Oct. 30, 2023
To the Securities and Exchange Commission: Please review the comments below regarding concerns with respect to the proposed rule. 1. THE PROPOSED RULE FAILS TO ESTABLISH ADEQUATE MONITORING AND EVALUATION OF CRYPTO CUSTODIANS. The SEC's proposed amendments to the custody rule fail to establish adequate monitoring and evaluation standards to ensure crypto custodians can properly safeguard client assets. The custody rule should require rigorous, ongoing oversight of custodians rather than relying solely on upfront due diligence. The SEC recognizes that "proving exclusive control of a crypto asset may be more challenging than for assets such as stocks and bonds." However, the proposal only mandates that investment advisers conduct reasonable due diligence on a crypto custodian's policies and procedures when initiating the relationship. See 17 CFR § 275.206(4)-2(a)(6). This limited, one-time review cannot provide assurance that the custodian will properly maintain "exclusive possession or control" and comply with custody rule safeguards on an ongoing basis. The custody rule should require investment advisers to conduct annual evaluations assessing whether crypto custodians meet control, segregation, and other standards in practice. Advisers should review a statistically significant sample of transactions, assess compliance with written policies and procedures, and test key controls. Authority to conduct on-site inspections would allow more rigorous monitoring. This approach is consistent with adviser obligations to oversee other service providers under SEC v. Capital Gains Research Bureau, Inc., 375 U.S. 180 (1963) and the Compliance Program Rule. See 17 CFR § 275.206(4)-7. Unlike traditional securities, loss or theft of crypto assets may be irreversible. As the SEC notes, blockchain transactions often makes it difficult or impossible to reverse erroneous or fraudulent crypto asset transactions. Upfront due diligence alone cannot mitigate risks associated with custody and transfer of crypto assets. By mandating ongoing oversight and evaluation of custodians, the custody rule would incentivize custodians to maintain stringent controls and help detect issues threatening client assets before losses occur. 2. THE PROPOSED RULE OVERLOOKS OPPORTUNITIES FOR KNOWLEDGE TRANSFER. The proposed rule risks overlooking opportunities for knowledge transfer from new entrants in the crypto custody marketplace to established qualified custodians. While the Commission expresses valid concerns about protecting investors from loss, theft or misuse of assets, the proposed requirements could have the unintended consequence of hindering innovation and preventing established custodians from learning best practices from new market participants. The Commission should consider modifying the proposal to encourage collaboration between traditional qualified custodians and new entrants seeking to develop novel custodial models optimized for emerging digital assets. Rather than a one-size-fits-all approach, the rule could establish a framework for conditional qualification whereby new entrants are afforded qualified status provided they partner with established custodians and implement rigorous controls vetted by the Commission. This collaborative approach has precedent in the SEC's own Fintech Action Plan (Release No. 34-83063) which aims to promote innovation through engagement with new technologies. Further, a rigid stance risks misalignment with Congressional intent in the Securities Exchange Act of 1934, 15 U.S.C. § 78c(a)(30), which defines "qualified custodian" broadly to include state-chartered trusts. Congress rejected past attempts to limit the definition. The Commission should be wary of circumventing this intent and denying qualification categorically to entire classes of custodians. While exercising authority to require strict controls, the SEC should embrace opportunities for established custodians to learn from new entrants. This balanced approach would uphold the Commission's mission to protect investors while fostering responsible innovation as contemplated by Congress. 