SEC urges stricter custody rules for assets, including crypto

The US regulator agrees to reduce the two-day waiting period for closing share trades by halving it Wall Street’s top regulator has proposed toughening safeguards around investors’ assets after the collapse of several high-profile crypto companies last year revealed that customer funds were not as safe as had been advertised.

On Wednesday, the US Securities and Exchange Commission agreed to present rules requiring investment advisors to protect all client assets, including so-called alternative investments like cryptocurrencies and artwork, with qualified custodians.

Following a string of failed digital asset markets, the proposed crackdown on custody is being considered. Fund companies promoted funds as separate and segregated, but consumers discovered in bankruptcy that their holdings were considered unsecured assets and part of the company’s estate that collapsed.

Although the SEC’s custody rules are intended to apply to all assets, the majority of the discussion was focused on crypto.

In remarks to introduce the proposal, Gary Gensler, SEC chair, stated that while some platforms claim to have custody of crypto investors’ cryptos, it does not necessarily mean that they are qualified custodians. “[This] proposal would cover all asset classes — even those that aren’t funds or securities and include all those currently covered by funds and securities.”

The SEC seeks to broaden the scope of its existing rules. This is in response to the Bernard Madoff scandal in 2010 when it was discovered that the fraudster’s clients had lost billions to Ponzi schemes.

These proposals are coming after a year of severe turbulence in crypto markets that has left millions of creditors waiting at bankruptcy court. This was due to the collapse of several groups, including exchange FTX and lending platform Celsius. Many cryptocurrency exchanges not only act as custodians for customer assets, but they also lend and borrow from customers. Some former managers of FTX have been charged for misusing customer funds.

The proposed rule would require investment advisers to make written agreements with qualified custodians in order to protect clients’ assets and ensure their segregation. Qualified custodians typically come from highly regulated financial institutions such as banks and trust companies.

Four of five SEC commissioners supported the proposal and it will now be open to public comment before being voted on again.

The SEC met earlier to finalize rules that will reduce the two-day window for settlement sharedeals. This was an urgent initiative after brokers like Robinhood were affected by the 2021 meme stock frenzy.

To protect settlement risk, brokers were required to provide additional collateral to clearing houses. This was the reason for their controversial decision to restrict customers’ access to certain high-demand stocks.

Brokers and market makers have claimed that the current window of two days poses risks to the financial sector. Clearing houses that act as intermediaries between buyers and sellers might demand more margin or insurance to cover deal failures during volatile periods.

Three of the five commissioners voted in favor of the rule. After expressing concerns about the May 2024 deadline being too tight, Mark Uyeda and Hester Peirce voted against this measure.

Many industry players argued that the switchover should take place in September 2024, to coincide with Canada’s plans.

Kenneth Bentsen of Sifma, a group representing the securities industry, stated that while we appreciate the finalization of the rule by the commission to provide certainty, we strongly disagree with May 2024 as the implementation date.

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