Subject: File No. S7-04-23
From: Matthew Kolesky
Affiliation:

May 7, 2023
Security and Exchange Commission
File No. S7-04-23; Release No. IA-6240
Response:


This response addresses the overarching implications of the proposed custody rule. Most of the comments will be limited to the proposal’s impact on the advisor/client/custodian relationship as it pertains to crypto/digital assets.
1. Second order effects
If the proposed custody rule passes, the additional compliance and accumulating regulatory burdens placed on RIA’s will have four major impacts on the RIA market:
a. It will accelerate industry consolidation by making it prohibitively costly for small and mid-size RIA’s to reasonably comply.
b. It will discourage new advisors to start RIA businesses due to the additional cost burdens.
c. It will discourage crypto/digital asset advice and asset management in the US.
d. It will push the industry toward a more AUA model, away from the AUM model, particularly for smaller firms.
A., b., and c. above will hamper innovation, encourage homogenized advice delivery and management of assets at scale. Smaller RIA’s and those RIA’s that offer boutique services will be less able to comply due to the additional cost associated with the rapidly expanding scope of new regulations. It will be more difficult for advisors to engage with clients regarding their digital asset holdings, despite a growing demand from consumers for this service.
If the rule passes as proposed, the end consumer will be harmed by fewer choices and less innovation.
Regarding d., this response is agnostic to how RIA’s deliver advice and structure relationships, however it should be acknowledged that complying with an AUA (Assets under Advisement) model will be relatively easier and less costly compared to an AUM (Assets under Management) model. Typically, an AUA model offers less service offerings.
An Advisor's fiduciary obligation, duty of care and loyalty to clients is paramount to the relationship, which is supported and reinforced by market forces. This is a more powerful deterrent to bad-faith operators and potential fraudsters than additional compliance burdens.

Fraud Concerns stemming from Non-DVP Settlement The proposal highlights a specific concern from the SEC around the manual settlement of trades for private funds, loan participation interests and other non-DVP settled trades and the potential for fraud and theft. This is brought up multiple times throughout the document:
Settlement - Page 33 
The adviser, for instance, could use its discretionary authority over a client’s assets to instruct an issuer’s transfer agent or administrator (e.g., the administrator for a loan syndicate) to sell its client’s interest and to direct the cash proceeds of the sale to an account that the adviser owns and controls, thereby depriving the client of ownership, unbeknownst to the client or its qualified custodian.

This is fraud or theft of client assets which breaks current laws and violates the Advisor's fiduciary obligation and duty of care. If this rare fraudulent activity is a growing concern for the Commission, then perhaps a more targeted approach to handling a very small percentage of trades should be considered instead of the proposed approach which will have adverse, negative second order effects on the RIA industry.

Specific to Digital Assets/Crypto Assets 
Advisors providing service to clients with respect to digital/crypto assets - Page 18 Additionally, we understand that many advisers may be reluctant to provide a full range of advisory services to their clients with respect to crypto assets because of concerns that a market for custodial services to safeguard these assets has not yet fully developed.
Advisors are increasingly being asked to deliver advice on digital assets by clients and prospective clients all while having concerns about custodial services for crypto assets. Having actively worked with digital asset custodians and exchanges, the lack of regulatory clarity is one of the major reasons the market hasn’t fully developed yet. 
Additionally, there are concerns about the regulatory stance toward crypto/digital assets in the US and its chilling effect on the industry.
As the Fidelity Institutional Investor Digital Asset Study published in October 2022 highlights, financial professionals in the US (74%) and around the world (81%) are increasingly convinced digital/crypto assets should be a consideration when constructing portfolios. The study also goes on to point out obstacles to investment – some of the responses in the US: 
Regulatory classification of certain coins 38%
Lack of clarity around qualified custody 32%
Lack of clarity around regulation 23%.
The proposal does little to address the above issues and makes it more difficult for advisors and custodians to comply. Advisors will then be forced to ignore the asset class despite a multi-year long trend of advisor adoption. Investors of all types will continue to invest in digital assets, and some will continue to explore offshore options and will turn to unlicensed financial advice providers through social media and other channels.
Custody for digital/crypto assets does present different challenges based on the nature of the asset. However, new ways of providing custody in a more safe and secure manner have emerged and will continue to evolve and advance technologically. Two current structures of wallets for digital asset custody are ready now: Multi-Signature and Multi-Party Computation. These fundamentally change the nature and relationship of custody, effectively moving the custody of assets on-chain, with the gatekeepers being the advisor, client and/or another trusted third party, abstracting away the traditional custodian to advisor/client relationship. 
The Commission expressly states its desire for new rules and regulations to be “evergreen” and agnostic to technology. Blockchain and AI will bring new, more transparent, and more secure ways of delivering traditional custody and exchange services. Any definition of qualified custody that doesn't consider these new technologies, fails in the stated objective. 
More assets, including the drive for RWA or real-world assets, are moving on-chain and the industry is craving clarity.
What is a “qualified custodian” with respect to a crypto/digital asset - Page 68 Because we understand that most crypto assets, including crypto asset securities, trade on platforms that are not qualified custodians, this practice would generally result in an adviser with custody of a crypto asset security being in violation of the current custody rule because custody of the crypto asset security would not be maintained by a qualified custodian from the time the crypto asset security was moved to the trading platform through the settlement of the trade.128 In light of our proposal to expand the rule’s application from “funds or securities”129 to “assets,”130 this practice would also constitute a violation of the proposed rule for an adviser with custody of client crypto assets if the adviser trades those assets on a crypto asset trading platform that does not satisfy the definition of “qualified custodian.”

