This article is for (1) investment advisors and funds with crypto clients or assets; (2) custodians who safeguard customers’ crypto assets, and (3) exchanges and other platforms engaged in digital asset activities.

Senator Cynthia M. Lummis (Senate Banking Committee) and Representative Patrick McHenry (the Chairman of the House Financial Services Committee) criticized SEC guidance on the accounting treatment of cryptocurrency assets by custodians and exchanges.

SEC Staff Accounting Bulletin 121(“SAB 121”) provides that custodians and exchanges of digital assets must reflect their customers’ digital assets on the custodian’s balance sheet.  This is a departure from traditional custodial rules for financial institutions.  Traditionally, financial institutions and custodians do not reflect custodial assets on their balance sheets; instead, custodial assets receive off-balance sheet accounting treatment, mainly because customers retain ownership of their assets and the custodians are prohibited from “touching” these assets or subjecting them to predatory trading.

The two leaders in Congress criticized SEC’s SAB 121 for the following reasons:

1. The on-balance sheet treatment of cryptocurrency assets by banks, credit unions, and other financial institutions would significantly increase their assets and liabilities and trigger a massive capital charge.  This would discourage regulated financial institutions from providing custodial services to customers with digital assets.
    
2. The scope of the definition of “digital assets” in SAB 121, which includes any digital assets “using distributed ledger or blockchain technology,” is overly broad and vague.  This vast scope of digital assets would exacerbate the negative impact that on-balance sheet treatment has on financial instruction’s balance sheet and capital charge.  

The two legislators cited the recent Celsius court decision classifying customers of custodial crypto assets as unsecured creditors and not as owners, resulting in their being unable to reclaim their assets from the debtor’s estate and having to wait for distributions as general unsecured creditors.

Celsius Decision

In the Chapter 11 case, the U.S. Bankruptcy Court for the Southern District of New York said that the custodian’s terms of use gave it the right to (i) hold digital assets under its name and (ii) included a Transfer of Title clause that granted it all rights, including ownership rights, to account holders’ digital assets.  As a result, the Court ruled that the digital assets became property of the bankruptcy estate, and the customers were unsecured lenders as opposed to owners.

Citing the above, the two leaders in Congress essentially concluded that SAB 121, combined with the recent court ruling, would leave millions of Americans with no safe place for their digital assets.

The legislators asked four regulatory agencies (the Federal Reserve, the FDIC, the OCC, and the NCUA) to respond by March 16, 2023.  Is Congress going to pass new laws soon to specifically address the custody of digital assets, the ownership of custodied digital assets, and the accounting and capital-requirements treatment of custodied digital assets and the protection of securities investors in companies that own digital assets?