More than two years ago, the SEC published accounting guidance, SAB 121, regarding how listed companies should disclose crypto-assets held on behalf of clients, requiring the assets to be counted on the balance sheet. This particularly affects banks because regulations on capital requirements are based on the contents of the balance sheet.
After both the House and Senate voted to overturn SAB 121, President Biden used his veto so that SAB 121 still stands. However, there has been some softening in the SEC’s stance, with the world’s largest custodian BNY receiving a specific exemption to custody assets for a crypto ETF. However, BNY and other banks have to apply for exemptions on a case by case basis.
A September speech by SEC Chief Accountant Paul Minter reveals the significant work required in order to achieve such exemptions. Ideally custodians should build crypto experience slowly with low volumes. But the processes required for the SAB 121 exemption means that only the largest opportunities will be worthwhile pursuing.
The rationale behind SAB 121 was that if the custodian lost control of the private keys, the assets they control might be hard to recover and could result in a claim on the custodian.
How banks, broker-dealers get SAB 121 exemptions
Mr Minter gave the example of a bank that had engaged on the topic both with the prudential regulator at the state level and its primary federal prudential regulator. Since 2022, banks are required to notify their regulator in advance of engaging with crypto-assets.
The bank had systems in place to safeguard private keys. Additionally, it ensured that its custody structure is bankruptcy remote, as confirmed by a lawyer, and its contracts with client institutions preclude re-hypothecation of the crypto-assets. The same contracts explicitly excluded liability for blockchain-specific risks. Finally, the bank had risk management processes in place for each specific crypto-asset that it safeguards.
The Chief Accountant also gave the example of broker-dealers, where a third party provides transaction execution and custody. An exemption to SAB 121 is likely to apply where the broker-dealer is just the introducer, doesn’t have the private keys, and the custodian third party is clearly the agent of the customer, rather than the broker-dealer.
He provided a list of points he’d want to see as confirmation, including contracts and evidence of the client having a direct relationship with the third party. The broker-dealer would also have to get a legal opinion reinforcing that the broker-dealer is not the customer’s agent.
SAB 121 remains questionable
Meanwhile, apart from the unorthodox accounting treatment required by SAB 121, and blocking banks from engaging with crypto-assets until now, in some ways SAB 121 has made it less safe for crypto-asset clients.
The largest custodians are each responsible for trillions in conventional assets, and have the headcount, experience and processes that are more likely to provide safeguards against hackers. Yet startups are currently the primary providers of crypto custody, particularly Coinbase for ETFs. That sort of concentration is usually something regulators are not keen on.
Plus, depending on agreements, assets under custody are conventionally treated as belonging to the client. By including them on the balance sheet, this implies the assets belong to the company, which could be bad news for clients if the custodian goes bankrupt.
We’re also reminded of a thought provoking paper by Duke University’s Steven Schwarcz on fintech regulation. He made an interesting observation that one regulatory option is to have the financial equivalent of the FDA in which all fintech innovations would need approval in advance. He dismisses this as an innovation killer. If you look at U.S. banks in the context of crypto-assets and crypto custody, they effectively have several FDAs – their own prudential regulators (plural) plus the SEC for SAB 121.
