In late 2020, MicroStrategy, led by CEO Michael Saylor, purchased $650 million worth of Bitcoin as a reserve asset. Morgan Stanley and its subsidiaries and affiliates also purchased a considerable part of MicroStrategy. In early 2021, the value of Bitcoin crossed $30,000. Then $40,000. Institutional investors started flocking to the asset. Even an old stodgy insurance company–Massachusetts Mutual Life Insurance (MassMutual), dipped its toes in the water to the tune of $100 million.
If you own or operate an investment adviser registered with the U.S. Securities and Exchange Commission (“SEC”) or if you are a financial professional, you have probably been asked questions about Bitcoin and other digital assets. This article is intended to help address the custody issue associated with rendering investment advice on Bitcoin and other digital assets. Additional posts will address other legal and operational issues stemming from managing these digital assets.
If you want to render investment advice on Bitcoin and digital assets, you need to be intimately aware of Rule 206(4)-2 under the Investment Advisers Act of 1940, as amended, or the “Custody Rule” and be prepared to comply with it.
Does Our Arrangement Currently Cause us to Have Custody or Will it in the Future?
The first issue to address is whether your firm would have “custody” over Bitcoin or any digital asset. The rule defines “custody” to include, among other things, “[a]ny arrangement (including a general power of attorney) under which [an investment adviser is] authorized or permitted to withdraw client funds or securities maintained with a custodian upon [the investment adviser’s] instruction to the custodian[.]”
If your investment adviser or any of its “related persons” have any arrangement where you are authorized or permitted to withdraw Bitcoin or other digital currencies from a client’s account (or wallet), you will likely be deemed to have custody of the client’s funds or securities under the Custody Rule.
Before you start managing Bitcoin and other digital assets for clients, you need to determine the framework. Will you rely on a custodian or will you do so directly by having access to your client’s wallet? The latter seems like a risky choice for most investment advisers and would seem to clearly implicate the Custody Rule. The former seems more practical and likely.
You should review any custodial agreements that your clients or your firm would be required to enter to determine what kind of authority you would have over their account. You should also conduct due diligence outside the walls of that agreement to understand what authority your firm will be granted. If the arrangement with the custodian only grants your firm the authority to issue instructions to effect or to settle trades, it may not implicate the Custody Rule at all. See IM Guidance Update (February 2017).
Definition of Funds or Securities
While the previous discussion assumed that Bitcoin and other digital assets are “funds or securities”, it is an unsettled matter. This very question was posed in a letter issued by the Division of Investment Management to the Investment Adviser Association in March 2019 titled Engaging on Non-DVP Custodial Practices and Digital Assets (the “IAA Letter”). I advise clients to generally treat digital assets as funds or securities, because you can almost predict with certainty that the first instance involving theft or fraud by an investment adviser or its associated persons will result in the SEC alleging that the digital asset in question is either a fund or a security.
What Does the Rule Require of Investment Advisers Deemed to Have Custody?
The Custody Rule requires investment advisers that are deemed to have “custody” over clients “funds and securities” to maintain those funds and securities with a “qualified custodian.” More specifically, the rule requires investment advisers to maintain the funds and securities with a qualified custodian (1) in a separate account for the client under the client’s name, or (2) in accounts that contain only the client’s funds and securities, under the investment adviser’s name as agent or trustee.
In addition, “[i]f you open an account with a qualified custodian on your client’s behalf, either under the client’s name or under your name as agent, you [must] notify the client in writing of the qualified custodian’s name, address, and the manner in which the funds or securities are maintained, promptly when the account is opened and following any changes to this information. If you send account statements to a client to which you are required to provide this notice, include in the notification provided to that client and in any subsequent account statement you send that client a statement urging the client to compare the account statements from the custodian with those from the adviser.”
Third, you must “have a reasonable basis, after due inquiry, for believing that the qualified custodian sends an account statement, at least quarterly, to each of your clients for which it maintains funds or securities, identifying the amount of funds and of each security in the account at the end of the period and setting forth all transactions in the account during that period.”
Lastly, the funds and securities over which you have custody must generally be “verified by actual examination at least once during each calendar year…by an independent public accountant, pursuant to a written agreement between you and the accountant, at a time that is chosen by the accountant without prior notice or announcement to you and that is irregular from year to year.”
Who is a Qualified Custodian?
Under the rule, qualified custodians include banks, registered broker-dealers, and registered futures commission merchants. It is currently ambiguous whether state chartered trust companies qualify, because that answer turns on whether “a substantial portion of the[ir] business  consists of receiving deposits or exercising fiduciary powers similar to those permitted to national banks under the authority of the Comptroller of the Currency, and [are] supervised and examined by State or Federal authority having supervision over banks or savings associations, and  not [be] operated for the purpose of evading the provisions of the [Advisers Act].”
To date, the SEC hasn’t taken any enforcement action to challenge any state chartered trust companies or advisers using them for custodial services. In November 2020, the Division of Investment Management Staff in Consultation with FinHub Staff released a statement inviting comment on this issue. (As an aside, I recently wrote an article suggesting that the SEC should quickly issue guidance on this point after the Wyoming Division of Banking issued relief to Two Ocean Trust back in October 2020.)
Investment advisers that manage Bitcoin and digital assets seem willing to accept the risk that a trust company meets the definition of “qualified custodian” under the Custody Rule. Even Fidelity’s custody of digital assets is provided by Fidelity Digital Asset Services, LLC, a New York State-chartered, limited liability trust company (NMLS ID 1773897)–and not a bank or broker-dealer.
As my friend, Tyrone Ross, Jr., recently informed me, Anchorage received conditional approval of its national trust charter from the Office of the Comptroller of the Currency (OCC) on January 13, 2021, which makes Anchorage Digital Bank National Association, the first federally chartered bank willing and able to hold digital assets.
It appears that other entities that meet the definition of “qualified custodian” will make an entry into the market in the very near future based on the SEC’s recent statement and request for comment regarding the custody of digital asset securities by broker-dealers and the recent decision by the OCC.
Plans May Change in the Future
In 2020, it appeared that the SEC was going to amend the Custody Rule based on its regulatory agenda, but that no longer appears to be the case. It seems like the current composition of the SEC has no appetite to tackle changes to provide additional clarity on the Custody Rule as it relates to Bitcoin and digital assets at the moment, but that could change with the appointment of a new chairperson.