3. SYSTEMIC RISKS REMAIN UNADDRESSED BY THE PROPOSED RULE. The proposed amendments by the Securities and Exchange Commission (SEC) to expand the investment adviser custody rule, Rule 206(4)-2, to cover additional asset classes such as cryptocurrencies, while seeking to enhance investor protections, do not clearly address systemic risks within the securities market. The SEC fails to demonstrate how the proposed changes would mitigate issues that have not already been addressed by existing regulations governing qualified custodians. Current regulations enforced upon broker-dealers, futures commission merchants, and banks acting as qualified custodians already impose stringent requirements to properly safeguard client assets through segregation and reporting. Absent proper justification, subjecting state-chartered trust companies that provide cryptocurrency custody to duplicate layers of restrictions is overregulation that stifles responsible innovation without proportionate benefit to investors or the integrity of markets. The SEC claims the rule change is partly aimed at risks related to loss and theft of cryptocurrencies. However, qualified custodians handling cryptocurrencies are already expected to implement "best practices" around private key storage and access controls. The SEC proposal does not articulate additional measures custodians should take, or how existing practices are deficient. Expecting qualified custodians to vaguely "demonstrate" exclusive control without guidance introduces uncertainty and liability concerns incongruent with responsible cryptocurrency custody services already emerging. While seeking to address misappropriation of client assets is a valid goal, the SEC fails to justify how applying a blunt, sweeping regulation to all digital asset classes meaningfully improves custodial protections above existing regulations tailored to the nuances of specific asset classes and markets. The proposal risks stifling responsible innovation in digital asset custody without clearly defining or addressing unresolved systemic risks to markets or investors. The SEC should reconsider the proposed custody rule changes and carefully evaluate regulatory impacts, unintended consequences, and alternative approaches before imposing broad, unqualified mandates upon custodians across all asset classes. 4. THE PROPOSED RULE WOULD PRODUCE IMPRACTICAL REQUIREMENTS FOR QUALIFIED CUSTODIANS OF CRYPTO ASSETS. The SEC's proposed Rule 223-1 would impose impractical requirements on qualified custodians seeking to provide custody services for crypto assets. Specifically, the requirement to demonstrate "exclusive possession or control" of crypto assets is impractical and inconsistent with the purpose of the custody rule to safeguard client assets. Under proposed Rule 223-1(c)(1), a qualified custodian does not "maintain" client assets unless it has "exclusive possession or control" of the assets, defined to mean "holding assets such that the qualified custodian is required to participate in any change in beneficial ownership of those assets." However, proving exclusive control of crypto assets may be challenging given their inherent characteristics. As the SEC acknowledges, crypto assets are transferable by anyone with the private key, so it may be difficult to demonstrate exclusive control. In fact, if private key information were publicly disseminated, any person could in theory control such assets. Requiring exclusive control of crypto assets is an impractical requirement inconsistent with the protective purpose of the custody rule. As the Supreme Court has noted, "the congressional purposes underlying a statute" guide its interpretation and implementation. See Corley v. United States, 556 U.S. 303, 314 (2009). The core purpose of the custody rule is to protect client assets from loss through the adviser's custody. Allowing qualified custodians to implement reasonable procedures demonstrating possession and control - even if not exclusive control - would provide the safeguards intended by the rule. Imposing a standard of proving exclusive control that may be impossible to meet would undermine the protective goals of the rule and discourage qualified custodians from providing needed custody services for crypto assets. The SEC should modify the exclusive control requirement to enable qualified custodians to demonstrate possession and control through robust procedures reasonably designed to safeguard crypto assets. This would fulfill the purpose of the custody rule while avoiding impractical requirements. 