Oct. 29, 2023
Dear Commissioners, Below are 10 concerns regarding the proposed rule. Thank you for your consideration. 1. THE PROPOSED RULE FAILS TO CONSIDER LIMITED ACCESS TO CRYPTO EXPERTISE AND TECHNOLOGY The SEC's proposed amendments to the custody rule under the Investment Advisers Act, which would impose stringent requirements on qualified crypto custodians, do not adequately consider the limited access many advisers currently have to the expertise and technology needed to properly store and secure crypto assets. While the goal of enhanced investor protections is laudable, the SEC must be mindful that crypto custody is still an emerging area where technological capabilities are rapidly evolving. As the Supreme Court has noted, agencies must offer a reasoned explanation for their actions that shows "a rational connection between the facts found and the choice made." State Farm, 463 U. S. 29, 43 (1983). Here, however, the SEC fails to demonstrate a rational basis for concluding that existing crypto custodians utilized by RIAs cannot adequately safeguard client assets consistent with the Advisers Act. The SEC appears to presume deficiencies in "new entrants" to crypto custody without citing evidence of actual failures to segregate client assets or specific cybersecurity risks unique to crypto. This lack of evidentiary support undercuts the reasonableness of the proposed rule. See Chamber of Commerce v. SEC, 412 F.3d 133, 142 (D.C. Cir. 2005) (agency must show that a proposed rule is supported by substantial evidence). Moreover, by limiting "qualified custodian" status to only those entities that can strictly comply with the proposed requirements, the rule ignores the reality that few custodians currently possess the technical capabilities to fully satisfy the "exclusive possession or control" test as applied to crypto assets. The SEC even acknowledges that proving exclusive control of a crypto asset may be more challenging given the distinct nature of blockchain transactions. Yet despite recognizing ongoing technological constraints in the crypto custody space, the SEC proposes amendments that would in effect disqualify the vast majority of existing crypto custodians from continuing to serve RIAs. This mismatch between the SEC's stringent custodial requirements and the current state of crypto security technology belies arbitrary rulemaking. See Motor Vehicle Mfrs. Ass'n v. State Farm Mut. Auto. Ins. Co., 463 U.S. 29, 43 (1983) (agency must "examine the relevant data and articulate a satisfactory explanation for its action including a rational connection between the facts found and the choice made.") (internal quotation marks omitted). By suddenly imposing custody obligations that few entities can presently satisfy, the proposed rule would leave many advisers without viable options to store crypto assets in compliance with their fiduciary duties. These advisers may be forced to choose between violating the custody rule or discontinuing crypto investing on behalf of clients contrary to their wishes. Such a dilemma conflicts with the intent of the Advisers Act, which seeks to eliminate conflicts of interest between advisers and their clients. See SEC v. Capital Gains Research Bureau, Inc., 375 U.S. 180, 191-92 (1963). The SEC should reconsider its proposed crypto custody amendments in light of the limited expertise and undeveloped state of custody technology in this emerging market. The SEC could mitigate concerns regarding crypto-specific risks by requiring enhanced disclosures about an adviser's custodial arrangements rather than effectively mandating a level of technical security that few can currently provide. By taking a less restrictive approach, the SEC would further the Advisers Act's objectives while still responding to the novel risks posed by crypto assets. 2. UNFAIR PENALTIES The SEC's proposed amendments to the custody rule under the Investment Advisers Act should not impose penalties that are unfairly disproportionate to the conduct at issue. While protecting investors is an important goal, penalties must be reasonable and tied to the specific wrongdoing involved. Excessive fines violate the U.S. Constitution's prohibition on cruel and unusual punishment. The Supreme Court has held that the Eight Amendment's Excessive Fines Clause applies to sanctions that serve punitive as well as remedial purposes (see Austin v. United States, 509 U.S. 602 (1993)). Punishments should not be grossly disproportionate to the offense committed (see Solem v. Helm, 463 U.S. 277 (1983)). Here, the SEC should avoid imposing severe penalties that are out of proportion to advisers' conduct. A RIA’s custody of clients’ assets may result in unfair or reasonably penalties. Strict liability for technical violations as drafted in the proposed order not causing investor harm may be unjust. Advisers acting in good faith to comply with complex regulations should receive reduced penalties for harmless errors. The SEC should consider all facts