November 15, 2023

Insights and analysis for the professional investor

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Welcome to Crypto Long & Short!

This week, Nathan McCauley, CEO and co-founder of Anchorage Digital, argues that the SEC's new Custody Rule requiring advisers to safeguard digital assets for clients, will change the game for advisers.

Then, Kunal Bhasin, partner and co-leader for KPMG Canada, outlines the due diligence standards companies need to adopt in the wake of FTX and other recent corporate governance scandals.

As always, get the latest crypto news and data from CoinDeskMarkets.com.

– Ben Schiller

From the Analyst

What an SEC Proposal Means for RIAs in Crypto

Imagine meeting with your financial advisor to plan for retirement, and seeing crypto products offered alongside other safe and regulated financial products. You decide to allocate to crypto products — not only as an investment vehicle, but also as a tool to execute tax-loss harvesting. What was once a holy grail in crypto adoption is quickly becoming a reality.

Demand from registered investment advisors (RIAs) to provide digital assets to end-clients is greater than ever. Just take a look at recent headlines from crypto wealth management platforms like Eaglebrook Advisors, Fidelity and L1 Advisors.

But against the backdrop of rising institutional demand, a little-watched SEC proposal could radically reshape how RIAs and asset managers access the digital asset class.

What has the SEC proposed?

In February 2023, the SEC proposed changes to the "Custody Rule." The Rule, which has been a key protection in U.S. financial services regulation for decades, requires RIAs to safeguard client funds and securities with a qualified custodian.

The recent proposal would broaden the current scope of the Custody Rule by requiring RIAs to safeguard all client assets — including digital assets — with a qualified custodian.

In choosing a qualified custodian, bankruptcy protections are key. Bankruptcy-remote custody solutions — like Anchorage Digital Bank, a federally chartered bank — would still meet the SEC definition of a qualified custodian. The analysis is more nuanced with respect to state-chartered trusts, which may vary widely in compliance standards, bankruptcy protections, and key storage safety.

Toward regulatory clarity

The SEC proposal shouldn't be a surprise; in traditional finance, it's well-established that RIAs must keep client assets with a qualified custodian.

While we have expressed some concerns with the SEC custody rule proposal, it is a step in the right direction.

If adopted, the SEC proposal would mark a significant step toward bringing crypto further under the fold of traditional financial regulation in the US—a win for consumers, a win for RIAs and a win for regulators.

Outlook for RIAs in crypto

The SEC is now considering next steps in the rulemaking process, after the public comment period closed late in October.

While the SEC has yet to make a final decision, the answer is clear: RIAs in crypto need to take a serious look at regulated custody.

In light of the proposal, RIAs offering crypto should consider a number of separate — but related — questions, including:

Are you safekeeping client digital assets with a qualified custodian?
Is your digital asset custody solution bankruptcy-remote?
Does your crypto partner provide compliant recordkeeping and reporting to meet SEC requirements?

Advisors are one of the most promising areas for institutional and mainstream adoption of crypto. Client interest is only growing, especially with recent movement around spot Bitcoin ETFs and the rise of crypto SMA platforms.

Safekeeping client digital assets with a qualified custodian allows RIAs to future-proof their crypto offerings in a changing regulatory environment, while meeting growing client demand for safe, secure and regulated access to the digital asset economy.

– Nathan McCauley, co-founder and CEO of Anchorage Digital

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Institutional Outlook

Navigating the Next Wave of Crypto Institutionalization: A Due Diligence Primer

Leading financial services institutions in the US are keenly awaiting the SEC's decision on their Bitcoin ETF applications, with critical deadlines from January to May 2024. The anticipated approval of these ETFs, already influencing Bitcoin's price with a 26% surge in the last three months, marks a pivotal moment in market evolution.

Source: Coindesk - Nov 13, 2023

The crypto sector is drawing attention due to factors like the upcoming Bitcoin halving (which is due to fall in April 2024), its status as an uncorrelated asset class, the "digital gold" narrative and prevailing macroeconomic conditions.

Bull runs in crypto markets have historically attracted significant interest from institutional investors and financial service providers that work with Virtual Asset Service Providers (VASPs) to offer trading, custody, and structured products, enabling an expansion beyond bitcoin into areas like tokenization, stablecoins, staking and private equity.

The entry or re-emergence of institutions in this space highlights the need for robust due diligence. A lack of understanding about the unique risks associated with digital assets and their management became evident following the collapse of FTX and findings from the recent trial.

