Yesterday, US Senator Cynthia Lummis and Representative Patrick McHenry sent a letter to banking regulators challenging the SEC’s cryptocurrency custody accounting rule. They claim the rule would put customers’ digital assets at greater risk and have directed their concerns to the Federal Reserve, FDIC, OCC and the National Credit Union Administration.

By convention, conventional assets held in custody are treated as belonging to customers and therefore do not appear on the custodian’s balance sheet. In late March 2022, the SEC issued accounting bulletin 121, which said that digital assets should appear as an asset and a liability on the custodian’s balance sheet due to the increased risks they pose, including cyber and regulatory risks.

In yesterday’s letter, lawmakers gave the example of the Celsius bankruptcy, where Earn’s clients were treated as unsecured creditors. They argue that SAB 121 forced assets to be on the balance sheet, creating legal risk. However, the accounting treatment of assets is different from the legal treatment.

There is a strong argument that even if SAB 121 had not existed, Celsius should have followed the asset/liability accounting treatment because it did not hold those assets in custody. Chief US bankruptcy judge Martin Glenn concluded the same when he ruled that the client’s Earn assets belonged to Celsius. Not because of the accounting treatment, but because of the “unambiguous terms of use of Celsius”.

However, the concerns of lawmakers about the accounting rule’s impact on custody and elevated risk are still potentially valid. Conventional banks and custodians are a safer pair of hands because they are more regulated. But this accounting treatment could discourage their participation. That’s a bit of a messy topic.

Banks, Basel and custody of digital assets

Last year, custodial banks were concerned that by including digital assets on the balance sheet, they would have to reserve additional capital, which would make digital asset custody unprofitable. That was even more concerning because it could also apply to tokenized securities. However, the Basel Committee confirmed late last year that, in most cases, it is not necessary to set aside capital for the custody of digital assets.

Most consider that the end of the story.

There is likely a gap between what the SEC tells banks to do with their accounts and how the Basel rules are applied.

However, it may not be so clear.

The Basel Committee would be assuming that the assets in custody are not on the balance sheet. The fact that the SEC requires these assets to be on the US balance sheet potentially muddies the waters. The two lawmakers assume that despite Basel’s green light for custody, it’s still a problem, but it’s not clear.

Another point is that each jurisdiction implements the Basel rules locally. The United States could customize the Basel rules to include rather than exclude custody of digital assets. Now, that would be bad news. And that’s an excellent reason for legislators to ask these questions.

We’ve reached out to a couple of custodial banks and accountants to get their views on the current situation, but didn’t hear back in time for publication.