Reed Smith In-depth

In a recent spate of eight spot Bitcoin ETF applications, no applicant designated a national bank as a custodian. Previously, the country’s most venerated financial institutions expressed an intention to custody crypto-assets. Why, then, was no national bank designated? One driving factor may be a controversial SEC bulletin regarding the treatment of crypto-assets by banks, financial institutions or others, which directs banks to hold crypto custodial assets on their balance sheet and creates corresponding capital implications.

Below, we address (i) the SEC’s guidance; (ii) its negative effects as highlighted by SEC Commissioner Peirce, the Federal Reserve and members of Congress; (iii) the inconsistency between the SEC and the Basel Committee, the primary global standard setter for prudential bank regulation; (iv) the vehicle through which the SEC chose to act (i.e., a bulletin versus public rulemaking); and (v) crucial implications for industry actors and customers moving forward.

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Background: the SEC’s guidance

Staff Accounting Bulletin No. 121 (SAB 121), issued by the staff of the Office of the Chief Accountant of the SEC on March 31, 2022, with an effective date of April 11, 2022, provides “interpretive guidance” for SEC reporting entitiesthat hold crypto-assetsin custody on behalf of clients to record that risk on-balance sheet.

This represents a significant departure from decades of generally accepted off-balance sheet accounting treatment for other custodied assets and raises questions about the feasibility of U.S. banking organizations scaling up their crypto-asset businesses.

Why the departure? According to SAB 121, safeguarding crypto-assets held on platform involves unique risks and uncertainties not present in arrangements to safeguard non crypto-assets. It advises that due to increased technological, legal and regulatory risks associated with safeguarding crypto-assets, including an “increased risk of financial loss,” an entity should record its obligations to safeguard crypto-assets for customers as a liability on its balance sheet along with a corresponding asset, measured at the fair value of the related crypto-assets.

The largest U.S. bank holding companies that are SEC registrants and their custodial bank subsidiaries have already noted in their SEC filings that they have implemented SAB 121 and that it currently has a de minimis impact on their financial statements and capital requirements. However, this may likely be because they are not offering crypto-asset custody at scale. The result of U.S. banking organizations offering crypto custody services at scale under this directive would result in knock-on effects in the prudential regulatory framework that could give rise to significant capital and liquidity costs3 and, as such, make it prohibitively expensive to provide these services.

It is not surprising, therefore, that the bulletin has generated substantial controversy among public officials as well as private actors.