As the two-year mark of the SEC’s controversial Staff Accounting Bulletin No. 121 (SAB 121) approaches, it is coming under increasing fire, particularly for its on-balance sheet requirement which effectively precludes U.S. banking organizations from providing digital asset custody services at scale.  Earlier this month, several prominent Banking Associations sent a letter to SEC Chair Gary Gensler urging targeted modifications to SAB 121. Separately, U.S. lawmakers introduced a bipartisan, bicameral Congressional Review Act resolution to overturn SAB 121.  These recent actions underscore the mounting opposition to SAB 121 and its implications for investors, U.S. banking organizations and the digital asset ecosystem. 

Background: The SEC’s “interpretive guidance”

SAB 121, issued by the staff of the Office of the Chief Accountant of the SEC on March 31, 2022, provides “interpretive guidance” for SEC reporting entities that hold crypto-assets in custody on behalf of clients to record that risk on-balance sheet. This represents a significant departure from decades of generally accepted off-balance sheet accounting treatment for custodied assets. 

Why the departure?  According to SAB 121, the safeguarding of crypto-assets involves unique risks and uncertainties not present in arrangements to safeguard non crypto-assets. SAB 121 advises that due to increased technological, legal and regulatory risks associated with safeguarding crypto-assets, and an “increased risk of financial loss,” an entity should record obligations to safeguard crypto-assets for customers as a liability on its balance sheet along with a corresponding asset, measured at the fair value of the related crypto-assets. 

U.S. banking organizations are effectively excluded from offering crypto custody services at scale under this directive, because the knock-on effects in the prudential regulatory framework would give rise to significant capital and liquidity costs, making it prohibitively expensive to provide these services. 

In previous commentary, A SAB state of affairs: SEC guidance deters U.S. financial institutions from providing crypto-asset custody, we noted that despite the use of the words “interpretive guidance,” the language in the bulletin reads as if it is enforceable by including, among other things, provisions for a transition period and dates by which to implement the guidance.  In using the bulletin format, which requires no notice and comment period, the SEC staff appears to have in effect circumvented the rulemaking process. In a Response to SAB 121, SEC Commissioner Hester Peirce raised concerns about the SEC’s choice of a Staff Accounting Bulletin as opposed to a “more deliberate approach to changing rules – one that involves consulting with affected parties.” 

The U.S. Government Accountability Office concludes that SAB 121 is a “rule” under the Congressional Review Act 

Following a congressional request for a decision on whether SAB 121 should be subject to the Congressional Review Act (the “CRA”), the U.S. Government Accountability Office (the “GAO”) issued a Decision on October 31, 2023 (the “GAO Report”) which concluded that SAB 121 is a rule for purposes of the CRA because it meets the Administrative Procedures Act definition of a rule, and no exceptions apply. 

Therefore, the SEC is required to comply with CRA submission procedures. Among other things, CRA requires an agency to report the issuance of a rule to Congress and it provides Congress with special procedures in the form of a joint resolution of disapproval, under which to consider legislation to overturn that rule.  If a CRA joint resolution of disapproval is approved by both houses of Congress and signed by the President, the rule at issue cannot go into effect or continue in effect. 

Bipartisan, bicameral Congressional Review Act joint resolution to overturn SAB 121

On February 1, 2024, citing the GAO Report, U.S. Senator Cynthia Lummis (R-WY), along with Representatives Wiley Nickel (D-NC) and Mike Flood (R-NE), introduced a bipartisan, bicameral Joint Resolution providing for Congressional disapproval of SAB 121. 

According to Senator Lummis, SAB 121 “has massive implications, and the SEC should have received feedback on it from the federal banking regulators and the public before implementing this legally binding directive.”  Representative Flood also highlighted concerns with the SEC issuing SAB 121 “without conferring with prudential regulators despite the accounting standard’s effects on financial institutions’ treatment of custodial assets,” and the SEC’s failure to go through the appropriate notice-and-comment process. Representative Flood stated that “[i]n the face of overreach by a regulator, it is the role of Congress to serve as a check.” 

Banking Associations call on the SEC to modify SAB 121

On February 14, 2024, the Bank Policy Institute, the American Bankers Association, the Financial Services Forum, and the Securities Industry and Financial Markets Association (collectively referred to as the “Associations”), sent a letter to SEC Chair Gary Gensler urging the SEC to make targeted modifications to SAB 121 to address recent policy developments and challenges SAB 121 poses for U.S. banking organizations. 

The targeted modifications requested by the Associations include:               1) exempting banking organizations that are subject to robust oversight by federal banking agencies from on-balance sheet treatment; and 2) narrowing the definition of “crypto-assets” to clarify and confirm the exclusion of certain asset types and use cases. 

The Associations pointed to the recently approved Spot Bitcoin ETPs and the noticeable absence of banking organizations serving as asset custodians, a role that they regularly play for other ETPs.  According to the Associations, “it is practically impossible for banks to serve as custodian for those ETPs at scale due to the Tier 1 capital ratio and other reserve and capital requirements that result from SAB 121.”  The Associations highlighted that this could also result in concentration risk, noting that one nonbank entity now serves as custodian for the majority of these ETPs. 

The Associations also emphasized concerns that the on-balance sheet requirement coupled with SAB 121’s overly broad definition of “crypto-asset,” which makes no distinction between asset types and use cases, has proven to be a barrier to banking organizations’ ability to develop responsible use cases for permissioned distributed ledger technology (“DLT”) projects, including those to record or transfer traditional financial assets using blockchain networks.     

Conclusion: Implications for investors and U.S. banks 

Unless SAB 121 is nullified, or sufficiently modified, it will continue to make it economically infeasible for prudentially regulated institutions like U.S. banks to provide digital asset custodial services at scale while competitor banks overseas continue to actively provide institutional-grade digital assets custody solutions. In its current form, SAB 121 not only puts U.S. banks at a disadvantage, but it also undermines consumer protection and is not in line with the SEC’s fundamental mandate to protect investors. If anything, events in the crypto space over the past two years have underscored the need for more trusted and regulated digital asset custodians to provide enhanced investor protections.