We have consistently heard from the Securities and Exchange Commission (SEC) that a prerequisite for a Bitcoin Exchange-Traded Fund (ETF) is that the ETF must have “good custody”. SEC Chairman Jay Clayton’s actual remark in an interview with CNBC in November of last year was:
We care that assets underlying that ETF have good custody and that they’re not going to disappear.
Clayton may sound clear enough about what he needs to feel “comfortable” with cryptos, but the term “custody” has no clear definition in the case of Bitcoin, for example. Custody in crypto parlance is a conundrum to be fixed.
Such is the intellectual argument crafted by Noelle Acheson, the Director of Research for Coindesk, in a recent newsletter. The simple truth in Crypto-Land is:
If you control the keys, you own the tokens.
This truth has become self evident after billions of dollars of digital assets have disappeared from the unregulated network of crypto exchanges, the obvious work of organized crime and professional hacking gangs. These stolen digital assets were moved about the blockchain, once the crooks controlled the right “keys”.
Per press accounts, however, Fidelity Investments and the highly anticipated and fully regulated Bakkt exchange were to re-write the rules of crypto custodial management in order to persuade the managers of “Big Money” to jump into the crypto investment fold. It sounded logical and plausible, according to the many articles that have been written on this topic, except for the unfortunate fact that no one today can define exactly what “custody” means in the digital world.
With Bitcoin, we are not dealing with a “security”, per an SEC ruling, such that what one might suspect applies to a “security” custodial arrangement may have no meaning, when you attempt to bridge over to BTC. The legal “term of art” that we have dates back to the SEC’s attempt to amend the Investment Advisers Act of 1940:
An adviser has custody of client assets… when it holds, directly or indirectly, client funds or securities or [has] any authority to obtain possession of them.
The key words become “holds” and “possession”, which can be difficult to apply to Bitcoin, as noted by Ms. Acheson:
Bitcoin, however, is a bearer asset, and as such, has no names attached. Instead, bitcoins are associated with addresses, which in turn are associated with “wallets.” The assets themselves don’t live in the wallets, nor in a central depository, nor in the account of the issuer; they live on the bitcoin blockchain, a decentralized global network with no identifiable accountability.
The point of confusion now rests with how regulators and lawmakers bridge the “gap” between security connotations and the digital world, when crafting new legislation. There have been attempts to cooperate with groups like the Financial Action Task Force to come to some agreement, but “possession” means having access to private keys, and as the crypto axiom states, once you have access to the private keys, you have the power to make transfers on the blockchain.
The improper application of existing statutes and terms to an evolving technology is not a new problem. Ms. Acheson refers to the Internet, as a prime example. Perhaps, we need new terms – in the nineties, would you have known what terms like the “net” or the “web” referred to? As she states:
Throughout history, the development of technology has easily outstripped the emergence of a vocabulary that fits the new concepts. Metaphors are employed to facilitate comprehension, and they usually work.
In order to “fix” the current conundrum, we may need to devise new terms or, at the very least, be more specific with how we use familiar words. Regulators would need to accept that “Custody” only means the “authorized safeguarding of private keys”, and a “custodian” is only the entity or person that provides this service.
Noelle Acheson concludes:
In the case of bitcoin and similar crypto assets, the problem is not so much that crypto custody is so different from traditional security custody – it’s that we’re trying to fit a new concept into an old box that doesn’t have the same dimensions.