Cryptocurrency traction is accelerating as regulatory frameworks around crypto custody are evolving to keep up with investor interest. It has not been smooth sailing in the US, though.
One of the more controversial developments happened in 2022 when the US Security and Exchange Commission (SEC) Staff Accounting Bulletin 121 (SAB 121) regulations introduced new compliance requirements for companies holding crypto assets on behalf of customers, aka “crypto custody”.
Recently, BNY Mellon, the oldest bank in the United States and one of the largest financial institutions in the world, secured an exemption from these rules, potentially setting the stage for future industry changes.
Understanding these developments is crucial for anyone involved in crypto, especially those managing taxes on their crypto holdings, as they signal significant shifts in how institutions and regulators will handle digital assets moving forward.
What is Crypto Custody, SAB 121, and Why Does It Matter?
In the context of the U.S. Securities and Exchange Commission (SEC) SAB 121, crypto custodial services refers to the practice of financial institutions or third-party companies holding and safeguarding cryptocurrency assets on behalf of their clients.
These services are similar to traditional custodial services in the financial world, where banks or custodians hold securities, cash, or other assets for safekeeping to prevent theft or loss. However, with crypto assets, custody involves a few additional complexities, particularly around the security of digital keys that control access to cryptocurrencies.
Here’s how crypto custodial services work in the SAB 121 context:
- Holding Customer Assets: Crypto custodians manage the private keys associated with clients’ cryptocurrency wallets. Since private keys are essential to accessing and transferring cryptocurrencies, losing these keys means losing the assets. Custodians provide a secure way to store these keys, ensuring clients don’t have to manage this responsibility on their own.
- Regulatory Implications Under SAB 121: According to SAB 121, any company offering crypto custodial services must account for the assets they hold on behalf of customers as both an asset and a liability on their balance sheets. The idea is that by holding customers’ crypto, the company assumes certain responsibilities and risks—such as the potential loss of assets due to hacking, theft, or other security breaches.
- Risk and Compliance Management: SAB 121 aims to make companies more transparent about their risks when holding customers’ cryptocurrency. Custodians must demonstrate that they are managing this risk effectively, which can involve using cold storage (offline wallets), multi-signature wallets (requiring multiple keys to authorize a transaction), and rigorous security protocols.
In short, crypto custodial services under SAB 121 involve the secure storage and management of digital assets for clients, but with new regulatory requirements that reflect the increased risk of holding and managing cryptocurrencies.
Balance Sheets Out of Whack: The SAB 121 Reporting Controversy
The requirement to record custodial crypto as both an asset and a liability under SAB 121 is controversial primarily because it differs from how accounting treats traditional financial (TradFi) assets. It also adds operational and financial burdens for companies in the crypto space. Here are the key reasons for the controversy:
1. Liability Treatment vs. TradFi Assets
In traditional finance, when a bank or custodian holds assets (such as cash, securities, or stocks) on behalf of a client, those assets are generally not recorded as liabilities on the custodian’s balance sheet. Instead, they are treated as off-balance-sheet items, since the custodian does not bear direct financial responsibility for those assets in the same way. The bank is simply holding them in custody for the client, without assuming ownership or liability beyond ensuring safekeeping.
However, under SAB 121, cryptocurrency custodians must recognize these assets and the liabilities on their balance sheets. The rationale behind this is that custodians bear significant risks in managing these digital assets, such as the potential for theft, loss, hacking, or technological failures.
Since cryptocurrency is more vulnerable to such risks due to its decentralized and digital structure, the SEC believes it should show as a liability on the balance sheet.
In contrast, with traditional financial assets, custodians are not typically exposed to the same level of risk. For example, a clearinghouse holds stocks, and cash is FDIC-insured.
This fundamental difference in risk is why the SEC treats cryptocurrency custodial assets differently.
2. Increased Burden on Balance Sheets
Recording crypto assets as liabilities creates a more complex and potentially negative impact on a company’s balance sheet.
