Tainted History of Coinbase Custody Partner

Coinbase, one of the largest cryptocurrency exchanges, stated earlier this week that it has signed up 10 customers for the recently started custodial service primarily focused on institutional clients and family offices.

However, there are reports that one of its partners does not command a high reputation when it comes to safeguarding clients’ funds. The partner being discussed here is Electronic Transaction Clearing.

Coinbase is seeking regulatory approval to function as a broker-dealer. The company has reached this level, mainly through inorganic growth. Even the custodial service was launched through the acquisition route and not through formal approval from the US SEC. Coinbase acquired ETC, a broker-dealer operating as an institutional level custodian, and established a similar service for cryptocurrencies.

While launching the custodial service, Coinbase said

“Coinbase Custody leverages the expertise and systems of our partner Electronic Transaction Clearing (ETC). ETC is an SEC-registered broker-dealer and FINRA member subject to regulated financial reporting and independent audits.”

However, ETC was subject to an SEC enforcement action recently. This information was dug out by New York Times reporter Nathaniel Popper.

In March, the SEC charged ETC with “repeatedly putting clients’ assets at risk.” This was four months after Coinbase announced the launch of an institutional custody product and less than four months before the actual launch of the product.

At that time, the SEC had blamed ETC of

“illegally placing more than $25 million of customers’ securities at risk in order to fund its own operations.”

SEC has quoted a few instances of mismanagement of clients’ assets. For example, in one instance, ETC used $8 million of clients’ deposits to solve its margin issues. In another instance, ETC used clients’ funds to the tune of $17 million as collateral for a loan. According to SEC, ETC had mismanaged clients’ funds several times in 2015.

The mismanagement did not affect clients’ funds in any manner. Nevertheless, the breach of trust is a violation of a provision in the Customer Protection Rule that necessitates custodians to have total control of customer assets. ETC neither acknowledged nor denied the inefficiencies in its system, but agreed to pay a penalty of $80,000.

However, such enforcement actions are not unique in the financial markets. Even JPMorgan, Goldman Sachs and Wells Fargo have paid millions of dollars as fine for breaching rules.