(Bloomberg) -- Traditional financial firms and the crypto custodians they’ve backed may be best-positioned to cash in on proposed changes to US regulation for safeguarding digital assets, thanks to an existing portfolio of licenses and a trusted reputation in handling client funds. 

But first, it’ll take some grit.

Digital asset custodians that are either wholly owned or backed by Wall Street names, like PolySign Inc.’s Standard Custody & Trust, Copper Technologies Ltd. and Zodia Custody Ltd., are among the firms that are seeing an uptick in interest from traditional financial clients for their services, according to interviews with more than half a dozen executives. Meanwhile large institutions including Bank of New York Mellon Corp. and Nasdaq Inc. are continuing to build out their own digital asset custody offerings as they assess how the proposed rule changes could affect their plans, according to spokespeople at the companies. 

“The bigger banks are the logical participants who would potentially benefit from [rule changes], in that they now have a roadmap to what they would need to do to support institutions who want to invest in crypto,” said Jack McDonald, CEO of Standard Custody, whose parent company counts Brevan Howard Asset Management, Soros Fund Management and Cowen Digital among its investors. 

The US Securities and Exchange Commission laid out a series of possible changes to rules on custody on Feb. 15, expanding its framework to explicitly cover a range of assets including digital tokens. The 434-page document proposed asking qualified custodians to give assurances that client assets are properly segregated and protected from insolvency, in addition to carrying out annual independent audits and turning over records upon request. The rules are set to be finalized in the coming months after a short period of consultation. 

• Read: Crypto Platforms’ Ties to Hedge Funds Under Fire in SEC Rule (1)

The proposal follows a year of tumult in crypto markets that saw several major firms file for bankruptcy in the US, including failed exchange FTX and lenders Celsius, Voyager Digital and BlockFi, leaving billions of dollars of client funds locked in legal proceedings. The collapses laid bare the weaknesses in the current structure of the crypto industry, where exchanges often carry out functions that in traditional finance are distributed among various independent entities — including custody and lending. Some of the bankrupt firms also allegedly maintained lax practices around segregation of customer funds.

These safeguards are now common on Wall Street after the SEC last adapted its custody rules in 2009 following the global financial crisis, which saw several major banks fail. The regulator was also grappling with scandals such as the Bernie Madoff Ponzi scheme at the time, which was enabled in part by weak independent controls. 

Slow-Moving Progress

Established financial institutions have been dipping their toes into digital assets since at least 2017, the year of the first Bitcoin bubble. Fidelity Investments was an early entrant, launching custody support for Bitcoin through its digital asset division a year later. Since then it has debuted exchange-traded products focused on the metaverse and Bitcoin 401(k)s, and significantly stepped up hiring for its crypto unit last year while industry natives laid off staff.

• Read: Wall Street Giants Spy Opportunities Rising From FTX Ashes

Still, progress has been slow. Offerings largely focus on Bitcoin, in part because banks are heavily regulated, large and complex organizations — traits that are not usually conducive to speedy innovation. BNY Mellon only launched its digital asset platform to custody Bitcoin and Ether in October last year, while Nasdaq’s remains under development. 

This is why some have resorted to backing or partnering with independent crypto custodians, executives said. While many digitally native firms already offer custodial services, the reputational benefit of being wholly owned by Standard Chartered and Northern Trust, has given an edge to Zodia, its CEO Julian Sawyer said.

Japanese bank Nomura formed a joint venture with technology firm Ledger and digital asset manager CoinShares in 2018 to launch crypto custodian Komainu. Meanwhile, London-based Zodia Custody announced earlier this month that it had signed a partnership with the digital asset arm of Japanese financial services firm SBI Holdings Inc — a move that expanded Zodia’s cryptoasset custody reach to Asia, one of Standard Chartered’s biggest markets.

Banks find building their own solutions “fundamentally difficult,” said Zodia’s Sawyer, because crypto represents something they’re not used to: a 24-hour, seven-days-a-week global market with no off-switch. “We are competing against the Wall Street players or whoever in our respective markets, but with that DNA of being bank-backed,” said Sawyer, adding that while Zodia does not currently operate in the US, it’s on the agenda for the longer term. 

London-based Copper, which is helping State Street Corp. build its digital asset custody business and is said to have received investment from Barclays Plc last year, expects to benefit from the rule changes as it believes more large firms will look for technology partners to set up custody offerings. Chief Operating Officer Sabrina Wilson said most big financial firms involved in crypto today have only made it there “through partnerships, not on their own merit.” 

In time, she expects a market structure may emerge where trading is entirely separate from custody — a factor which is “critical” for a traditional finance playbook. Such a landscape would make “the value proposition of an integrated exchange much more complicated going forward,” she added.

Copper’s own journey has not been without bumps. The firm has been raising its current series C funding round since late 2021, delayed by roiling crypto prices and market instability. It also experienced a security incident in December, though Copper said no client information was compromised.

Crypto Native

To be sure, established crypto trading platforms like Coinbase and Gemini have entities that are already licensed as qualified custodians in the US, and both firms have said they expect to remain compliant if the SEC’s changes are enacted. The existing foothold they have on the market, as well as their ability to safeguard a wide range of tokens, may make it hard for traditional financial firms to catch up.

Banks also have to contend with increasingly wary regulators, who are keen to prevent contagion from crypto markets spreading to traditional institutions. The Federal Reserve and other US banking watchdogs warned financial firms in January about the hazards associated with delving into crypto, now viewed as a precursor to the SEC’s proposal.

• Read: US Crackdown Seeks to Push Crypto Back to Fringe of Finance (1)

There are some crypto firms already ahead of the curve. Anchorage Digital, a US crypto custodian which also has a bank charter, could forge its own approach to victory because it can easily straddle the same divide as those that are bank-backed, said Simon Taylor, head of strategy at crypto startup Sardine.

But some see the changes as bad for innovation overall, if smaller firms cannot compete under blanket rules that aren’t specifically tailored to the unique nature of crypto. “If the SEC changed the rules so only qualified custodians can hold crypto for others, then it sets up a new gatekeeping system where the only custody solution is regulated banks,” said Maya Zehavi, a cryptocurrency angel investor. 

--With assistance from Yueqi Yang and Olga Kharif.

©2023 Bloomberg L.P.