Crypto’s Custody Conundrum

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Asset managers know that they will need to house digital assets with qualified third-party custodians eventually, but reaching that point while coloring within the regulatory lines will be difficult, according to the experts.

“The fact that the custody rule says, in essence, that you have to keep your client funds and securities at a qualified custodian is, quite frankly impossible,” said Karl Cole-Frieman, a managing partner at the law practice Cole-Frieman & Mallon, during a recent webinar hosted by Hedge Fund Law Report. “I think there was some 2017 thinking, which shows how kinetic the regulatory environment is, that if you just had bitcoin, ethereum, and things like those that you do not have to comply with the rule because bitcoin is neither client funds or securities.”

The US Securities and Exchange Commission Chairman Jay Clayton previously has stated that regulator does not consider either digital currency a security.

However, Cole-Freiman noted the ample anti-money laundering Federal case law that define bitcoin as funds under the plain meaning of “funds.”

“It is very difficult for the SEC to come and say that bitcoin is not client funds,” he added.

It not only puts asset managers in a regulatory bind because of the dearth of qualified custodians for digital assets that are available but the examiners as well. If they enforce the rule, they would shut everyone down.

Asset managers could put policies and procedures in place that would facilitate the move towards qualified custodians, but that would be a bit of a prophylactic, according to Cole-Freiman. “It is a little more form over substance, but is appropriate in context if you are going to be examined.”

Meanwhile, if asset managers decide to self-custody their digital assets, they are taking on a good amount of risk, added fellow panelist Matthew Johnson, co-founder and chief product officer at Digital Asset Custody Company.

“There is no Depository Trust & Clearing Corp. to go to arbitrate and get your assets back if they are compromised,” he said. “There is no SWIFT message to clawback a wire transfer. If the assets go to a nefarious person on the blockchain, it’s immutable, and you won’t get it back.”

Asset managers that decide to self-custody also take on the responsibility for creating and providing access to private key materials, according to Johnson. This could entail having access to the key for the safety deposit box where the private keys are kept in cold storage.

“There is an SEC no-action letter about verifying assets in your ledger or wallet and putting it into your safety deposit box and keeping your keys in the safety deposit box and that in itself is a way to handle the custody issues,” said Lisa Roitman, business development and marketing strategy at Bloomberg Enterprise Services and who participated in the webinar.

The safety deposit-box approach is not uncommon since smaller asset managers often lack secure locations within their offices, such as server rooms to which third parties like cleaning staff do not have access, she added. “Give some thought to the decision you make and make sure that it goes into your compliance manual if you decided to keep stuff on site.”

“The good news is that third-party custody exists today in a way that it didn’t as little as 12 to 18 months ago,” added Johnson.