SEC Proposes Broad Custody Changes for Advisers & Registered Funds, Including New Crypto Custody Pathways
The SEC’s Custody Proposal would create new pathways for adviser self-custody and state trust company custody of crypto assets, while modernizing certain custody requirements under the Advisers Act and 1940 Act. Crypto custody is the main headline, but the Custody Proposal reaches beyond digital assets, with several proposed changes to longstanding custody practices that would apply broadly to investment advisers, registered funds, and BDCs.
Key Takeaways
- The Custody Proposal would create new pathways for crypto custody. Advisers could, subject to significant conditions, self-custody crypto assets when they have a reasonable basis for believing that no qualified custodian is available to maintain them, and registered funds and BDCs could hold crypto assets through their advisers on the same basis, subject to board oversight. The proposal also would treat certain state trust companies as qualified custodians for custody crypto assets and related cash.
- Crypto asset self-custody would come with ongoing obligations. For advisers, self-custody would require more than determining that a qualified custodian is unavailable. Advisers would need to meet certain requirements, including documenting appropriate safeguarding expertise; maintaining systems addressing private-key management, joint authorization, and client-by-client segregation; implementing cybersecurity controls; obtaining an independent internal control report; conducting annual reviews; providing specified information to clients at least quarterly; and, unless an exception applies, continuing to obtain the annual surprise examination.
- Discretionary trading. Proposed rule 223-1(b)(9) would except from the rule funds and securities over which an adviser has custody “due to [its] authority to trade at [its] discretion” if the adviser trades only in designated accounts in the client’s name, has no authority to move assets to itself, a related person, or any nonclient account (other than at the client’s direction in connection with trading), and complies with the rule for every other source of custody.
- Inadvertent custody. Proposed rule 223-1(b)(10) would except custody that arises solely from a client’s custodial agreement, but only if the adviser did not “recommend, request, or require” the custodian and either lacks knowledge of the authority or promptly repudiates it in writing.
- Standing letters of authorization. Proposed rule 223-1(b)(8) would codify surprise-examination relief for standing letters of authorization (SLOAs), but not where the custodian is the adviser or a related person.
- Some changes could provide meaningful compliance relief, while the new crypto frameworks would bring new obligations. The proposed treatment of discretionary trading authority, SLOAs, inadvertent custody, and certain audit requirements could simplify recurring custody issues for advisers. The proposed crypto self-custody and state trust company frameworks would require certain diligence, controls, documentation, and ongoing monitoring for firms, but could offer firms a workable framework for crypto custody.
- Advisers Act rule redesignation. The SEC proposes to move the Advisers Act custody rule from rule 206(4)-2 to rule 223-1, replacing its current anti-fraud framing with an express safeguarding obligation under Section 223 of the Advisers Act.
- Important elements remain open for comment. The SEC is seeking comment on several aspects of the Custody Proposal, including availability of qualified custodians, conditions for self-custody, safeguarding and cybersecurity requirements, custody by state trust companies, and modernization of existing custody regimes.
The Custody Proposal is best understood as two related projects. The first is a crypto custody framework intended to address circumstances in which the existing qualified custodian model has not provided a workable path for particular crypto assets or providers. The second is a broader modernization of custody requirements that reaches more traditional assets and long-running interpretive questions. Firms that do not advise on crypto assets could still be affected by the proposed rules on discretionary trading authority, pooled vehicle audits, standing letters of authorization, inadvertent custody, broker-dealer custody, recordkeeping, and reporting.
The SEC also would redesignate the Advisers Act custody rule—now rule 206(4)-2—as new rule 223-1, as was proposed in the 2023 Safeguarding Rule proposal. The 2023 proposal indicated that, although this is no longer under the anti-fraud Section 206 of the Advisers Act, the SEC would maintain its ability to pursue advisers for failing to properly safeguard client assets under the Advisers Act’s antifraud provisions (which is not expressly stated in the Custody Proposal). Although this may appear largely technical, the change could have practical implications for investor and client reporting, representations, and due diligence questionnaires.
A related modernization theme is the Custody Proposal’s treatment of positions that have developed through SEC staff no-action letters, FAQs, and interpretive guidance, as well as established industry practices. In several areas, the SEC is proposing to make those positions (or modified versions of these positions) into SEC-level rules or otherwise clarify SEC views on the issue. That shift would give firms that have relied on this guidance greater regulatory certainty, subject to any revised requirements. If the Custody Proposal is adopted, it would supersede any inconsistent staff views.
The Custody Proposal’s crypto provisions are generally narrower than the SEC’s withdrawn 2023 Safeguarding Rule proposal. The proposed Advisers Act custody framework continues to apply to client “funds and securities,” meaning the new crypto provisions do not generally expand the custody rule to every crypto asset but rather only those that are “funds” or “securities.” Similarly, the 1940 Act custody provisions apply to a registered fund’s or BDC’s “securities and similar investments.”
The release emphasizes these scope limitations while proposing special mechanisms for crypto assets that are already within the relevant custody regime. As a result, native digital commodities such as bitcoin and ether generally would remain outside the Advisers Act custody rule for clients other than registered funds and BDCs, while payment stablecoins and tokenized deposits would be treated as client “funds.”
