The industry was in shock when the SEC’s complaint against Coinbase classified several large-cap tokens as securities. However, the same complaint contained an argument that may prove to be far more impactful. The SEC argued that Coinbase was responsible for facilitating secondary market transactions through the Coinbase Wallet. This argument may be pivotal for the future of crypto since it lays the foundation for a custodial liability of non-custodial wallet providers.
A NEW APPROACH TO LIABILITY
The SEC’s argument is novel and probably considered absurd by most industry experts. Extending this line of reasoning to the custodian duties of a ‘non-custodial’ product may be challenging for some to grasp. However, when you consider the argument in more detail, it established a new way of thinking about liability and, thus inherently, a duty. In other words, by providing a product that is designed to undertake specific actions, the provider of that product is wholly or partially responsible for those actions. Thus that provider has the duty to take appropriate measures dictated by law.
When you consider that a non-custodial wallet is designed to be intrinsic to the control of crypto assets and thus designed to be intrinsic to the exercise of proprietary rights of crypto assets, the SEC’s reasoning establishes a certain custodian relationship between the provider and the user. The provider provides a product that is purposefully designed to control i.e. own crypto assets. Without the wallet, the user would not be able to perform the action of control over the assets allocated to the wallet’s public key and thus not be able to “own” those crypto assets.
However, the SEC in the same complaint states that Coinbase Wallet does not hold crypto assets in custody. At first glance, this argument makes sense and contradicts the above. Due to the lack of control after the wallet is accepted by the user, the provider cannot perform the functions of safekeeping, monitoring or representation in the “TradFi-custody” sense. A non-custodial wallet in its basic form is in fact not much more than a data vassal that allows you and only you to control your crypto assets. Even more so, the simple fact that importing your seed phrase into another wallet, provided by another provider, creating a situation where separate wallets control the same assets, renders the notion of custodian duties of a provider rather farfetched.
EVOLVING NON-CUSTODIAL WALLETS
That being said, non-custodial wallets are not as basic as they used to be. They are becoming one-stop-shop financial applications. For example, smart contract wallets that provide features that allow the users to recover control. A legal expert might look at this situation and define such a wallet as ‘a product designed to own crypto assets that includes a mechanism allowing the users to regain ownership of their assets but only via the mechanism provided by this entity and/or with the assistance of that entity. I.e. by supplementing the autonomous seed phrase recovery with a more advanced method, increasing dependency on the provider, the non-custodial wallet has become closer to its custodial cousin.
If we continue down this path, an MPC wallet does not allow the user alone to sign a transaction. The wallet provider has designed a mechanism that requires multiple (computational) to partake in signing transactions. Upon reviewing the information accompanying these wallets, it’s easy to overlook statements in the realm of ‘even if our systems go down, our backup systems allow you to continue to sign transactions’. However, considering such a statement from a legal standpoint, it becomes akin to the mandatory insolvency protection of TradFi-custody, where the custodian has to implement a system guaranteeing that the owners can collect their investment when the custodian goes under. Equally so, having to rely on the wallet provider to be able to transact (i.e. exercise one’s proprietary rights) is akin to the notion of representation. Again, a pillar of TradFi custody.
Coming back to the SEC’s argument, providing the tool extends the responsibilities and duties of the provider of that tool up to the extent to which the tool is (meant to be) used. When you consider this in light of the advancements made to non-custodial wallets you can argue that the further the wallet provider enhances the wallet with safekeeping-, monitoring- and representational-like features, the more custodial it becomes (and the more likely it will become subject to rules and regulations that are/will be applicable to custodial wallet providers).
A NEED FOR REGULATION
Currently, this argument is not supported by regulators. Even the SEC, laying the groundwork for this novel way of viewing non-custodial wallets, argues the opposite. Equally so, the EU’s MiCA regulation exempts non-custodial wallets from its scope. This raises two key questions. Firstly, will this change? Secondly, should we want this to change? The answer to the first question is that time will tell. The answer to the second question is that we might.
The crypto industry is often vocal in its wish to remain unregulated. However, regulations are often necessary to combat nefarious extremities (Celcius, Terra/Luna, FTX, etc.). Also, it’s fair to say that non-custodial wallets are pivotal to the industry, especially since the bankruptcies of the Crypto Winter. Combine this with the development of advanced, custody-type features, and would it be such a bad idea to subject non-custodial wallet providers to regulation? Aren’t we more and more reliant on those products to keep our assets safe? Implementing a fair and balanced regulatory regime with clear security standards and practices might not be a bad development and, perhaps, will lead to trust where there currently is non.
To conclude, it’s fair to say that non-custodial wallets are evolving rapidly. Non-custodial wallet providers have started to promise recovery, security and insolvency-resistant backups and thus should make sure that the promises they make are kept. As of now the self-regulating mechanism of the crypto industry is what’s keeping the providers in check. Considering all this, which wallet provider would dare to take the next step by embracing the duties of a true custodian whilst maintaining the freedom and security of self-custody? Would you not prefer to secure your crypto with their wallets?