The SEC announced significant changes in February to the law that governs the custody of assets. The Custody Rule 20(4)-2 was adopted in 1962 by the SEC. It focused mainly on physical custody, namely stock and bond certificates, which were to be held in a bank and kept separate from advisor assets.

In 2003, SEC updated the rule in order to reflect the technological advancements that have improved the efficiency of virtually all aspects of the advisory business. The modernized rule has served advisors and their clients well. It better defines custody and removes any assumption of paper asset.

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Digital assets, including cryptocurrency came a few short years later. In the early 2000s, the bitcoin whitepaper was published as a way to send money across the Internet without the use of a third-party. The Ethereum whitepaper appeared five years later. Since then, a new asset class emerged and advisors have been asked to help investors understand it.

Crypto in the Asset Mix

“The proposed rule would expand the definition to include all digital assets and crypto assets even if they are not securities or funds.”

At first glance, this may not seem like a major step. After all, most advisors already apply their fiduciary duty to their entire client relationship. The new rule limits what advisors can use to be a “qualified holder” of digital assets. This paragraph is from pages 33-34.

We believe that it is essential to include “discretionary power” in the definition of custody. We propose a limited exemption to the surprise inspection requirement because we believe that the risk of loss is lower when a qualified custody participates in transactions. The exception would apply in general to assets held by clients with a qualified custody when the only basis for applying the rule is the adviser’s discretionary authority which is limited to instructing a client’s qualified Custodian to conduct transactions on assets that settle exclusively via delivery versus Payment (DVP).

The SEC may allow this exemption to be applied based on the way crypto assets are settled – whether on an order book or even on the chain. This will only increase the doubts of an advisor population that is already sceptical.

The rule is not followed

Through various wallet architectures, some advisors help clients manage their crypto or digital assets on-chain. This includes the growing supply of real-world assets. This group also doesn’t receive any clarity or relief from the proposal, despite the goal of “allowing the rule to be ‘evergreen'” as the types assets held by custodians change (page 78).

This new rule would make it more difficult for advisors and managers to provide the responsible advice required for digital/crypto asset management. The asset class is unique, trades 24 hours a day, and has characteristics that are not compatible with the current regulations or product packaging designed in 1990s. ETFs).

This proposal will not have a significant impact on many current products offered by a traditional custodian, such as trusts or ETFs which provide clients with a way to gain exposure to digital assets.

The new rule may have the following effect: It doesn’t affect advisors who use the assets under advisement model (AUA), but it does impact those using the assets under management model (AUM) that has discretion. This could push the industry towards the AUA model, especially for advisors providing services and advice on digital assets. This shifts the responsibility of custody and it is unclear how many clients are willing to accept such a future.

Pete Pachal is the editor.