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SEC crypto custody accounting rule: a serious blow for bank custodians?

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Yesterday the SEC published guidance about how corporations should account for the custody of crypto-assets on behalf of clients. If other regulators, such as the Basel Committee, concur with the SEC’s position, crypto custody could become unattractive for banks. Currently, the Basel Framework considers custody as out of scope.

That’s because banks have regulatory requirements to have a certain amount of equity which partly depends on the makeup of their balance sheet. The SEC says these crypto-assets should appear as both an asset and a liability. In contrast, the custody of conventional assets does not touch a balance sheet.

Coincidentally, this announcement was made the same day that the world’s largest custodian BNY Mellon revealed its first big crypto custody deal to be the primary custodian for the USDC stablecoin, which has a market capitalization of $52 billion.

How accounting usually works for custody

BNY Mellon provides custody or administration for conventional assets to the tune of $46 trillion. The assets belong to clients, not the bank, and hence they do not appear on its balance sheet. It also looks after some client monies. As a bank, those deposits – $319 billion in 2021 – are the bank’s liability to the customer and make up the majority of its $400 billion in liabilities. It has a mix of assets that can support these liabilities.

If it treated all the conventional assets for which it provides custody as liabilities, its liabilities would be more than $46 trillion instead of $400 billion.

The SEC is effectively asking any organization that custodies crypto-assets to treat them in a similar way to money. The same amount will appear as both an asset and a liability on the organization’s balance sheet. For non-bank institutions, that may not matter other than having a very large balance sheet, potentially making audits more expensive. But for banks, it could have a far bigger impact, as we’ll see.

The rationale given by the SEC is that looking after cryptographic keys is particularly risky at a technical level. And the risks extend to the legal and regulatory realms. For example, the courts might debate how cryptocurrencies should be treated, and the entities for which custody is provided might not comply with regulatory requirements.

On the Basel III radar?

Last year, the Basel Committee on Banking Supervision, which imposes capital requirements on banks through Basel III rules, made some proposals for crypto-assets. Basel rules are complex, but the general idea is that the riskier a bank’s activities, the more bank equity that needs to appear on the balance sheet. 

And the risk is often assessed based on what appears on its balance sheet with some adjustments.

The Basel Committee proposed that pure cryptocurrency exposures be given a maximum 1250% risk weighting. Stablecoin exposures have a lower but still significant risk weighting. It is the sum of the risk associated with the backing asset plus a risk weighting as if a bank had granted an unsecured loan to the stablecoin holder.

Before the SEC’s guidance, a bank like BNY Mellon would say it’s only providing custody for the assets, so it’s not on the balance sheet, and it has no direct exposure to cryptocurrency risks. Usually, banks would expect to put crypto-assets on the balance sheet only if it was trading crypto. The SEC is saying that it needs to account for the risks even if it’s only providing custody.

The Basel crypto-asset consultation

When the Basel Committee published a consultation document on crypto-assets, it strongly implied it was not considering custody. A footnote related to tokenized conventional assets, including stablecoins states, “The Basel Framework does not set out a description of the requirements that apply to banks that provide services (eg, custody services) to customers that invest in traditional assets.” And it prefaced that with: “The consultation document does not attempt to define a prudential treatment for crypto-assets in cases where no existing prudential treatment is defined in the Basel Framework for traditional assets.”

The translation is that there are no Basel III requirements for crypto-asset custody. BNY Mellon responded to this specific point as part of the consultation, stating, “BNY Mellon supports this position.”

So the big question is whether the SEC recommendation will impact the Basel Committee’s treatment of bank crypto custody. If the Committee changes its view and Basel III rules are imposed on bank custody, then it could make it unattractive for banks to provide custody services for crypto-assets.

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