This news service recently spoke to a US-based digital custody business serving wealth managers and asset managers, L1, about how the approach to custody needs to change to bridge a gap between modern and traditional forms of finance.

The US regulatory climate as it affects cryptocurrencies is in flux, and wealth advisors interested in the space need to find a way to bridge traditional methods of handling finance in the new digital world.

In 2023, the Securities and Exchange Commission updated custody rules, which meant that advisors dealing with cryptos who wanted to have custody, had to deal with qualified custodians (QCs). Self-custody is not subjected to SEC rules on custody.

In practice, the US regulatory approach means that “most people in crypto are left outside [the regulatory umbrella],” according to Miguel Kudry, founder of L1, a digital custody business serving wealth and asset management firms. “If you want to access certain assets, such as most tokens and especially DeFi [decentralized finance] protocols, you cannot do that from QCs.”

A problem with this is that advisors who contemplate this crypto area are understandably afraid of it, Kudry said. 

At present, QCs put a structure around a client’s assets, which limits clients’ ability to use them in certain ways. Institutions’ rules of procedure may require them to use a QC. A qualified custodian offers legal recourse if there is a dispute.

Hybrid
Kudry says a hybrid model – mixing the qualified custodian approach and self-custody approach – makes sense. 

With a QC, a client could add co-signatories, for example, as a security in the event of fiduciary issues. “You could bring you own SC wallet to an RIA and give them power, but they don’t have custody access,” Kudry said. 

The potential for the market is large as more asset classes are tokenized, he continued. 

Registered investment advisors that have less than $5 billion in AuM are the fastest-growing slice of the advisory market, and they are battling to win digital-native investors who crave access to alternatives, Kudry said. 

Opening firms to operate “on-chain” will “let these firms offer every asset class from the same wallet,” he said.

There is great potential for wealth managers to become more involved in the digital asset ecosystem.

“When every asset lives in a single wallet, that wallet becomes a bank, a brokerage, and a payment rail. That removes a ton of complexity from the current system,” Kudry said. “Suddenly, the lines between payments and investment portfolios are blurred; real-time tax swaps that once required a family office retainer are now available to anyone; an endowment-style model portfolio that is custom-tailored to every single client can be managed by a single person. Tokens turn a static brokerage account into a programmable portfolio, opening possibilities we have barely started to price in,” he said.

There are changes afoot under the Trump administration.

“The regulator has signaled that it is okay to do crypto,” Kudry said.

In April, under acting chair Mark Uyeda, the SEC compared current crypto regulation to the historic founding of securities trading, signaling a dramatic shift from the more restrictive approach applied by former SEC chair Gary Gensler. At an industry roundtable attended by representatives from Coinbase, Uniswap and others, the SEC discussed a time-limited framework allowing US crypto firms to innovate while developing long-term solutions. 

There are now “roundtable” conversations taking place between exchanges, advisors, and the SEC discussing these issues, Kudry said. 

Cryptos in retirement plans?
Regulatory changes continue. Yesterday, the US Department of Labor’s Employee Benefits Security Administration said it had rescinded a 2022 compliance release that previously discouraged fiduciaries from including cryptocurrency options in 401(k) retirement plans.

“The Biden administration’s department of labor made a choice to put their thumb on the scale,” US Secretary of Labor Lori Chavez-DeRemer, said. “We’re rolling back this overreach and making it clear that investment decisions should be made by fiduciaries, not DC bureaucrats.” The department said its move means that it is taking a “neutral stance.”  

The DoL comments have already stirred controversy. Knut Rostad, of the Institute for the Fiduciary Standard, described the DoL statement as “plain awful.”