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Biden administration wants cryptocurrency exchanges to keep customer and corporate money separate

Updated: Sep 26, 2022

According to a source familiar with the plan, US President Joe Biden's administration will lobby Congress to require cryptocurrency exchanges to keep their customers' money separate from their own corporate funds. This could limit how the industry operates.

Following Coinbase's (COIN) recent disclosure that customers' money would be frozen if the company went bankrupt, federal officials plan to press lawmakers to fix the problem by requiring crypto firms to keep customer assets walled off in the future legal framework. This type of custody rule is common for financial firms like futures exchanges, but crypto exchanges routinely mix their funds with their customers' holdings in the same pot, a situation the administration wants to change through legislation. Funds are frequently mixed in the securities industry, but the investments are also more heavily regulated.

The change will be pushed into any crypto bill considered by Congress in the coming weeks, according to the source, building on a contention made last year in the President's Working Group on Financial Markets report on stablecoins: Companies that host cryptocurrency wallets must be closely regulated by the federal government. The administration believes that trading platforms should continue to allow customers' assets to be pooled, allowing companies to manage trades internally rather than putting each transaction on a blockchain.

In a filing to the Securities and Exchange Commission last week, Coinbase, a publicly traded company and one of the industry's largest exchanges, admitted that "in the event of a bankruptcy, the crypto assets we hold in custody on behalf of our customers could be subject to bankruptcy proceedings and such customers could be treated as our general unsecured creditors." When a company fails, that is the lowest rung of people paid back, implying that a mistake by Coinbase could lock up clients' tokens indefinitely – or funnel them away to pay other creditors.

"Don't think you actually own your tokens when you go into a digital wallet," Securities and Exchange Commission (SEC) Chair Gary Gensler said this week at a conference, highlighting some of the federal government's concerns about investor asset custody. "If the platform goes down, guess what, you just have a counterparty relationship with the platform. Get in line in bankruptcy courts. "

According to Gensler, when a company takes a customer's tokens, it can use them however it wants. He claims that the exchanges "often trade against you." Customers lost billions of dollars in Luna's algorithmic stablecoin, terraUSD (UST), so his investor-protection advocacy may gain traction.

In a research note released this week, Jaret Seiberg, a Washington-based analyst at Cowen Group, Inc., predicted that "Congressional Democrats will follow his lead and escalate their calls for greater oversight.  The troubles with TerraUSD and the drop in crypto valuations will make it politically more challenging for Republicans to effectively oppose Gensler's policy agenda. "

Coinbase, for one, assured its worried customers and investors that the distressing splash of its SEC filing was not meant to signal anything about its prospects, despite a share price drop of more than 80% since last year. The disclosures were made in response to a new SEC requirement, according to Founder and CEO Brian Armstrong, and his company is not in danger of filing for bankruptcy.

For the time being, crypto's leading platforms – including Binance.US, FTX, and Kraken – do not have to strain to meet the administration's demand for a custody rule. A deeply divided and largely immobile Congress is unlikely to pass legislation this year, especially as lawmakers prepare for the bloodbath of the November midterm elections. When the dust settles on the new Congress next year, the most optimistic predictions predict that a crypto bill will gain traction.

However, not everyone believes that enclosing customers' funds is the best solution.

"Instead of focusing on the lack of client asset segregation at digital asset exchanges, which is also true with securities held in ‘street name’ at DTCC," Dave Weisberger, co-founder and CEO of CoinRoutes, Inc., said, "egislators should work on a Digital Asset Investor Protection Act that mirrors the Securities Investor Protection Act." It may grant investors "primary status in bankruptcy proceedings," as well as establish a backstop fund to cover losses similar to the one available to securities investors.

For others, a law prohibiting companies from combining their customers' assets with their own would be the bare minimum for those calling for strict investor protections.

"There is a lot more that has to be done," said Patrick McCarty, a financial consultant and former regulator who teaches cryptocurrency classes at Georgetown Law. He called segregated accounts "a significant step forward" but argued that strict regulations and a deeper overhaul of the business model are required to return to crypto's founding ideas of recording every transaction on an incorruptible public ledger.

"Why would one advocate for a band aid – albeit significant – when it looks like major surgery is needed to protect investors?" McCarty said.


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