A comprehensive due diligence framework that captures the unique risks in digital asset space is essential in guiding institutions through this complex landscape. It should include:

Governance & Operational Resilience: This involves risk management frameworks and control functions to address board effectiveness, roles, responsibilities, and leadership accountability. Operational resilience covers business continuity, disaster recovery, third-party oversight, and segregation of duties. It also includes understanding the governance and decentralization of Layer 1 and Layer 2 blockchains, where applicable.
Regulatory Compliance: VASPs should implement robust processes for evolving regulations, encompassing KYC/AML controls and crypto intelligence tools, trust structures, client asset segregation, data protection, conflict of interest and ethics.
Digital Asset Operations: Prioritizing the secure custody of digital assets is crucial. Technology controls should cover key lifecycle management, stablecoin management, staking activities, account management, transaction handling, change management, and an understanding of tokenomics and blockchain technology. Contrary to popular belief, reviewing a SOC report may not be sufficient to address the risks in these business operations.
Financial Analysis & Reporting: VASPs should focus on financial metrics beyond traditional assessments, including on-chain reviews for insights into management and transactions, initial distributions, key personnel holdings, and related party transactions. Understanding reserve asset management, customer liabilities, balance sheets, and digital asset encumbrances is vital. Additionally, evaluating accounting treatments and counterparty risks provides a comprehensive view of financial health and exposure. While proof of reserve is gaining momentum, there are currently no standards from professional accounting bodies to ensure its sufficiency.
Financial Risk Management: Strategies for liquidity risk management, funding strategy assessment, digital asset liquidity and quality, and supporting systems are necessary. VASPs should also have mitigants for financial risk metrics, stress testing for liquidity events, capital management processes, and frameworks for credit, interest rate, and currency exchange risk. The presence of an internal audit department is a positive indicator.

Each category in this framework demands thorough exploration to uphold higher standards in managing risks effectively, fostering a more matured and secure crypto industry.

As the crypto market continues to evolve and intersect with traditional financial systems, the importance of these due diligence practices cannot be overstated. They are not just compliance checkboxes but vital tools to safeguard the integrity of the financial market and protect investor interests.

It's imperative for institutions to move beyond mere participation in the crypto space to becoming informed, responsible actors. This responsible approach is crucial for ensuring that the crypto market's potential is fully realized, paving the way for its sustainable growth and integration into the broader financial landscape.

All views are personal.

- Kunal Bhasin, partner and co-leader for KPMG Canada

Takeaways

From CoinDesk Managing Editor Stephen Alpher, here is some news worth reading:

GENSLER'S POLITICAL AMBITION: With it becoming increasingly clear that there's no logical reason for the SEC to continue delaying or outright rejecting all attempts to launch a spot bitcoin ETF, it's only natural to wonder what else is at work. Cathie Wood, whose ARK Invest is among the applicants for the spot product, pointed to "speculation" that SEC Chair Gary Gensler wants to be U.S. Treasury Secretary. "What does the Treasury Secretary do," asked Wood. "It's very focused on the dollar,"
BOGUS XRP ETF FILING: To be fair to the SEC chief, Gary Gensler has repeatedly said crypto is rife with fraud and hucksters … And he's got a point. A quiet Monday afternoon quickly became unsettled when a corporate registration in the state of Delaware for the iShares XRP Trust became public. The price of XRP quickly shot higher by more than 10% on the improbable news that asset management giant BlackRock might soon file paperwork for a spot XRP ETF in similar fashion to its applications for spot bitcoin and ether ETFs. Within minutes, a BlackRock spokesperson confirmed to CoinDesk that the corporate registration was indeed bogus. The price of XRP gave up its gains and the rest of the crypto market turned sharply lower. And perhaps in an office in Washington, D.C., the SEC chair was nodding his head, saying "I told you so."
IRS 'RAIDED': The Internal Revenue Service weeks ago opened for comment its proposal for a digital assets taxation regime. Believing the proposal was an existential threat to investor privacy and crypto projects, the industry sprang into action. Perhaps aided by AI tools, digital asset advocates flooded the IRS with more than 120,000 comments to be sifted through. Drawing particular ire was the proposal's definition of a "broker" that would need to comply with the rules. "The digital asset middleman category stretches the statutory language beyond its breaking point in direct contravention of the relevant legislative history," wrote the DeFi Education Fund. The proposal won't become final until the IRS weighs this new input and then writes and approves a final version.