What is a Qualified Custodian? (The True DeFi Frienemy)

The year 2022 was a grave for many large crypto companies. The bankruptcies of such giants as FTX, Celsius, and Voyager have increased authorities' scrutiny within this sector. 

Thus, on February 15th, 2023, the five-member panel of the Securities and Exchange Commission (SEC) voted 4-1 in favor of a new proposal that concerns qualified custodians.

If approved, the amendments to the law can make it much harder for trading and lending platforms that act as crypto custodians to run their businesses. 

Gary Gensler, the chair of the SEC, stated that “though some crypto trading and lending platforms may claim to custody investors’ crypto, that does not mean they are qualified custodians.” At this, the new rules may pose a real threat to many centralized cryptocurrency exchange platforms and hedge funds that fail to meet the new standards.

Let’s take a closer look at the proposed changes to understand what effect they may have on those involved in crypto trading and lending. Also, let’s see what solution to all these new threats the crypto industry itself may provide.

Qualified Custodian Definition

A qualified custodian is a financial institution that holds and safeguards assets on behalf of investors. These assets can include securities, commodities, and other types of financial instruments. In order to be considered a qualified custodian, the institution must meet certain regulatory requirements and hold the necessary licenses and certifications.

This helps ensure that investors' assets are protected and that the custodian is operating in a trustworthy and secure manner. In the United States, qualified custodians are typically subject to oversight by the Securities and Exchange Commission (SEC) or other regulatory bodies.

Who is a Qualified Custodian?

According to SEC’s investor bulletin, custody by investment advisers implies direct holding of customers’ assets on segregated accounts. At the same time, each of these accounts should bear the customer’s name on it.

At this, any financial company that holds these assets in a separate account for every customer fall under the definition of a qualified custodian. It may be a state chartered bank, a registered broker dealer, a futures commission merchant, or a foreign company.

To ensure the security of customers’ assets, qualified custodians must follow a set of specific rules. For example, they must regularly deliver account statements to their customers. Also, qualified custodians are subject to annual surprise examinations by independent public accountants.

What Do the New Custody Rules Imply?

The existing law for investors’ protection also known as the “2009 Custody Rule” already covers a significant amount of the financial security aspects. 

Yet, it leaves out companies operating with cryptocurrencies, simply because SEC turned its attention to crypto much later than Bitcoin was invented. Therefore, “investment advisers cannot rely on them as qualified custodians”, according to Gensler.

The new rules apply to institutions who want to execute custody of any customers’ assets including crypto. According to the adjustments, US and offshore companies would have to become “qualified custodians” which means better security for investors’ funds.

At this, the proposal offers the following amendments:

1. Proper asset segregation. 

Qualified custodians would have to segregate all customers’ assets into personalized accounts. Such an approach should contribute to these assets’ security in case the custodian goes bankrupt.

In fact, storing assets on segregated accounts has already become the standard best practice when it comes to traditional bonds and securities. The new rule expands these rules to the digital area regardless of how large the amount of crypto assets one keeps with the custodian.

2. Written agreements. 

Second, for better funds protection, qualified custodians and advisers should sign written agreements with their customers. Such a form of collaboration would require such companies to pass annual evaluations from public accountants and to provide all the necessary records upon request.

Aside from that, the proposed rules cover foreign financial institutions putting them on the same page together with US-based companies. Also, they improve the security of discretionary trading when registered broker dealers buy or sell assets on behalf of investors.

Would The New Custody Rules Make Investors More Protected?

Gary Gensler, the chair of the SEC, claimed in a tweet that all these amendments only serve for higher protection of investors’ funds. 

Yet, just like any other changes in the law, this medal has a reverse side as well. At this, here’s what crypto investors can expect should the proposal be accepted.

We @SECGov just proposed to expand & enhance the role of qualified custodians when registered investment advisers custody assets on behalf of investors.

Thru our rule, investors would get the time-tested protections—and qualified custodians—they deserve.

What does this mean? ⬇️ pic.twitter.com/RerUGnpArI

— Gary Gensler (@GaryGensler) February 15, 2023

Pros of New Qualified Custodian Legislation

1. Higher security of crypto funds on centralized platforms. 

Not all of the centralized cryptocurrency exchanges store a significant amount of crypto on segregated accounts. This enables them to make use of customers’ assets to increase their own profits and serves as a single entry point for hackers’ attacks.

For example, should the ill-fated FTX follow this practice, the scope of the disaster could’ve been lesser.

At this, segregating customers’ assets on dedicated accounts would help crypto platforms prove their responsibility, and lead to a better user experience.

2. Reduce fraud.

Should the qualified crypto custodians segregate customers’ funds, it would be way more difficult for them to put their hands on these funds themselves and perform exit scams.

Cons of New Qualified Custodian Legislation

1. Smaller ROI.

In the case of TradFi, the highest level of returns one may get is from hitting early on startups. Unfortunately, the majority doesn’t stand a chance to participate in such fundraising campaigns because of the high requirements for accredited investors.

The crypto industry, on the contrary, gives much more opportunities of such kind. However, it seems that it follows the same path. As the rules change for qualified custodians, investment processes will get more complicated as well. 

Thus, the number of possibilities to get a high ROI will get smaller and smaller.

2. More bankruptcies. 

Tougher rules will surely reduce the number of qualified custodians across centralized exchanges since not all of them would be able to follow them. Many of the existing platforms will have to quit their businesses being unable to meet the new requirements.

The survivors will be only those who have proved their reliability. But will it make the economy, in general, more healthy? Hardly so.

3. Higher entry barriers for new players.

Implementing higher security standards will surely come at a cost. As a result, fewer companies will be able to launch their businesses.

4. Higher centralization.

Finally, the smaller the number of players, the higher the centralization of a given market. Those companies that manage to bear the changes, will eventually become large monopolies with all the relevant consequences.

Thus, they would be able to change the rules in their own favor leaving fewer chances for regular users to make fair profits.

Is Decentralization the Best Way to Go?

Although cryptocurrencies were initially invented as a payment solution to bypass centralized financial institutions, the crypto industry as a whole becomes more centralized every year.

The new SEC’s proposal is just another step on the way toward centralization. 

On one hand, it will help large companies solidify, reduce fraud and improve customers’ trust. Yet at the same time, it will make it much harder to get any place in the sun for small startups or those companies that authorities don’t like for some reason. 

Monopolization has hardly ever done any good to any market, hasn’t it?

The good news is that the new legislative initiatives cover only centralized platforms so far. Decentralized finance solutions yet don’t fall under any regulatory framework since they don’t have custody of their customers’ assets.

At this, they represent a much more secure and reliable solution while still leaving windows open for investors of all sizes.