SEC Prompts Crypto Custodians to Move Client Assets On-Balance Sheet

Coinbase logo on laptop

Andrew Wright

Coinbase logo on laptop
Photo by PiggyBank on Unsplash

Coinbase, one of the world’s largest crypto custodians, has disclosed that “in the event of bankruptcy, crypto assets we hold in custody on behalf of our customers could be subject to bankruptcy proceedings.” The admission was part of a quarterly earnings report the company filed with the US Securities and Exchange Commission (SEC). Coinbase CEO Brian Armstrong revealed that this was because of the recent publication of SEC Staff Accounting Bulletin (SAB) 121 which requires any crypto asset custodian to ‘present a liability on its balance sheet to reflect its obligation to safe-guard the crypto-assets held for its platform users.’ The SEC expects such disclosures to be made by all businesses that ‘custody’ crypto assets no later than in financial statements covering the first interim or annual period after 15 June, so we will potentially see a wave of similar disclosures in the near future.

Coinbase’s declaration that customers’ assets may potentially form part of any bankruptcy estate, and that the customers may be treated as general unsecured creditors, has caused a stir within the crypto industry. Were Coinbase to go bankrupt, the implication is that many of the assets it holds for customers may go with it. Coinbase Custody, which has a New York state banking licence, points out that it has never had a security incident in over 7 years of operations. However, customers choosing from competing custody services will want the absolute minimum risk in exchange for their fees.

Coinbase’s custody business is standalone from the rest of the group and only provides cold storage, so it could rapidly end up being obsoleted and out-competed by traditional, larger bank custodians. This is a view shared by Nadine Chakar, the head of State Street Digital, as expressed at a recent Fund Forum panel discussion. Global Custodian reports Chakar as commenting, “unless you have larger custodians moving into the space and be the big kids at the table, it’s (digital assets) unlikely to see institutional adoption”. She called for more regulation to provide clarity.

SAB 121, published on 31 March, expresses the views of SEC staff but is not a formal rule. Despite this, it is very prescriptive regarding the detail and format of disclosure it expects to see. The financial statement impact is as simple – and dramatic – as moving the value of assets under custody onto the service provider’s balance sheet through a liability and matching asset at the fair value of those assets at the time of each filing (broken down into each significant crypto asset in notes to the accounts). The suggestion is that this should take place regardless of the entity’s assessment of the actual “legal ownership of the crypto-assets held for platform users, including whether they would be available to satisfy general creditor claims in the event of a bankruptcy”. As such, it would mark a sharp divergence in practice compared to the accounting treatment for assets under custody in traditional asset classes. Further, there should be a detailed discussion of the technological and legal risks and uncertainties facing the business in relation to safekeeping digital assets in other areas of filings outside the financial statements.

Coinbase’s lawyers will doubtless have considered the potential impact of this disclosure but, due to the lack of clear legislation and regulation cited by Chakar, and a desire to be seen as compliant with SEC expectations, have concluded that they should acknowledge that clients’ custodied assets “could be subject to bankruptcy proceedings”. It remains to be seen whether other crypto custodians will fall into line given the arguably optional nature of this guidance, pending the debate it is causing being worked through to a conclusion.

The new guidance overrides the Financial Accounting Standards Board’s (FASB) Accounting Standards Codification 940, which states that broker-dealers holding client assets should keep them off-balance sheet – although the SEC is not yet licensing broker-dealers for crypto activity – and that otherwise custodians should assess whether they have a sufficient degree of control over those assets, as they would with traditional assets under custody. In other words, the FASB treats this as a judgment-based decision that may hinge on aspects such as the degree of customer control of their own assets through measures such as key sharing.

One of the five Commissioners of the SEC, Hester Peirce (a Trump appointee) has responded to the bulletin. Her view is that the SEC and the market have been aware of risks for a long time and already review custodians’ financial statements; that an interpretive Staff Accounting Bulletin is not the appropriate place to make rule changes; and that the SEC has itself been partially responsible for creating the legal and regulatory risks that have driven this accounting treatment by failing to provide adequate guidance on crypto assets. She also believes that some consultation with the FASB and with affected companies would have been helpful.

These are fair points, if politically motivated; the end result may be worthy, but Peirce is far from alone in denouncing the SEC’s methods. Around the same time, on 16 March, members of Congress from both parties wrote to Chair Gensler to criticise the SEC’s behaviour relating to crypto businesses, pointing out that its many requests for voluntary disclosures outside its remit amount to a jurisdictional land-grab by stealth, and also set it up in competition with the CFTC in some areas. These requests are accompanied by enforcement actions and fines despite clear guidance from the SEC; a reluctance to license broker-dealers and to authorise crypto-backed ETFs; and a determination that interest-bearing lending products are unlicensed securities. President Biden’s recent Executive Order may effect a change in attitude, particularly as one of its main goals is to ensure that the US is a competitive and attractive market for digital assets and related technologies.