Applying the Custody Rule to Cryptocurrency Holdings
The still unresolved question of whether cryptocurrencies might be identified as an asset class subject to the qualified custodian aspect of the rule played a prominent role in discussions at the CoinAlts Fund Symposium in New York. Longstanding regulations require Investment Advisers to use a qualified third-party custodian, such as a bank, registered broker dealer, futures commission merchant, for certain asset classes, to protect client funds and securities over which the adviser has custody. But because the nascent crypto market remains subject to constant fluctuation as regulations and applications evolve, questions remain about how it will be categorized. However, the SEC and other regulatory bodies continue signaling their acknowledgement that the market is significant and are letting the public know they are looking at how to address safeguards for cryptocurrencies.
The custody rule requires:
- Use of “qualified custodians” to hold client assets
- Notices to clients detailing how their assets are being held
- Account statements for clients detailing their holdings
- Annual surprise exams
- Additional protections when a related qualified custodian is used
If you are an investment adviser holding cryptocurrencies, you do not have certainty that you are complying with the Qualified Custodian requirement, as the SEC has not yet commented on the rule. However, based on the above, the concept of the related custodian, or “Self-Custody” has been popular within the cryptocurrency community. Rule 206(4)-2 does not require use of independent custodians, but if an independent qualified custodian is not used, the rule contains additional requirements to adhere to when client assets are maintained by the adviser itself or by a “related person” (any advisory affiliate and any person that is under common control with your firm). The rule requires that the adviser is subject to a surprise examination and should obtain an internal control report from the independent public accountant unless the related person is operationally independent of the adviser.
It is imperative for investment advisors to take the necessary precautions to safeguard their cryptocurrency holdings. Actions that should be taken as a precautionary measure include keeping diligent notes and records of process driven work flows and operations as they pertains to crypto holdings to share with auditors. A few other ways to safeguard cryptocurrency holdings include the tracking of private wallet addresses, the monitoring of information flows and the evaluation of individual cryptocurrency exchanges to ensure they are up to standard when it comes to the qualified custodian rule.
No exchanges have been registered with the SEC as of yet, but companies are working to solve the issue of qualified custodians for cryptocurrencies in various ways. New custodial companies have pending registrations with FINRA, including the Digital Asset Custody Company (DACC). BitGo, a blockchain security company, has entered an agreement to buy Kingdom Trust, a qualified custodian. Coinbase, currently one of the most popular cryptocurrency exchanges, has launched a custody product. Custodian options for cryptocurrency and other digital assets are expanding. The expectation is that new custodial companies will work to become registered entities, and many will be acquired or merge with traditional custodians as the industry evolves. Even as the future development of the cryptocurrency space remains unclear, though, one thing will remain the same. As the industry continues to change and grow, investors will need to continue to take a diligent and focused approach towards compliance.
 See Regulation of Custodial Practices Under the Investment Advisers Act of 1940 Rule 206(4)-2 Investment Adviser Association, Investment Adviser Compliance Conference 2014, Robert E. Plaze