In September 2024, the digital asset custody landscape entered a new era with the settlement of Galois Capital, a now-defunct crypto hedge fund, with the Securities and Exchange Commission (SEC) for $225,000 over “custody failures” related to safeguarding clients’ crypto assets. While the monetary amount of the settlement may seem relatively small, the implications for the Registered Investment Advisor (RIA) community, the digital asset industry, and custodians are significant.
The case involving Galois Capital represents a pivotal moment in how digital asset custody is and will be regulated, signaling the SEC’s intention to bring crypto custody further under federal jurisdiction. The SEC’s release on Galois Capital outlined that the hedge fund had failed to ensure that crypto assets were held with a qualified custodian, thereby violating the Investment Advisers Act’s Custody Rule. Galois Capital had improperly custodied assets at FTX, a platform that held a South Dakota state trust license but was deemed “not a qualified custodian” by the SEC. This lack of proper custody practices led to customers losing access to their funds when FTX collapsed, as client assets had been commingled with the platform’s assets.
The SEC’s Custody Rule has traditionally aimed to protect investors’ funds by requiring RIAs to custody funds and assets with a custodian that maintains segregation between client and firm assets. While this rule had historically applied primarily to traditional financial assets, the rise of digital assets prompted the SEC to emphasize its oversight over this new domain. In 2023, the SEC proposed formal amendments to the Custody Rule to explicitly cover digital assets. Although these changes have not yet been finalized, the Galois Capital case demonstrates that the SEC is already holding firms accountable for not custodying crypto assets through a qualified custodian, highlighting the importance of compliance with regulatory standards.
Qualified custodians play a crucial role in the digital asset space, raising questions about what constitutes a “qualified custodian” in this evolving landscape. According to the SEC’s Proposed Safeguarding Rule, a qualified custodian is generally a federal or state-chartered bank or savings association, certain trust companies, a registered broker-dealer, a registered futures commission merchant, or certain foreign financial institutions (FFIs). However, many non-depository trust companies claim to be “qualified custodians” without specifying whether this claim is under state law or the Investment Advisers Act of 1940/SEC Custody Rule. The lack of clear distinction regarding licenses that grant “qualified custodian” status under state or federal law places the burden of due diligence on RIAs to ensure compliance with custody standards.
The case of Prime Trust, a Nevada-chartered trust company that declared bankruptcy in 2023 after using customer funds to cover losses, serves as a cautionary tale about the risks associated with non-qualified custodians. Similarly, the scrutiny faced by FTX’s South Dakota state trust license following the loss of clients’ funds highlights the importance of selecting custodians that meet regulatory requirements. Ultimately, the strength of a custodial license is only as robust as the regulators’ ability to oversee custodian actions, underscoring the need for RIAs to conduct thorough due diligence when choosing custodial partners.
For RIAs managing digital assets, the Galois Capital settlement offers several key takeaways:
Review Custody Arrangements: Given the evolving custody standards, it is essential to review existing relationships to ensure compliance with regulatory requirements.
Evaluate Custodial Partners: Seek out custodians that adhere to the highest regulatory standards to mitigate risks associated with non-compliance.
Assess Self-Custody Risks: As federal oversight increases, self-custodying assets may introduce additional risks, prompting a reassessment of custody practices.
As the SEC clarifies its expectations regarding digital asset custody, RIAs that proactively adopt best practices in custody can differentiate their offerings to clients while reducing the risk of enforcement actions. The evolving regulatory landscape underscores the importance of staying informed and compliant with custody standards to navigate the digital asset industry effectively.
