Use of State-Regulated Entities to Custody Assets: Will SEC Expand Playlist?

Just before the October federal government shutdown, the SEC staff issued a no-action letter providing some clarity as to when a state-regulated banking or trust institution can serve as a “qualified custodian” under the Investment Advisers Act of 1940 or a permissible custodian under the Investment Company Act of 1940 with respect to digital assets that are subject to the custody provisions of those acts (crypto assets). The no-action letter provides needed clarity as to the use of these state-regulated entities (SREs) to custody crypto assets and, as a result, expands the universe of entities that can be used for that purpose.

The letter also, however, raises the question of whether investment companies and registered investment advisers can use SREs to custody non-crypto assets.

The letter points out the robust nature of the current regulatory regime in place for SREs, such as minimum capital requirements, investment restrictions, and periodic reporting and examination obligations. Moreover, the letter specifies conditions for custodying crypto assets with these entities, including independent audits of SREs' financials, maintenance by SREs of procedures designed to protect custodied assets, and prohibitions on certain transfers of interests in custodied assets. However, nothing in the letter’s discussion of the current regulatory regime for SREs or the letter’s conditions seems intrinsically limited to crypto assets. Rather, the regulatory regime and conditions described in the letter seem equally applicable to any asset for which a registered investment adviser or registered investment company would have a custody obligation.

Nevertheless, because the letter is by its terms addressed to the custody of crypto assets, registered investment companies and registered investment advisers may decide to consult with the SEC staff before custodying non-crypto assets with an SRE. To be sure, there may not be the need for a broader supply of custodians for non-crypto assets, as there is for crypto assets. Nonetheless, given the increased focus on avoiding unnecessarily restrictive regulatory requirements under the current administration at the SEC, there seems to be a reasonable prospect that any such consultations would yield a favorable result.