The assumption here is that the SEC has already determined what is a “qualified custodian” and what isn’t for the digital/crypto asset space. In the above scenario, both now and after the proposal, an Advisor is deemed to have custody through the trading and settlement of a crypto asset security, even though they cannot affect the settlement of the trade. This is like a traditional system, even with a trade-away or prime broker agreement, the advisor has very little opportunity to commit fraud by interfering with the normal settlement of a transaction.
If the proposal passes it leaves Advisors and end clients with few clear options and more questions as this proposal would reduce the potential number of qualified custodians in the crypto/digital asset industry leaving less choice. The SEC also continues to challenge state-chartered trust companies and their ability to serve Advisors and clients which casts further doubt and uncertainty across the industry and reduces competition.


Expanded definition of assets - Pages 27-28: However, the proposed rule also would apply to other positions held in a client’s account that are not funds or securities.
Moreover, the fiduciary duty extends to the entire relationship between the advisor and client regardless of whether a specific holding in a client account meets the definition of funds or a security. Consequently, the proposed rule’s definition of assets would include investments such as all crypto assets, even in the instances where such assets are neither funds nor securities. (28) (bold added by responder)
The SEC mentions the fiduciary duty already extends to entire advisor/client relationship. The duty of care to clients is paramount for advisors as they assess custodians, complete due diligence checks, perform best execution tests, etc. The expanded definition of assets to the more-broad definition will not impact most advisors currently advising on crypto-assets as they are already acting as fiduciaries to their clients. However, many advisors have determined that certain crypto/digital asset custodial entities meet the current definition of being a “qualified custodian.”
From a non-crypto/digital lens, other assets specifically mentioned by the SEC could make advising on them more problematic and costly for the advisor:
Additionally, physical assets, including art, real estate, precious metals, or physical commodities (e.g., wheat or lumber), would also be withing the scope of the proposed rule. (page 28)
This expanded definition is a key catalyst for one of the opening comments – this will drive more advisors to adopt an AUA model, instead of an AUM one as the opaqueness around custody is now extended to more assets, not less.


Beginning on page 62 - Qualified custodians to demonstrate “possession or control” of client assets. We believe our proposed definition of possession or control (i.e., being required to participate in any change of beneficial ownership) is consistent with how the concept of possession or control is understood currently by most qualified custodians and does not conflict with the requirements of qualified custodians’ respective regulatory regimes. The proposed rule would formalize that understanding.

