Banks lobby SEC to ease crypto custody rules for Bitcoin ETFs, DLT

After years of shunning the crypto industry and blocking access to exchanges, major banks and financial institutions in the United States have now asked the Securities and Exchange Commission (SEC) to re-adjust the definition of crypto assets to allow them to provide crypto-related services to clients. 

According to a Feb. 14 letter addressed to SEC Chair Gary Gensler, a trade group coalition comprising the Bank Policy Institute, American Bankers Association, Financial Services Forum and Securities Industry and Financial Markets Association have asked the regulator to “consider targeted modifications to Staff Accounting Bulletin No. 121 (“SAB 121”) to address recent policy developments and the challenges that SAB 121 has posed for U.S. banking organizations since it was issued on March 31, 2022.”

SAB 121 includes “interpretive questions” that address: (1) How covered entities should account for their obligations to safeguard crypto-assets held for platform users, (2) what disclosures staff would expect in those circumstances, and (3) when the guidance in SAB 121 should be applied to financial statements. 

With the two year anniversary of the issuance of SAB 121 approaching, the coalition thinks it’s an opportune time to “examine and discuss the implications of SAB 121 for regulated banking organizations,” the letter said. 

They cited several developments over the past two years, including the launch of spot Bitcoin (BTC) ETFs in the U.S., and said, “The Associations and Commission share the common goals of ensuring the highest levels of investor protection and implementing policies that advance principles of market integrity and financial stability.”

“We believe the recommendations set forth in this letter are consistent with those principles and would remove unintended barriers for well-regulated U.S. banking organizations to engage in certain activities,” they said. 

The associations noted that they had petitioned the SEC on multiple occasions to argue that the “on-balance sheet requirement of SAB 121 negatively impacts U.S. banking organizations and investors due to the associated prudential implications,” and warned that “on-balance sheet treatment will preclude highly regulated banking organizations from providing a custodial solution for digital assets at scale.”

“Moreover, the Associations have highlighted that the on-balance sheet requirement, coupled with the overly-broad definition of ‘crypto-asset’ in SAB 121, will have a chilling effect on banking organizations’ ability to develop responsible use cases for distributed ledger technology (DLT) more broadly,” they added. 

The letter said that while banking organizations have been blocked from providing custody services over the past two years, various non-banking organizations have been able to offer these services, “thereby keeping activity outside the prudential perimeter and avoiding the necessary oversight by regulators.”

“Indeed, if regulated banking organizations are effectively precluded from providing digital asset safeguarding services at scale, investors and customers, and ultimately the financial system, will be worse off, with the market limited to custody providers that do not afford their customers the legal and supervisory protections provided by federally-regulated banking organizations,” they warned. 

The signatories noted that none of the recently approved spot Bitcoin ETFs have a banking organization serving as the asset custodian despite it being a role they “regularly paly for most other ETPs.” 

“These ETPs have already experienced billions of dollars in inflows, but it is practically impossible for banks to serve as custodian for those ETPs at scale due to the Tier 1 capital ratio and other reserve and capital requirements that result from SAB 121,” they said. “This raises important questions about the safety and stability of this ecosystem.”

They warned that this could “raise concentration risk, as one nonbank entity now serves as the custodian for the majority of these ETPs,” referring to Coinbase. They said this risk could “be mitigated if prudentially regulated banking organizations have the same ability to provide custodial services for Commission regulated ETPs as qualified nonbank asset custodians.”

The letter also noted that banking institutions have increasingly been exploring the use of DLT to record traditional financial assets, such as bonds. 

They said “the use of DLT has the potential to expedite and automate payment, clearing, reconciliation and settlement services,” but noted that “SAB 121 has proven to be a barrier to banking organizations’ ability to meaningfully engage in DLT-based projects due to the breadth of the definition of ‘crypto-asset.’” 

SAB 121 defines a crypto asset as “a digital asset that is issued and/or transferred using distributed ledger or blockchain technology using cryptographic techniques.” 

“Under this definition, a traditional financial asset issued or transferred using DLT could be considered a ‘crypto asset’ and thus within scope of SAB 121, regardless of the applicable risks,” they noted. 

The letter said that a “Clear indication from the Commission that the use of DLT to record or transfer traditional financial assets is consistently outside the scope of SAB 121 would alleviate associated challenges.”

The associations asked that the SEC “Narrow the definition of ‘crypto-assets’ to clarify and confirm the exclusion of certain asset types and use cases,” and “Exempt banking organizations from on-balance sheet treatment but maintain the disclosure requirements.” 

“SAB 121 is premised on the risks posed exclusively by cryptocurrencies, and traditional financial assets recorded or transferred using blockchain networks should be excluded because they do not present the same risks as cryptocurrencies,” they argued. “The use of DLT does not change the underlying nature or risk of traditional assets.” 

Bloomberg Intelligence senior ETF analyst Eric Balchunas summed up his views on the letter succinctly in a post on X.

US banks, left off key bitcoin ETF roles, are pushing SEC to tweak guidance around holding digital assets. A bank trade gp coalition sent SEC letter asking them exclude ETFs from broad crypto umbrella. They want a piece of the action. I don’t blame them, it isn’t fair.… pic.twitter.com/advPa94nK2

— Eric Balchunas (@EricBalchunas) February 15, 2024