and circumstances surrounding purported violations before imposing any sanctions. Penalties should further the primary purpose of protecting investors, not punish inadvertent and harmless regulatory missteps. Excessive fines are unconstitutional and serve no valid purpose and would be counterproductive here. 3. DECREASED LIQUIDITY IN THE DIGITAL ASSET MARKET UNDER THE PROPOSED RULE The proposed amendments to the custody rule under the Investment Advisers Act of 1940 would impose stringent requirements on qualified custodians of digital assets that could significantly decrease liquidity in the digital asset market. By limiting the types of entities that can serve as qualified custodians for registered investment advisers (RIAs), the proposed rule risks severely constraining capital formation and innovation in the digital asset sector. The proposed rule requires that a qualified custodian have "exclusive possession and control" over digital assets at all times. This narrow definition would preclude many digital asset companies currently serving as custodians from continuing to do so. The result would be a dramatic reduction in the number of available custodians that can fully comply with the proposed requirements. With fewer viable custodians, RIAs will have limited options for investing client assets in digital assets. The decreased accessibility of custodial services will act as a barrier to entry, reducing the flow of capital into digital assets from RIAs. Illiquid markets carry more risk and dampen investor interest. If the proposed amendments are adopted without modification, we can expect liquidity in the digital asset market to decline sharply. Less liquidity also means less efficient markets. With shallow markets, digital asset prices will not reflect fundamental value as accurately. This harms investors and advisers alike who rely on liquid markets with transparent pricing. The proposed rule should be revised to provide more flexibility in defining "possession and control" over digital assets. Strict physical possession of private keys should not be an absolute requirement. Advances in multiparty computation cryptography enable constructive possession and control. The final rule should account for such technological innovation to avoid strangling liquidity. While the SEC's goals of enhancing custody protections are valid, the unintended consequences of diminished liquidity must also be considered. Constructive revisions to the custody requirements for digital assets will strike the right balance between safety and market health. I urge the SEC to recalibrate the proposed amendments accordingly. 4. LACK OF TRANSPARENCY AND OPPORTUNITY FOR PUBLIC COMMENT The SEC's proposed amendments to Rule 206(4)-2 lack transparency and deny the public sufficient opportunity to comment. The SEC should withdraw the proposal, clarify several ambiguous provisions, and repropose the amendments for additional public comment before moving forward. The proposal leaves unclear what specific actions a qualified crypto custodian must take to demonstrate “exclusive possession or control” over crypto assets. This ambiguity means the public cannot adequately assess the rule's costs and feasibility. The SEC claims proving exclusive crypto control “may be more challenging” without explaining why. Legally and technically, qualified custodians can demonstrate the same level of control over crypto assets as any other asset. The SEC also solicits comments on prohibiting advisors from holding certain crypto assets at all. This raises due process concerns by regulating through questions rather than providing the public definitive rule text to evaluate. Fundamental changes like prohibiting access to certain assets require transparency through concrete rule proposals. By leaving key definitions ambiguous and proposing major restrictions only through questions, the SEC denies the public adequate notice and opportunity to comment under the Administrative Procedure Act. The SEC should clarify these provisions and allow additional public input before moving forward. 5. INEFFECTIVE REMEDIES UNDER PROPOSED RULE 223-1 The proposed amendments in Rule 223-1 fail to provide registered investment advisers (RIAs) with workable remedies to comply with the rule's expanded custody requirements, particularly with respect to digital assets. By subjecting all digital assets to the custody rule without providing feasible qualified custodian options, the rule places an impossible burden on advisers. This overbroad application renders the rule ineffective and unlawfully extends the SEC's authority under the Investment Advisers Act. The proposed rule goes beyond the SEC's power to regulate custody of "funds and securities" by encompassing digital assets, many of which likely fall outside the categories of funds and securities. The SEC lacks authority to regulate digital assets that are not funds or securities, as acknowledged by former SEC Commissioner Hester Peirce. Expanding