For crypto custodians, this double-entry requirement means that the more crypto assets they hold, the larger their liabilities appear, even though they do not technically “owe” these assets to anyone like a debt. This requirement can lead to inflated liability figures that do not accurately reflect the company’s financial position.
In traditional financial services, custodians would only report the assets they are managing, not the corresponding liability, because they are not assuming full financial risk for those assets.
With crypto under SAB 121, companies must account for the risk associated with safeguarding digital assets, which makes their balance sheets look riskier and potentially more leveraged than they actually are.
3. Operational and Compliance Costs
The requirement to treat custodial crypto assets as liabilities also imposes additional operational and compliance costs. According to the SEC’s guidelines, companies must implement new systems to track and report these assets and liabilities.
Moreover, traditional custodians of financial assets do not face these additional accounting complexities, making the crypto space appear more challenging and costly in comparison. This regulatory difference can discourage financial institutions from entering the crypto custody space, as they may not want the added regulatory complexity on their balance sheets.
All of the above has sparked compliance challenges and concerns for the crypto industry. Many companies offering crypto custody services must navigate these strict accounting measures, which can complicate balance sheets and add operational costs.
By ensuring companies properly account for the risk associated with holding crypto, SAB 121 aims to protect investors, but its implementation has also generated pushback from companies that feel the regulation is too burdensome.
The Oldest Bank in the US Laying the Groundwork for Crypto
While the cryptocurrency industry wrangles with the SEC on one front, US financial titans have lumbered into action on the TradFi front.
BlackRock successfully petitioned the SEC for the approval of the first Bitcoin spot ETF in early 2023, marking a significant milestone in the institutional acceptance of cryptocurrency. In 2022, BNY Mellon, the oldest bank in the US, launched its digital asset custody platform, offering institutional clients the ability to hold Bitcoin and Ethereum.
These pioneering steps into the crypto space mark a significant shift and signal the growing legitimacy of digital assets among major financial institutions.
For BNY Mellon, the significance of the bank’s role extends beyond its service offerings. By becoming one of the first major financial institutions to offer crypto custody, they have demonstrated that institutional crypto adoption is not just possible but already happening.
BNY Mellon’s involvement moves the industry closer to mainstream acceptance, as the involvement of trusted entities helps reduce concerns about the risks associated with crypto. It also signals regulators that we can integrate crypto into the traditional financial system under the right conditions.
Why the SEC Granted an Exemption to BNY Mellon
BNY Mellon’s leadership in the financial industry played a critical role in its exemption from SAB 121. The bank’s exemption allows them to offer custody without the need to fully comply with the same balance sheet liabilities other institutions face under the regulation. This distinction is significant because it shows that major institutions can operate within the crypto space while still gaining regulatory approval for adjusted compliance requirements.
There are several key reasons why the SEC granted this exemption**.
Risk Management
First, the bank’s longstanding reputation and expertise in cryptocurrency custody and asset management likely gave the SEC confidence in its ability to manage the unique risks of holding cryptocurrency.
Compliance Assurances
Second, the bank’s ability to handle institutional custody while adhering to stringent compliance measures suggests that the bank has effectively negotiated a middle ground between innovation and regulatory demands.
Federal Reserve Relationship
BNY Mellon has a close relationship with the Federal Reserve as a key player in traditional finance. This relationship likely helped secure its exemption from SAB 121, allowing it to offer crypto custody services with fewer regulatory burdens.
Future Outlook of the Crypto Industry Under SAB 121
SAB 121 has introduced a level of regulatory oversight that some see as burdensome. Yet, BNY Mellon’s success in securing an exemption shows that the system is flexible for institutions that can demonstrate robust risk management.
The critical takeaway for crypto investors and ZenLedger users is that regulation continues to evolve, especially in the US. Staying informed is essential.
For those navigating these changes, tools like ZenLedger can help you manage your crypto tax obligations effectively, no matter how the regulatory landscape evolves. Get started today!
This material has been prepared for informational purposes only and should not be interpreted as professional advice. Please seek independent legal, financial, tax, or other advice specific to your particular situation.
