Last week marked an exciting moment in technological innovation. The Ethereum blockchain – a global, decentralized computer that anyone can use – changed the way it verifies transactions in a long-anticipated update called the Merge.
Despite opening additional opportunities for innovation, this dramatic change highlights legal uncertainty for crypto investors and asset managers. Strict adherence to the U.S. Security and Exchange Commission’s (SEC) “custody rule” would suggest asset managers, acting on behalf of investors, stay away from crypto staking. This is at odds with the fiduciary duty asset managers owe their clients by denying a legal and potentially lucrative revenue stream. It’s a catch-22.
Scott Walker is chief compliance officer at Andreessen Horowitz and Neel Maitra is a partner in the Washington D.C. office of Wilson, Sonsini, Goodrich & Rosati.
What the law dictates is clear: Registered advisers must comply with the SEC’s custody rule, which is designed to reduce the risk of misappropriation of investor holdings. More specifically, this rule usually requires that advisers place client assets (funds and securities) with a “qualified custodian” (often a bank or broker-dealer), and that an independent public accountant periodically verify the assets.
Unfortunately, regulatory uncertainty in this area frustrates even the most compliance-minded asset manager. Only a handful of clearly qualified crypto custodians operate in the U.S. – and these few qualified custodians service only a limited number of crypto assets. Notably, when one of these qualified custodians provides crypto custodial services, their services seldom extend to staking, voting or other participatory features of crypto assets.
Responsible investment advisers who manage crypto assets have, when possible, already been staking assets for years on other blockchains.
Though digital assets as a whole are often considered risky investments, there’s an argument to be made that avoiding crypto staking abdicates an obligation to clients. Investment advisers have a fiduciary duty to optimize portfolios and, where appropriate, make informed governance decisions for their investments.
For example, a manager that does not vote for the shares it manages in General Electric (GE) or IBM (IBM) or declines to take dividends, runs the risk of legal action from its clients and regulators alike. Crypto asset holders deserve similar protections from their investment advisers.
Yet, asset managers are caught in a bind. The custody rule continues to require advisers to custody crypto assets with custodians who may have inadequate arrangements for staking, voting or other participatory features. Custodians, like all institutions, have limited time and resources to onboard assets and attendant features.
Holders of crypto assets are the greatest losers from all of this – deprived of robust crypto custodial solutions, deprived of the legal certainty that would require their advisers to stake and/or vote their assets and deprived of a reliable return.
It doesn’t have to be this way.
This dilemma – drawn into sharper focus by the Merge – is one the SEC is uniquely positioned to resolve. Unlike the plethora of complex policy issues facing crypto, this issue could be settled easily. The SEC could acknowledge the novel features of certain crypto assets, such as staking and voting, and adjust the existing custody rule accordingly.
Updating the SEC’s custody rule is consistent with, and arguably compelled by, two fundamental parts of the agency’s mission; namely, protecting investors and maintaining orderly markets.
Given the scarcity of crypto custodial solutions, the SEC could clarify that, in certain circumstances, registered investment advisers (that are not qualified custodians) can use a combination of software and comprehensive internal controls to self-custody crypto. This doesn’t have to result in any relaxation of custodial rules – in fact, we strongly believe the SEC should put in place robust, technology-neutral principles regarding crypto custodianship.
For instance, the SEC could adopt or modify rules that require:
- Transparency around self-custodied crypto holdings so that advisory clients can independently review their holdings via the internet
- Investment advisers who self-custody crypto to periodically assess the quality of the software they use and to have some legal recourse for any relevant service provider’s commercial and technological failures
- Advisers to provide robust and clear disclosures regarding the risks of crypto custody and the security measures they adopt, as well as to have the appropriate insurance for cyber risks and audit arrangements around crypto
We know these measures are feasible because the best crypto asset managers already have one or more of them in place. Ideally, the SEC would backstop and police these measures through its examination program, which already has the capabilities to evaluate and assess crypto holdings and risk programs.
Indeed, the SEC has a long history of performing robust examinations of custody practices and has routinely brought enforcement actions to protect investors. These are good investor protections, and it seems reasonable to hold crypto asset managers to the same standards as other investment advisers.
If the SEC really wants to protect investors in crypto assets in the same way it protects investors in more conventional investments, as its chairman recently declared, then implementing the suggestions set out above would allow the commission to demonstrate that in a meaningful way.
The SEC has the ability to solve this issue on behalf of investors. We hope it elects to do so.
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