custody requirements to digital assets exceeds the SEC's rulemaking authority and ability to provide remedies. RIAs should not be subject to a custody rule that the SEC itself states may be impossible to satisfy. Further, the stringent "exclusive possession or control" standard for custodians of digital assets and skepticism of multi-signature arrangements leave few, if any, options for compliant custody. This effectively prohibits RIAs from holding many widely-used digital assets. Absent additional SEC guidance on permissible custody models, the rule imposes overly vague requirements and inadequate remedies. By acknowledging "it may be difficult to actually demonstrate exclusive possession or control" of digital assets, while providing no workable framework for compliance, the SEC has crafted a rule lacking effective remedies. The SEC should clarify acceptable methods for RIAs to comply with digital asset custody or exempt non-security digital assets from the rule. Otherwise, RIAs face liability for inevitable violations of unworkable requirements. 6. INADEQUATE RESPONSE TO COMMENTS The SEC's proposed amendments to the custody rule fail to adequately address significant issues raised in prior comments on the custody of digital assets. The SEC has an obligation under the Administrative Procedure Act to respond to material comments, but the current proposal brushes past critical concerns without due consideration. The SEC does not substantively engage with fiduciary objections to its functional custody theory. Commenters including the Investment Advisers Act Working Group have argued that defining advisers as having custody over digital assets through control creates problems by imposing fiduciary obligations even when the adviser lacks total control. See Comment Letter Type A. The SEC claims to have addressed this concern, 87 Fed. Reg. at 12884, but does not explain how advisers can meet heightened duties where control is shared or limited. The cursory dismissal violates the APA's requirement that an agency meaningfully address significant comments. Perez v. Mortg. Bankers Ass’n, 575 U.S. 92, 96 (2015). The SEC fails to address whether its interpretation of control is overinclusive. The proposed amendments indicate that shared control and limited powers may still trigger custody obligations. 87 Fed. Reg. at 12867. But commenters including Coinbase noted that defining advisers as custodians in these scenarios would create obligations the adviser cannot actually meet. See Comment Letter Type B. Rather than grappling with the logic of these critiques, the SEC simply asserts that its interpretation is appropriate. 87 Fed. Reg. at 12884. Such conclusory reasoning does not satisfy the agency's duty to confront contrary evidence and explain its position. Butte Cnty. v. Hogen, 613 F.3d 190, 194 (D.C. Cir. 2010). The SEC does not adequately consider less burdensome alternatives. Multiple commenters have argued that the SEC could address custody risks without deeming advisers to have custody, by directly regulating third-party custody arrangements. While the SEC proposes due diligence and disclosure rules to police third party custodians, it does not explain why this more limited approach would not suffice. An agency must adequately address alternatives that are neither frivolous nor out of bounds. Chamber of Commerce v. SEC, 412 F.3d 133, 145 (D.C. Cir. 2005). The SEC's failure to do so renders the proposal arbitrary and capricious. 7. THE PROPOSED RULE TAKES AN INFLEXIBLY STRICT APPROACH TO CRYPTO CUSTODY THAT FAILS TO ALLOW FOR RULE MODIFICATIONS TO ACCOMMODATE NEW TECHNOLOGIES AND ASSET CLASSES The SEC's proposed amendments to the custody rule reflect an inflexibly strict approach to crypto custody that is inconsistent with existing statutes and regulations and fails to accommodate new technologies and asset classes. While the goals of enhanced investor protection are admirable, the Proposed Rule goes too far in effectively foreclosing crypto custody by state-chartered trust companies that are already regulated at the state level. Section 206 of the Investment Advisers Act grants the SEC authority to prescribe rules that are necessary or appropriate to prevent fraudulent or manipulative practices by investment advisers. 15 U.S.C. § 80b-6(4). This authority does not permit the SEC to adopt rules that are arbitrary, capricious, or manifestly contrary to statute. The Proposed Rule's functionally absolute bar on state-chartered trust companies serving as qualified custodians for crypto assets exceeds the SEC's statutory authority. Nothing in the Advisers Act precludes state-chartered trust companies from serving as qualified custodians where they effectively meet the definition of "bank" in Section 202 and satisfy the rule's custodial requirements. 