Cont. on page 66-67:

a. Application with respect to crypto assets
As discussed above, we believe that under their existing regulatory regimes, qualified custodians are generally considered to have “possession or control” of assets that are in their exclusive or physical possession or control. We understand, however, that proving exclusive control of a crypto asset may be more challenging than for assets such as stocks and bonds. For example, while we understand that it is possible for a custodian to implement processes that seek to create exclusive possession or control of crypto assets (e.g., private key creation, maintenance, etc.), it may be difficult actually to demonstrate exclusive possession or control of crypto assets due to their specific characteristics (e.g., being transferable by anyone in possession of a private key). Moreover, we are mindful of crypto asset custody models in which an advisory client and a qualified custodian might simultaneously hold copies of the advisory client’s private key material to access the associated wallet with the client’s crypto assets, and thus both have authority to change beneficial ownership of those assets.125
As discussed above, the proposed rule’s definition of possession or control turns on whether the qualified custodian is required to participate in a change in beneficial ownership of a particular asset. While demonstrating that a qualified custodian has exclusive possession or control of an asset would be one way to demonstrate that the qualified custodian is required to participate a change of beneficial ownership, itis not the only way. For example, under the proposed rule, a qualified custodian would have possession or control of a cryptoasset if it generates and maintains private keys for the wallets holding advisory client crypto assets in a manner such that an adviser is unable to change beneficial ownership of the crypto asset without the custodian’s involvement.126 Importantly, however, to comply with the proposed rule, an adviser with custody of client crypto assets would generally need to ensure those assets are maintained with a qualified custodian that has possession or control of the assets at all times in which the adviser has custody.127While this is true for most client assets over which an adviser has custody, it is particularly relevant with respect to crypto assets because, as we understand, much of the crypto asset trading volume occurs on crypto asset trading platforms.

It is unclear what the commission means by “crypto-asset trading platform.” Based on the trading comments, we will assume this to mean “centralized crypto asset trading platforms” rather than open-sourced, decentralized blockchain based-protocols.
This "possession and control of assets to remain with a qualified custodian” expanded definition says that it will only serve to formalize the current understanding. However, the nuance of who/what effects the change of beneficial ownership being limited to a “qualified custodian” seems to mean centralized digital asset custodians. What if the client desires a change of ownership and works with the advisor and a smart contract/code-based custodian to effect that change? In this instance, the smart contract could execute and effect the change after the necessary pre-determined qualities of the change have been met. The code and smart contract platform(s) becomes the custodian and potentially exchange, settlement system and feature provider for the end-client and advisor.
If an advisor takes custody of digital/crypto assets, the risks are great with loss of private keys being the most obvious. Even still, the market has expressed a need as digitally native clients are seeking advice from licensed financial professionals in the US only to be met with roadblocks and unclear rules of engagement.
Many industry leaders and advisors attempting to help this growing segment may unwillingly or unknowingly take custody, have expressed difficulty in finding an accounting firm capable of providing a surprise audit to satisfy the advisors regulatory obligation.
This leaves the current state of the industry, and the clients, in limbo. 
Advisors aren’t creating demand for crypto and digital asset advice; however, we are being asked to supply compliant offerings.
Additionally, trading volume on digital, open-sourced exchanges, such as Uniswap, has increased significantly and now regularly surpasses volumes on US based crypto asset trading platforms.

Answers to selected questions posed by the proposal:
5. Yes, most Advisors currently hold digital assets at a qualified custodian and many of these may or may not fit the current definition of “funds or securities.”
10. Absolutely – Advisors have safeguards in place to protect client assets from theft and misappropriation from policy and procedures to ensuring proper protections with current custodians.
14. Yes there should be an exception for custody in cases where an advisor acts as a co-trustee of a trust and no single co-trustee is able to effect any change in control of the beneficial ownership of the trust’s investments without the prior written consent of a co-trustee(s) that is not a related person.
46. Given the nature of crypto assets, it is possible to demonstrate exclusive possession or control of a client asset. Using the features of on-chain wallet transparency can make the regulators and auditors jobs more efficient as well as potentially reducing the compliance cost for Advisors.
50. This question can be answered by smart contracts and wallet architecture acting as a custodian or exchange – and therefore can be programmed appropriately to satisfy various angles and nuances described by the questions around possession and control.
52. Yes there are differences to how digital/crypto asset transactions are settled with respect to a centralized or decentralized trading platform. The former is generally settled on the internal ledger while the latter is generally traded and settled on-chain.

Matthew Kolesky CDAA
Compliance Committee Chair PlannerDAO