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Does the new SEC approach to custody push investment advisors from CEXes to OTC trading?

February 21, 2023

The SEC recently proposed expanding and enhancing qualified custodians when registered investment advisers manage assets on behalf of investors.
Finery Markets’ non-custodial multi-dealer marketplace could benefit from the proposal in the long run, as institutional trading shifts towards electronic OTC markets.

What exactly happened?

Gary Gensler, the chairman of SEC, made a statement related to crypto assets:

“Make no mistake: Today’s rule, the 2009 rule, covers a significant amount of crypto assets. As the release states, “most crypto assets are likely to be funds or crypto asset securities covered by the current rule.” Further, though some crypto trading and lending platforms may claim to custody investors’ crypto, that does not mean they are qualified custodians. Rather than properly segregating investors’ crypto, these platforms have commingled those assets with their own crypto or other investors’ crypto. When these platforms go bankrupt — something we’ve seen time and again recently — investors’ assets often become property of the failed company, leaving investors in line at the bankruptcy court.

Make no mistake: Based upon how crypto platforms generally operate, investment advisers cannot rely on them as qualified custodians.”

What does that mean for institutional crypto trading?

This could have major implications for institutional crypto trading. Currently, most CEXes in crypto combine trading, clearing, and custody together, unlike traditional capital markets, where these are separated. The proposal enhances the protections that investors receive through the custody process to help ensure that their assets are properly segregated, which helps protect their assets should the adviser or custodian go bankrupt. According to SEC rules, “investment advisers” are required to hold assets with a “qualified custodian” in a client’s name. Investment advisor means not only people who advise clients about their investments, but also firms who manage funds, including some hedge funds and mutual funds.

Given Gensler’s statement, investment advisors will not be able to operate via centralized exchanges in its current form. In the short-term, we share Commissioner Hester Peirce’s concerns that “these statements encourage investment advisers to back away immediately from advising their clients with respect to crypto.”

However, in the long-run, crypto is surely here to stay, and we believe a large portion of institutional demand will try to find a compliant way to operate in crypto and meet the “qualified custody” rule. We have been always advocating an institutional trading shift from retail-focused CEXes towards more matured elements of market structure like electronic multi-dealer or single dealer-platforms. Of course, we never expect this might be forced by a regulatory action.

What does it mean for Finery Markets?

Finery Markets is a custody-agnostic multi-dealer platform for institutional crypto trading. By utilizing Finery Market’s electronic marketplace, investment advisors can comply with the SEC requirements and hold assets with any qualified custodian of their choice.

The SEC will soon start a 60-day comment period on the proposal once it is published in the Federal Register, so keep an eye out for any developments.

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