The Biden administration’s digital asset custody rules are raising the cost of capital

The Biden administration is cracking down on digital asset exposure throughout the financial markets. Federal financial regulators are targeting trillions of assets under custody, which could harm returns for retirement funds, increase compliance costs and require banks to sit on capital instead of allocating it to individuals and businesses.  

The Securities and Exchange Commission (SEC) published Staff Accounting Bulletin No. 121 (SAB 121), which requires banks and non-banks that perform custodial services to place digital assets on their balance sheets. The conventional method of accounting keeps custodied assets off a financial institution’s balance sheet. Now, custodians would have to hold a commensurate asset on-balance sheet “at initial recognition” and “at the same time,” the digital asset is custodied. According to a letter written by Sen. Cynthia Lummis (R-Wyo.) and Rep. Patrick McHenry (R-N.C.) this “would trigger a massive capital charge” for credit unions, banks and “other financial institutions.” 

This new accounting method, coupled with existing Basel III requirements as prescribed by the Basel Committee on Banking Supervision (BCBS) could impede banks from being able to service assets under custody. The SEC considers custodied digital assets on-balance sheet, which would lower banks’ leverage ratios and force them to increase retained earnings instead of lending out capital for credit cards, mortgages, student loans and automobile loans. 

The Federal Reserve Bank of New York admits that Basel-dictated requirements to hold onto certain amounts of capital, such as the leverage ratio, “makes a large balance sheet costly for banks.” The SEC’s on-balance sheet requirement for custodied digital assets will increase costs for banks and likely result in increased costs for consumers. 

This capital crunch would not just apply to large banks, but also to small community banks and de novo banks complying with their own leverage ratios. Rural communities that rely on these banks could see more capital collecting dust than being put to work. Restricting this capital at the same time the Federal Reserve is continuing to increase interest rates would only exacerbate the eventual reduction in consumer spending and potential recessionary period.  

An imminent rulemaking from the Federal Reserve, Office of the Comptroller of the Currency, and the Federal Deposit Insurance Corporation implementing final Basel III standards could deter banks from offering services for clients’ digital assets. The capital surcharge for global systemically important banks, which is based on BCBS metrics that have no legal authority in the U.S. and have never been vetted through Congress, will likely increase for banks serving as digital asset custodians because of potential operational risk, or the legal or cybersecurity risk that could jeopardize custodied assets. This will limit the amount of capital that banks will be able to loan.

The Federal Reserve’s vice chair for supervision, Michael Barr, recently spoke about the “legal uncertainty about custody practices” while acting comptroller Michael Hsu reiterated his determination to “implementing enhanced regulatory capital requirements that align with the final set of Basel III standards.” The writing is on the wall, custody services for digital assets will penalize banks. This is an egregious example of regulators picking and choosing what services banks can provide.  

Adding insult to injury, the SEC is restructuring the market for all custodied assets. The agency’s proposed custody rule is clear government intervention in contracts between registered investment advisers (RIAs), banks, broker-dealers and individual investors. The SEC admits that the enhanced scope of “assets subject to the proposed rule could create costs for those advisers (and their clients) with custody of crypto assets.” The significant compliance costs in the rule, such as additional written assurances and stricter legal liability for negligence, could push custodians out of the market, reduce competition and make it incredibly more expensive for RIAs to find a qualified custodian to safeguard pension fund assets owned by state employees.  

SAB 121 and the proposed custody rule are clear examples of the SEC unilaterally expanding its authority to start regulating beyond its remit.  

Congress needs to take the reins and ensure that America’s financial regulators draft rules that promote the usage of custody services without imposing unnecessary compliance costs on financial institutions and the owners of custodied assets, which in many cases are retirees. 

The SEC should also scrap SAB 121 and crack down on excessive capital requirements that are unjustified based on the lack of evidence that a market failure currently exists, and additional protections are needed.      

Bryan Bashur is a federal affairs manager at Americans for Tax Reform and executive director of the Shareholder Advocacy Forum.