In a settlement reached earlier this month, the U.S. Securities and Exchange Commission (SEC) imposed a $225,000 fine on Galois Capital, a crypto-focused hedge fund once praised for its market insight and trading strategies. The SEC charged Galois with violating the Investment Advisers Act’s Custody Rule. It failed to ensure that client assets were stored with qualified custodians, a critical lapse in fiduciary responsibility.
According to the SEC’s findings, Galois Capital stored significant portions of its crypto assets with FTX, the now-defunct cryptocurrency exchange that collapsed spectacularly in November 2022. FTX’s implosion led to major losses across the crypto landscape and Galois was no exception. It relied on FTX as a custodian and lost approximately half of its assets under management, reportedly worth around $40 Million.
Custody Rule Violations
The SEC’s charges stem from Galois’s failure to adhere to the Custody Rule. The rule mandates that investment advisers holding client assets must use qualified custodians, such as regulated banks or broker-dealers, to safeguard those assets. FTX, despite being a major player in the crypto space before its collapse, was never a qualified custodian. The SEC contends that by placing client assets with FTX, Galois exposed investors to undue risks, including potential loss or misuse of funds.
This lapse, according to Corey Schuster, Co-Chief of the SEC’s Asset Management Unit, represents a severe breach of investor protection obligations. “By failing to comply with Custody Rule provisions, Galois Capital exposed investors to risks that fund assets, including crypto assets, could be lost, misused, or misappropriated,” Schuster stated.
Misleading Investors and Preferential Treatment
In addition to the custody violations, the SEC accused Galois Capital of misleading investors about its redemption policies. The firm informed some investors that they needed to provide at least five business days’ notice before withdrawing funds but allowed others to redeem assets with shorter notice periods. This uneven application of withdrawal terms raised further concerns about Galois’s transparency and operational integrity.
Reputational Damage and Broader Implications
Before its regulatory troubles, Galois Capital was highly regarded in the crypto investment space. It was known for making contrarian bets such as its early warnings on the collapse of Terra’s UST stablecoin. However, the firm’s internal failures—both in terms of custody practices and misleading communication—have damaged its reputation. The SEC’s fine, though relatively small, highlights the risks that stem from inadequate operational oversight in the crypto fund management space.
This case also illustrates a broader issue in the cryptocurrency industry: the need for clear compliance with investor protection laws. As the SEC continues to scrutinize firms that operate within the emerging crypto sector, the Galois Capital case serves as a cautionary tale for fund managers. The consequences of poor asset management and failure to use qualified custodians are severe, particularly in a market as volatile and rapidly evolving as cryptocurrency.
Lessons for the Crypto Industry
The Galois Capital case sheds light on the importance of adhering to regulatory requirements, especially in the context of digital assets. Many in the crypto world have argued for the need to balance innovation with compliance. This case underscores the challenges firms face in navigating these complexities. The fallout from FTX, coupled with regulatory penalties like those imposed on Galois Capital, signals that crypto fund managers must prioritize operational discipline. Compliance is essential if they are to maintain investor trust and long-term viability.
>>> Read more: Crypto Industry Slams SEC Over FTX Stablecoin Repayment Plan
Galois Capital’s market strategies once made it a prominent player in the crypto investment space. Its failure to uphold core fiduciary responsibilities has cast a shadow over its operations. This settlement, coupled with the ongoing regulatory tightening, marks a crucial moment for the crypto industry, as firms grapple with the need for stronger oversight and risk management.
Readers’ frequently asked questions
What exactly is the Custody Rule that Galois Capital violated, and why is it important?
The Custody Rule is a regulation under the U.S. Investment Advisers Act requiring investment advisers to safeguard client assets with a “qualified custodian.” These custodians must be regulated entities, such as banks or registered broker-dealers, authorized to hold client funds. The rule protects investors from fraud, loss, or misuse of their assets. It ensures that assets are stored in secure, regulated environments. Galois Capital violated this rule. It placed a significant portion of its assets with FTX, though the cryptocurrency exchange was not recognized as a qualified custodian. When FTX collapsed, Galois’s failure to comply with the rule became a major factor in losing approximately half of its assets under management. The Custody Rule is crucial in protecting investor funds, especially in the volatile world of crypto, where regulatory oversight is still developing.
Why was Galois Capital using FTX as a custodian, and what went wrong with FTX?
Galois Capital, like many other crypto firms, used FTX as a platform to trade and store digital assets. After all, FTX was one of the largest cryptocurrency exchanges in the world before its collapse. However, FTX was never a qualified custodian, meaning it wasn’t subject to the same regulatory standards as traditional financial institutions. FTX’s collapse in November 2022 was caused by a liquidity crisis and allegations of fraudulent activities. This led to billions in customer funds being frozen or lost. Galois’s decision to store assets on FTX exposed it to significant risk. When FTX collapsed, Galois lost about half of its assets under management. This illustrates the risks of relying on unregulated or improperly managed platforms for asset custody in the crypto space.
What broader impact does the Galois Capital case have on the cryptocurrency industry?
Crypto-focused investment firms like Galois Capital face growing regulatory scrutiny. This settlement highlights the need for fund managers in the crypto industry to adhere to the same fiduciary and operational standards as traditional financial firms. The SEC’s action against Galois is part of a larger regulatory push. It wants to ensure crypto firms properly manage risks, comply with investor protection rules, and use qualified custodians for client assets. This case, along with the collapse of FTX, underscores the importance of operational transparency, regulatory compliance, and risk management in the crypto space. For fund managers, the lesson is clear: they must adopt stricter oversight and custody practices to avoid similar penalties and protect investor assets. This scrutiny is likely to increase as regulators continue to focus on investor protection in the emerging cryptocurrency sector.
What Is In It For You? Action Items You Might Want to Consider
Evaluate Your Custodians Carefully
If you’re managing or investing in crypto, always ensure that your assets are stored with a qualified custodian. The Galois Capital case demonstrates the risks of entrusting funds to unregulated platforms like FTX. It ultimately collapsed, taking investor assets with it. Before placing your assets anywhere, research the platform’s regulatory status and verify that it meets recognized custodial standards. This will protect you from potential losses due to platform failures or regulatory breaches.
Stay Transparent with Your Investors or Partners
If you’re running a fund or managing assets for others, consistency and transparency are critical, especially when it comes to policies like withdrawals and redemptions. Galois Capital’s downfall was partly due to offering preferential redemption terms to certain investors, which violated their stated policies. To maintain trust and avoid regulatory trouble, always adhere to clear, consistent, and transparent practices regarding withdrawals and client communications.
Diversify Your Asset Storage
Don’t put all your assets on one exchange or platform, especially in the volatile crypto environment. Galois Capital’s major losses were a direct result of holding too many assets with FTX. Diversifying your asset custody across multiple trusted platforms – ideally ones with strong regulatory oversight – can mitigate risk and protect your holdings from unexpected platform failures.
