Why did the SEC relax restrictions on SAB 121?

Author: Alex Thorn, Source: Twitter @intangiblecoins; Compiled by: Baishui, Golden Finance

On Monday, September 9, Paul Munter, Chief Accountant of the U.S. Securities and Exchange Commission (SEC), delivered a speech in which he revealed that the Commission did not object to the bank's assessment that the SAB 121 balance sheet accounting requirements did not apply to the bank.In the speech, Munter described the situation of bank holding companies and private transactions that established a fact pattern that, in the SEC's view, did not require SAB 121 accounting treatment for the bank. In short, this could pave the way for some banks to enter the crypto asset custody market.

Background

The U.S. Securities and Exchange Commission proposed Staff Accounting Bulletin 121 ("SAB 121") in 2022. Under SAB 121, public companies must account for digital assets held on behalf of customers on their corporate balance sheets. This could leave the firms’ custodial clients as unsecured creditors if the custodian goes bankrupt. Because many banks are public companies, and because separate bank capital rules require banks to hold cash on their balance sheets at a 1:1 ratio to crypto assets, the effect of SAB 121 is to prevent any bank from custodial crypto assets on behalf of depositors.

In May 2024, both houses of Congress passed a bill making SAB 121 a formal rule, claiming that the SEC violated the Administrative Procedure Act by issuing it without a formal rulemaking process (e.g., providing a comment period, publishing in the Federal Register, etc.). 21 House Democrats joined Republicans in passing the bill, which would effectively overturn SAB 121, despite a threatened White House veto, and 11 Democrats and 1 independent joined Senate Republicans in passing the bill. President Biden vetoed the bill on May 31, arguing that overturning SAB 121 “would inappropriately limit the SEC’s ability to develop appropriate guardrails and future issues” and “risks undermining the SEC’s broader authority over accounting practices.” Biden went on to say his “administration will not support measures that jeopardize the welfare of consumers and investors.”

What Happened

In his remarks on Monday, Munter insisted that “the staff’s view on SAB 121 remains unchanged,” but he nevertheless outlined two different fact patterns that, if applicable to a company, would not require SAB 121 to apply.

First, bank holding companies have a path to SAB 121 relief if they: 1) obtain “written approval from a state-level prudential regulator”; 2) customer crypto assets will be held in a bankruptcy-remote manner and that isolation is confirmed by a legal opinion; 3) the bank negotiates clear prudential standards in its contracts with institutional depositors; and 4) regulatory, legal, and technical risks are continually mitigated and assessed.

Second, introducing brokers also have a path to SAB 121 relief if they: 1) they do not hold the encryption keys to customer assets; 2) the third party is the customer’s agent, not the introducing broker; and 3) the introducing broker obtains a legal opinion supporting its position with respect to crypto asset activities.

Analysis

In short, this appears to be good news. Banks that wish to custody crypto assets and clearly meet the described fact pattern have a clear path to avoid SAB 121 accounting. There are countless types of institutional investors who would like access to the highest form of qualified custody – bank custody. If the world’s most trusted custodian bank could custody crypto assets – let alone tokenized assets – this could ease a huge barrier to adoption that has been in place for years.

But there was something odd about this speech. The private guidance and subsequent speech outlining the fact pattern for achieving relief effectively carves out a large portion of potential SAB 121 reporting companies. In fact, if banks don’t need to do this, that would only leave Coinbase and a few publicly traded fintech companies. There is perhaps some nuance, though – the fact pattern specifically mentions that banks “received written approval from a state-level prudential regulator.” So, according to this speech, a nationally chartered bank (i.e., one regulated by the OCC) may not meet the fact pattern and therefore need to go to the SEC and make their case. Given the current attitude of national bank regulators toward cryptocurrencies, it may be difficult to get written approval from the OCC given the agency’s current hostility toward digital assets. If national banks want to get in on the action, they may need to spend more time and money convincing the SEC that they, too, deserve relief. (This process reminded us of SEC Commissioner Hester Peirce’s eloquent speech about “The Secret Garden.”) However, there are still some very large state-chartered custodial banks. The two largest custodial banks in the world are state trusts (Bank of New York Mellon in New York and State Street in Massachusetts).

The speech also repeatedly and specifically mentioned that bank holding companies would hold customer assets in a bankruptcy-remote manner, which was very important to the SEC staff’s analysis, allowing banks to avoid SAB 121 accounting. But the impact of the accounting rules on those who do apply may actually have the opposite effect. Coinbase itself disclosed after SAB 121 was issued in May 2022 that “customers may be treated as our general unsecured creditors.” So on the one hand, in order to avoid SAB 121 accounting, this unknown bank assured the SEC that the crypto assets it would hold for its customers would be bankruptcy-remote, but on the other hand, a public company like Coinbase explicitly warned that SAB 121 could mean that their customers’ crypto assets were bankruptcy-remote. This is really confusing.

Why can’t the SEC simply amend or revoke SAB 121? Why can’t the SEC take formal action through the normal process on a rule that both houses of Congress agree violates the Administrative Procedure Act? In a way, the SEC has painted itself into a corner on this issue — the Commission denies that SAB 121 is in fact a formal rule (even though both houses of Congress disagree), but they can’t provide formal relief (e.g., via a no-action letter) if it isn’t a formal rule. They can’t provide clarification through the formal rulemaking process because they’ve been so intransigent over the past two years that they needed a presidential veto to save them after being ostracized by both parties in Congress. Given this conundrum, it seems like the best the SEC can offer is guidance that removes entities from applicability. The crypto industry has been loudly calling for the SEC to develop formal rules and guidance, but apparently everyone is limited to behind-the-scenes conversations with staff, allowing the rules to be watered down in secret.

The SEC’s chief accountant said “staff’s views on SAB 121 haven’t changed,” but he just announced a loophole that will allow a slew of companies to which the act applies to ignore it. The convoluted nature of this logic makes it hard to believe that politics aren’t at the heart of this issue. To be honest, the SEC never seemed to think banks would want to get involved in crypto, originally intended this rule to apply only to crypto-native companies (perhaps punitively), and now they’ve figured out a way to let traditional banks off the hook that saves face without changing their tune for the past two years.