Recently, there has been much discussion over what is a ‘qualified custodian’ for digital assets, including the curiosity of the Securities and Exchange Commission (SEC) staff exploring the concept as of this Monday. For many investors, learning what cryptocurrency is can be a daunting enough task; having to also decipher the financial vocabulary around the meaning of custody for digital assets is a journey into the metaphysical realm from which you may never return.
This article will walk you through the definitions and meaning of some of the key concepts that are being discussed so you can decide for yourself whether it is safe or not to custody your cryptocurrency with a particular company.
When you hear someone talk about how their crypto is held in custody, that typically means their crypto is held like you would hold precious jewelry or physical cash in a vault. The important thing to consider when you are going to entrust your cash, are things such as what is the experience of the company in safekeeping precious items for customers, how well do you trust the organization that has the vault, and how strong is the vault in being able to prevent a criminal from ‘cracking the safe’.
However, when you hear the terms ‘qualified custodian’ and ‘fiduciary’, these reference the concept around active trading for your crypto. The company has a ‘fiduciary’ responsibility or duty of care and loyalty, in acting in your best interest financially when you are entrusting your assets . Additionally, the company also needs to be a ‘qualified custodian’, a term defined by the Securities and Exchange Commission (SEC).
The latest ‘Final Rule’ on Custody of Funds defines ‘Qualified custodians’, “…under the amended rule include the types of financial institutions that clients and advisers customarily turn to for custodial services”. The amended rule by the SEC from 2004 also notes, “In order to allow advisers that also offer futures advice to comply with Commodity Futures Trading Commission rules, “qualified custodians” also include registered futures commission merchants”.
Coinbase Custody, a division of Coinbase and part of the Forbes Blockchain 50, currently serves as a qualified custodian under the SEC definition for Grayscale Investments. The world’s largest digital currency asset manager with more than $5.9 Billion in assets under management as of September 30, 2020, Grayscale has two investment products that are designated as SEC reporting companies (Grayscale Bitcoin Trust and Grayscale Ethereum Trust). The custodial agreement filed with the SEC for the Grayscale Bitcoin Trust states the following, “Trust Company (Coinbase Custody) is a fiduciary under § 100 of the New York Banking Law and a qualified custodian for purposes of Rule 206(4)-2(d)(6) under the Investment Advisers Act of 1940, as amended, and is licensed to custody Client’s Digital Assets in trust on Client’s behalf”.
A Coinbase Custody spokesperson explained, “As you can see on our website, we indicate that we are a qualified custodian (here). It might be helpful to take a few steps back and understand that the requirements of a “qualified custodian” is provided under the Investment Company Act of 1940, as amended (the “1940 Act”), and the Investment Advisers Act of 1940, as amended (the “Advisers Act”). So, based on the definition of a “qualified custodian” as provided in the 1940 Act and the Advisers Act, we believe that Coinbase Custody is a qualified custodian and satisfies the definition of a qualified custodian under the definitions set forth in each of the Investment Advisers Act and Investment Company Act.”
The agreement between Coinbase Custody and Grayscale also highlights the fact that Coinbase Custody is only a fiduciary holding the Bitcoin in trust and that Grayscale as the client remains the owner of the assets at all times. This is important to understand since Coinbase Custody is chartered as a Trust company in New York and is acting as a Trustee through the exercise of its fiduciary powers with Grayscale.
Coinbase Custody highlighted its commitment under this charter and the level of compliance as a custodian it has achieved. According to the Coinbase Custody spokesperson, “…our status as a limited purpose trust, chartered and supervised by the New York State Department of Financial Services, reinforces Coinbase’s commitment to maintaining the highest standards of security and compliance. Coinbase Custody is the only crypto custodian to attain both its SOC1 and SOC2 compliance reports.”
The important thing regarding what Coinbase is doing is not related to its size in the market – the key appears to be in the SEC amended definition that a qualified custodian can be who is ‘customarily used’ to custody assets. Whether it is Bakkt for Bitcoin Futures, or Coinbase Custody for the Grayscale Bitcoin Trust, it seems fair these companies are customarily used to custody crypto – as well as being licensed by a state regulator.
Gemini, a fierce competitor to Coinbase, also spoke out on the issue of being a crypto custodian. “In order to build trust in crypto markets it is important for crypto custodians to be properly regulated under appropriate regulatory frameworks, including as a New York Department of Financial Services licensed and regulated Trust company,” stated a Gemini spokesperson.
The spokesperson went on to explain crypto custody is a fast developing space with an emergence of custodial frameworks at the state and federal level. “Regulation is a core pillar at Gemini, and we have always believed in the importance of thoughtful and constructive dialogue with regulators, including the DFS and the SEC, as regulation around the safeguarding of customer digital assets continues to evolve,” said the Gemini spokesperson.
For something that is a complicated issue, the SEC appears to signal that perhaps it is ready for the industry to come together and work on standards around qualified custodianship for digital assets. The SEC does appear to caution the example of the letter from the state regulator in a footnote that regulators should be coordinating and consulting with one another when standards such as what a bank is becomes applicable.
“With respect to one aspect of this analysis – whether any entity’s business consists of exercising fiduciary powers similar to those permitted to national banks as required by the definition of “bank”– the Staff expects that it would consult with the staff of the Office of the Comptroller of the Currency,” states the SEC letter. The SEC subtly suggests that state and federal regulators also work together – which is of course as an ex-regulator, you would hope to be the case to help foster the growth of the crypto industry here in the United States.