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US lawmakers question SEC crypto custody accounting rule

digital asset custody

Yesterday U.S. Senator Cynthia Lummis and Representative Patrick McHenry sent a letter to banking regulators querying the SEC’s crypto custody accounting rule. They assert that the rule would put client digital assets at greater risk and addressed their concerns to the Federal Reserve, FDIC, OCC and National Credit Union Administration. 

By convention, traditional assets held in custody are treated as belonging to clients and hence do not appear on the custodian’s balance sheet. At the end of March 2022, the SEC issued accounting bulletin 121, which said that digital assets should appear as both an asset and liability on the custodian’s balance sheet because of the heightened risks they represent, including cyber and regulatory risks.

In yesterday’s letter, the lawmakers gave the example of the Celsius bankruptcy, where Earn clients were treated as unsecured creditors. They argue that SAB 121 forced the assets to be on the balance sheet, creating a legal risk. However, the accounting treatment of assets is different from the legal treatment. 

There’s a strong argument that even if SAB 121 had not existed, Celsius should have followed the assets/liability accounting treatment because it didn’t hold those assets in custody. The Chief United States Bankruptcy Judge Martin Glenn concluded as much when he ruled that the customer’s Earn assets belonged to Celsius. Not because of accounting treatment but because of “Celsius’s unambiguous Terms of Use”.

However, the lawmakers’ concern about the accounting rule’s impact on custody and elevated risk is still potentially valid. Conventional custodians and banks are a safer pair of hands because they are more regulated. But this accounting treatment might discourage their involvement. That’s a slightly messy topic.

Banks, Basel and digital asset custody

Last year, custody banks were worried that by putting digital assets on the balance sheet, they’d have to set aside extra capital, which would make digital asset custody uneconomic. That was even more worrying because it could apply to tokenized securities as well. However, the Basel Committee confirmed late last year that, in most cases, no capital needs to be set aside for digital asset custody.

Most consider that the end of the story.

There’s likely a separation between what the SEC tells banks to do with their accounts and how the Basel rules are applied.

However, perhaps it’s not clear-cut.

The Basel Committee would be assuming the assets under custody are not on the balance sheet. The fact that the SEC requires these assets to be on the balance sheet in the United States potentially muddies the waters. The two lawmakers assume that despite the Basel green light for custody, it’s still a problem.

Another point is that each jurisdiction implements Basel rules locally. The United States could customize the Basel rules to include rather than exclude digital asset custody. Now that would be bad news. And that is an excellent reason for lawmakers to be asking these questions.

We’ve contacted a couple of custody banks and accountants to get their views on the current situation but didn’t receive a response in time for publication.

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