By Jonathan Weil

An odd thing happened when Coinbase reported its quarterly financial results last week. The bulk of its assets and liabilities abruptly disappeared.

The cryptocurrency exchange had shown $291 billion of assets as of Sept. 30. At year-end, they were $23 billion. Total liabilities, once $282 billion a few months earlier, dropped to $12 billion.

There wasn't any great change economically. Rather, the company started using a different accounting treatment for the digital tokens it holds on behalf of customers. Now they are off Coinbase's balance sheet. They used to be on.

The shift highlights a lingering issue: Who ultimately owns those digital assets? The off-balance-sheet treatment suggests the customers do, rather than Coinbase. But Coinbase in its latest disclosures to investors still says the issue isn't clearly resolved. If Coinbase went bankrupt, the bitcoins and other tokens held on behalf of customers could be considered the property of the bankruptcy estate, and such customers could be treated as unsecured creditors.

Coinbase in its annual report said that it doesn't believe that would happen and that it has structured its customer agreements with an eye toward preventing such an outcome. But it also cautioned that, "due to the novelty of crypto assets, courts have not yet considered this type of treatment for custodied crypto assets."

The company's old balance-sheet treatment adhered to an interpretation of the accounting rules that the Securities and Exchange Commission published in 2022. In that document, called Staff Accounting Bulletin No. 121, the agency's staff cited risks and uncertainties unique to crypto assets that don't exist when custodians safeguard traditional financial assets such as stocks and bonds.

Consider, for instance, a large custody bank such as Northern Trust. It has $156 billion of total assets on its balance sheet. But it also has many trillions of dollars of "assets under custody." Those aren't on its balance sheet because the assets without question belong to clients, not to Northern Trust.

With crypto assets, the delineation isn't necessarily so clear. The SEC's 2022 accounting bulletin cited a dearth of legal precedent for how the customers of cryptocurrency platforms would be treated in bankruptcy. Providing custodial services for crypto assets involves maintaining the cryptographic keys needed to access them. In that respect, crypto assets have similarities to bearer shares, where whoever possesses them essentially owns them.

After some crypto trading platforms failed in 2022 and 2023, bankruptcy judges indeed ruled that many of the customers were unsecured creditors and that the crypto assets being stored belonged to the companies' bankruptcy estates. Among the crypto platforms where customers lost money in bankruptcy proceedings were BlockFi, Celsius Network, Genesis Global Capital and Voyager Digital Holdings.

Nevertheless, the SEC in January rescinded the prior accounting bulletin, after its change in leadership following the presidential election. That gave Coinbase license to stop abiding by the prior bulletin and to shrink its balance sheet. SAB 121 had been a political hot potato from the start. Last year, both houses of Congress passed a joint resolution to rescind the bulletin, but then-President Joe Biden vetoed it.

The SEC's rescission of SAB 121 drew applause from the crypto industry and its enthusiasts. The policy change in their eyes removed an obstacle blocking more widespread acceptance of bitcoin and other cryptocurrencies.

Before the change, few mainstream banks showed interest in providing custodial services for crypto assets. In part that is because banking regulators determine banks' capital requirements as a percentage of assets. The more assets a bank has on its balance sheet, the more capital it is required to have as a financial cushion to absorb future losses. That made custodial services for crypto a nonstarter for all but a handful of banks, so long as the old accounting bulletin was in effect.

Coinbase's cautionary wording about what might happen in a bankruptcy has been part of its risk-factor disclosures to investors since 2022. Its balance sheet used to have a line item called "safeguarding customer crypto liabilities" and another called "safeguarding customer crypto assets." Each was $273 billion as of Sept. 30. Now those line items are gone.

While the balance-sheet treatment has changed, the cautionary wording by Coinbase remains. That shows the question of who ultimately owns the digital tokens is still a live one, even if the accounting doesn't reflect that anymore.

On the other hand, the accounting change may make it feasible for more mainstream companies to provide custodial services for crypto, which could ultimately work against Coinbase commercially. The rescission of SAB 121 could attract more competition from banks and broker-dealers, although they would need approval from other regulators. Some already have a head-start. Bank of New York Mellon was among the financial institutions that received exemptions from SAB 121 last year, after the SEC determined their services for safeguarding crypto assets would provide the same protection as their custodial services for other assets.

Yet there is also reason for would-be competitors to stay away from the business. If the SEC's accounting interpretations can change on a dime because the incumbent party lost the White House, they can change back, too. For banks, that in turn could raise the prospect of a sudden rise in capital requirements if assets got placed back on the balance sheet.

Politics have driven much of the instability in the crypto world's accounting rules. That shows no signs of changing.

Write to Jonathan Weil at jonathan.weil@wsj.com

(END) Dow Jones Newswires

February 19, 2025 05:30 ET (10:30 GMT)

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