November 6, 2024

Custody of Crypto – Where Exactly Are We Now?

November 6, 2024

With the Securities and Exchange Commission’s settlement with Galois Capital Management LLC, the pressing issue of proper custody of cryptocurrency assets has again bubbled to the surface.  Has this issue gained clarity?  Do we still exist in the limbo of regulation by enforcement and not really knowing where the boundaries are until the SEC comes along and tells us that we crossed a line? Despite the civil penalty of $225,000, lawyer’s fees, and press release, that still appears to be where we are – though hopefully just for the time being.

The basic facts of Galois are straightforward, but not particularly illuminating. The SEC determined that Galois, an adviser to a private fund, “held certain crypto assets in online trading accounts on crypto asset trading platforms, including FTX Trading Ltd., that were not qualified custodians” and that about “half of the fund’s assets under management from early to mid-November 2022 were lost in connection with the collapse of FTX.” Lesson #1 – don’t do business with fraudsters, though that is a lesson more easily recognized in hindsight.

The second part of the SEC order indicates that Galois appears to have panicked. Facing the loss of over half their assets, Galois allowed some investors to redeem on short notice while telling other investors that “redemptions required at least five business days’ notice before month end.” Lesson #2 – (i) stay calm, (ii) treat similarly situated members of the fund the same, and (iii) stick to your established policies and procedures, particularly during chaotic events. This lesson is more easily articulated than followed, particularly the instruction not to panic.

For good measure, the SEC also tagged Galois for generally failing to adopt or implement written policies reasonably designed to prevent Advisers Act violations. And while this seems to be a catch-all charge given everything else; it can be a very real problem for many advisers who don’t take the time and care to make their policies fit their business and operations (let’s consider this – Lesson #2.5).

The “Custody Rule” (Rule 206(4)-2 of the Advisers Act), requires that funds controlled by investment advisers must typically be held by a “qualified custodian” and must be subject to a surprise or annual audit, depending on the type of asset under consideration. The proposed “Safeguarding Rule” would expand and replace the coverage of the current rule in an attempt to further protect investor assets. Among other things, the Safeguarding Rule will strengthen the requirement that advisers keep client assets with a “qualified custodian,” mandate that banks and savings associations segregate client assets in bankruptcy remote accounts, and tie foreign financial institutions to U.S. rules regarding anti-money laundering, which can be met by being subject to the Financial Action Task Force rules. Whether the final version of the forthcoming rule will be able to efficiently accomplish that goal in a rapidly changing industry will shortly be seen as the next iteration of the Safeguarding Rule is expected soon. With either rule, the ultimate goal of Rule 206(4)-2 remains the same - the fortunes of one’s fortune should not depend on the solvency of your adviser.

Article by Randy Heinig and Rex Lien Doan.

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