15 U.S.C. § 80b-2(a)(2). Furthermore, the SEC's inflexible approach conflicts with its own prior guidance recognizing the need to modify rules to accommodate new technologies like blockchain and crypto assets. The SEC's Framework for Investment Contract Analysis of Digital Assets explained that federal securities laws are flexible enough to meet the innovation of the modern economy. By taking an unduly strict stance that would effectively shut out regulated state-chartered trust companies as qualified crypto custodians, the Proposed Rule undermines the SEC's own policy of adapting rules to new technologies. The Proposed Rule also departs from the flexible approach taken by the Office of the Comptroller of the Currency in allowing national banks to provide crypto custody services. By contrast, the SEC's categorical skepticism of crypto custody by state-chartered trust companies as expressed in the Proposal and Chair Gensler's accompanying statement does not align with the more measured, adaptable approach of other regulators. This inflexibility risks denying investors access to qualified custodians best positioned to keep pace with rapid innovation in the crypto asset space. Moreover, the Proposed Rule's demand for "exclusive possession and control" of crypto assets sets too high a standard that fails to recognize custodial practices that sufficiently safeguard investors against loss or theft. The SEC should take a less rigid approach focused on whether the custodian's processes effectively minimize risk rather than mandating absolute exclusivity of possession and control. Setting unrealistically demanding expectations will either squeeze out state-chartered trust companies as qualified custodians or foster noncompliance. In summary, while the SEC is rightfully concerned about protecting investors, the Proposed Rule takes an unduly inflexible and strict approach that exceeds statutory authority. The SEC should revisit the Proposed Rule in a manner that allows for modifications to reasonably accommodate crypto custody services by state-chartered trust companies that satisfy core custodial safeguards and aligns with other regulators embracing crypto innovation. Only a more flexible, adaptable rule will fulfill the SEC's duty to facilitate responsible innovation alongside investor protection. 8. INSUFFICIENT MONITORING OF CRYPTO CUSTODY ARRANGEMENTS The proposed rule fails to establish sufficient monitoring and examination protocols for crypto-asset qualified custodians. While the rule lays out requirements for qualified custodians to segregate and identify client assets, it does not provide guidance on how the SEC will verify compliance with these requirements. Unlike traditional securities, the decentralized and pseudonymous nature of crypto-assets makes effective monitoring more challenging. Without rigorous monitoring and onsite examination procedures, there is a risk that qualified custodians could falsely claim to be properly segregating assets while actually misappropriating client funds. Cases like that of QuadrigaCX in Canada, where a crypto exchange falsely claimed to be holding client assets in cold storage, illustrate the potential for fraud even among regulated entities. To mitigate fraud risk, the SEC should provide guidance on minimum auditing and reporting standards for crypto qualified custodians. This could include requirements to submit to regular third-party attestation audits and provide data to the SEC on client asset holdings. Frequent onsite inspections must also be conducted. Imposing these requirements would be consistent with 15 U.S. Code § 80b–4, which authorizes the SEC to prescribe rules preventing fraud and requiring records by investment advisers. It would also align with precedents like 17 CFR § 1.20, which establishes robust monitoring for commodity trading advisors. Without proper oversight encoded into the final custody rule, clients face unacceptable risks of loss from fraud by regulated custodians. 9. THE AMENDED CUSTODY RULE CREATES CONFLICTS WITH EXISTING LAWS GOVERNING QUALIFIED CUSTODIANS, PARTICULARLY STATE-CHARTERED TRUST COMPANIES The proposed amendments to Rule 206(4)-2 seek to provide enhanced protections for registered investment advisers' (RIAs) clients by expanding the definition of "custody" to include crypto assets and imposing stricter requirements on qualified custodians. However, in doing so, the amendments create conflicts with existing laws governing certain qualified custodians, namely state-chartered trust companies. Under the Investment Advisers Act of 1940, the definition of "qualified custodian" includes a bank as defined in the Act. This includes any state-chartered trust company that meets certain requirements related to its fiduciary powers and the regulation of its activities. See 15 U.S.C. § 80b–2(a)(5). State trust companies have served as qualified custodians of both conventional assets and crypto assets, subject to regulation and examination by state regulators. The powers and responsibilities of state-chartered trust companies as qualified custodians are well-established. The proposed amendments to Rule 206(4)-2 would impose significant new