The problem with the SEC’s custody guidance

Their problem dates back to 2022 when the market watchdog issued Staff Accounting Bulletin 121, a statement that, despite its bland name, has potentially huge ramifications for crypto custodians.

Banks and other firms that hold ordinary assets such as stocks or bonds on behalf of customers aren’t required to record those on their balance sheet, as custodied assets are considered to belong to the customer rather than to the custodian.

While that remains the case for most assets, the new guidelines force publicly-listed custodians to account for and disclose digital assets held on behalf of others in such a way as to make offering custody extremely expensive, especially for global custodian banks.

That’s because larger banks are also subject to federal banking regulation.

Under those rules, banks with risky assets on their balance sheets must offset that risk by holding capital and liquidity to cover potential instability or disaster such as a bankruptcy.

For banks, holding these reserve assets is costly, because they lose the revenue that capital could generate if it were invested.

So SAB 121, in conjunction with capital and liquidity standards, has kneecapped any potential for crypto custody to emerge at scale, its critics say.

“The net effect of SAB 121 is that any kind of institution that has to reserve against liabilities on the balance sheet can’t meaningfully hold crypto,” Nathan McCauley, CEO and co-founder of digital asset custody platform Anchorage Digital, told DL News.

“The cost of capital that it takes to reserve against liabilities is more than customers pay in custody fees. So it just becomes completely non-viable as a business model,” McCauley added.

It doesn’t help, bank lobbyists say, that the wording of SAB 121 is vague, with, for example, a very broad understanding of what a “digital asset” is.

It’s not even clear exactly what kind of capital charge would result from holding a digital asset on the balance sheet.

Crypto custodians hindered

The uncertainty is enough to deter US custodian banks and other firms from offering crypto custody services.

There’s been broad interest in doing so, but firms have slowed their early efforts, or outright axed them.

BNY Mellon launched a digital asset custody platform a year ago, but may not have realised it would run afoul of SAB 121, according to an application acquired by American Banker.

In March, State Street ended its deal to provide digital custody with UK-based Copper, which at the time partly blamed the “uncertain regulatory environment” in the US.

In July, exchange operator Nasdaq halted plans for its own service.

SAB 121 has played into broader fears about an administration-level conspiracy to unbank the crypto industry — dubbed Choke Point 2.0 — fears that were exacerbated by the fall of a series of crypto-friendly banks earlier this year.

Unique risks

The SEC argues in the SAB 121 text that more firms want to offer digital asset custody, but these assets present new and unique risks — whether technological, regulatory, or legal.

Hacks of custodians aren’t unknown, after all. Fortress Trust lost about $12 million, mostly in Bitcoin, in a recent hack.

Lobbyists for the global custodians counter that the risks the SEC identifies are mitigated by the heavy regulation big banks already face.

In the vacuum, firms can turn to companies such as Anchorage, which is federally regulated and to which SAB 121 does not apply. But a choice of strong custodians would build a resilient market structure, McCauley said.

“The way you build an anti-fragile system is to have several very good options for institutional investors,” he said.

“Anything that means that only a small number of players is able to participate hurts the growth of the whole ecosystem,” McCauley added.

Joanna Wright is DL News’ Regulation Correspondent. Got a tip on policy, politics or anything else? Reach out to her via email joanna@dlnews.com.