requirements on qualified custodians that conflict with the existing laws governing state-chartered trust companies in several ways: The requirement to provide written assurances and meet strict liability standards may exceed what is required by state laws governing state-chartered trust companies. This creates direct conflicts between federal and state regulation. The requirements related to segregation of assets conflict with state laws permitting trust companies to maintain pooled accounts and funds. Segregation would undermine efficiency and likely increase costs significantly. The requirements related to demonstrating "exclusive" possession and control of crypto assets may not be feasible under existing state laws governing crypto asset custody by trust companies. This effectively bars state-chartered trust companies from qualifying. By imposing broad new requirements without regard for existing state laws governing qualified custodians like state-chartered trust companies, the proposed amendments create troubling conflicts and confusion. The result may be to push crypto asset custody to federally chartered institutions like national banks, undermining state regulation. The SEC should reconsider the proposed amendments and coordinate with state regulators to avoid conflicts with existing state laws governing qualified custodians such as state-chartered trust companies. Failing to do so would undermine the long-standing role of state-chartered institutions as qualified custodians and create significant legal uncertainty. 10. DISPROPORTIONATE FOCUS ON PUNITIVE MEASURES RATHER THAN PREVENTIVE ACTIONS. The proposed qualified custody rule goes too far in punishing state-chartered trusts providing cutting-edge custody solutions. The rule should instead focus on reasonable investor safeguards that empower innovation. The proposed rule would effectively prohibit state-chartered trusts from qualifying as custodians of cryptoassets. It does so by setting impossible standards for “exclusive possession or control” over assets like Bitcoin and Ethereum. Even traditional securities can be transferred without a custodian's participation. The SEC even acknowledges “it may be difficult to actually demonstrate exclusive possession or control of crypto assets.” Rather than take a measured, principles-based approach, the rule simply writes off state-chartered trusts. But well-capitalized, regulated companies like Anchorage Digital and BitGo have safely custodied billions in cryptoassets using innovative security protocols like multi-party computation and air-gapped cold storage. Their track records prove that cryptoassets can be securely custodied without the absolutist requirements proposed. The SEC justifies its punitive stance based on “how crypto platforms generally operate” - i.e., a few negligent actors like Celsius. But tarring an entire industry for isolated failures is an overreaction. The SEC wouldn’t ban all equity custodians if Robinhood committed misconduct. Similarly, Enron’s fraud didn’t prompt bans on traditional asset custodians. A better approach is to set reasonable custody and disclosure requirements scaled to asset risks - the SEC’s standard practice. Section 17(a) of the Exchange Act, 15 U.S.C. § 78q(a), gives the SEC flexibility to set such safeguards as the Commission may deem necessary or appropriate for custodians. Rather than reflexively prohibit certain custodians, the SEC should use its discretion to demand procedural safeguards like redundancy, insurance, and ethical walls. Section 15(c)(3) of the Exchange Act, 15 U.S.C. § 78o(c)(3), likewise empowers the SEC to tailor capital, custody, and other broker-dealer obligations to asset risks. The SEC has used this flexibility before, such as exempting certain broker-dealers from Section 15(c)(3)’s stringent custody rules. The agency should bring the same nuanced approach to cryptoasset custody. Clamping down on state-chartered custodians also contravenes principles of cooperative federalism. States have carefully regulated companies like Anchorage Digital, recognizing their benefits to local economies. Yet the proposed rule overrides these state policies, contrary to Supreme Court precedent counseling deference to state regulation of fiduciary relationships. See Merrill Lynch, Pierce, Fenner & Smith v. Ware, 414 U.S. 117 (1973). Rather than steamroll states, the SEC should harmonize federal custody standards with state frameworks. Congress supports this approach: the Securities Acts Amendments of 1975 direct the SEC to consult and cooperate with...State securities authorities when feasible. 15 U.S.C. § 78o(i). In short, while the SEC is right to demand strong custody protections, banning proven cryptoasset custodians goes too far. A wiser path forward would set custody standards scaled to asset risks, drawing on states’ expertise overseeing fiduciaries. With careful tailoring, cryptoasset custody can grow responsibly - benefiting investors and state economies alike.