5. THE COMMISSION HAS INADEQUATELY ASSESSED THE IMPACT OF THE PROPOSED RULE CHANGES. The Securities and Exchange Commission's proposed amendments to Rule 206(4)-2 under the Investment Advisers Act of 1940 fail to adequately assess the impact the rule changes would have on state-chartered trust companies providing cryptocurrency custody services. Specifically, the SEC does not provide sufficient data or analysis to support its assumptions that: Cryptocurrency custody by state-chartered trusts companies poses significant risks to clients that justify imposing stringent new requirements, as articulated in proposed Rule 206(4)-2(a)(6). The SEC has not conducted or cited any studies quantifying loss rates of cryptocurrencies held in custody by state-chartered trusts versus other qualified custodians. Absent data showing disproportionate loss rates, the assumption of excessive risk appears speculative and arbitrary. See 15 U.S.C. § 80b-2(c) (requiring the SEC to consider whether proposed rulemaking is "necessary or appropriate in the public interest"); Bus. Roundtable v. SEC, 647 F.3d 1144, 1148 (D.C. Cir. 2011) (vacating SEC rule for inadequate economic analysis). State-chartered trusts cannot reasonably implement procedures to protect client cryptocurrency assets consistent with proposed Rule 206(4)-2(a)(6). The SEC acknowledges crypto custody is possible but speculates state-chartered trusts may face challenges demonstrating exclusive control. However, the SEC does not cite evidence that compliant custody by state-chartered trusts is infeasible. Conclusory statements are insufficient. Imposing strict, new federal regulations on state-chartered institutions is necessary and appropriate. Expanding federal regulation of state-chartered institutions raises federalism concerns. The SEC must justify preempting state regulation and oversight per Executive Order 13132. The proposal lacks any discussion of state laws governing cryptocurrency custodians or analysis of whether existing state regulation sufficiently mitigates risks. In sum, the SEC has not conducted an adequate assessment of the impacts proposed Rule 206(4)-2(a)(6) would have on state-chartered cryptocurrency custodians and federalism, rendering the proposal arbitrary and capricious under the Administrative Procedure Act. See 5 U.S.C. § 706(2)(A). The SEC should withdraw the proposed amendments pending further study. 6. THE PROPOSED RULE CREATES UNFAIR TREATMENT RESULTING FROM REGULATORY CONFUSION ACROSS INTERNATIONAL BORDERS. The proposed amendments seek to expand the custody rule to cover "crypto assets" in a client’s account. While the goal of enhanced investor protection is admirable, the amendments go too far by encompassing assets that have cross-border implications. This overreach creates regulatory confusion and unfairly disadvantages U.S. investment advisers operating abroad. The custody rule should not apply extraterritorially. The presumption against extraterritoriality is a "longstanding principle of American law" (Morrison v. National Australia Bank Ltd., 561 U.S. 247, 255 (2010)). Congress legislates with domestic concerns in mind and does not intend to regulate conduct abroad absent clear intent (Kiobel v. Royal Dutch Petroleum Co., 569 U.S. 108, 115 (2013)). Here, nothing suggests Congress intended the custody rule to apply extraterritorially. The rule implements the Investment Advisers Act, which focuses on regulating domestic conduct. Subjecting non-U.S. assets to U.S. requirements based solely on an adviser's U.S. registration stretches the custody rule beyond its intended scope. This overreach causes regulatory confusion. The custody rule would conflict with foreign laws governing crypto assets' transfer and custody. Unlike traditional securities, crypto assets rely on blockchain technology that is borderless by design. Imposing U.S. requirements on crypto assets held abroad would undermine other countries' regulatory regimes. The rule should avoid this confusion absent clear Congressional intent. The extraterritorial application also unfairly disadvantages U.S. advisers operating globally. Advisers with offshore clients or non-U.S. crypto assets must navigate inconsistent regulatory obligations. This impedes U.S. firms' ability to compete internationally. Moreover, firms may respond by limiting services to U.S. persons, reducing investment opportunities. The SEC should construe the custody rule narrowly to avoid regulatory confusion internationally and unfair impacts on U.S. firms abroad. At most, the rule should cover assets held domestically or transactions executed on U.S. exchanges. Absent express Congressional directive, the custody rule should not apply extraterritorially. The SEC should tailor the proposal accordingly. 7. THE PROPOSED RULE FAILS TO ADEQUATELY CONSIDER THE UNIQUE NEEDS AND CHALLENGES OF UNDERREPRESENTED COMMUNITIES IN THE DIGITAL ASSET SPACE. The U.S. Securities and Exchange Commission's (SEC) proposed amendments to Rule 206(4)-2 and the introduction of new Rule 223-1 under the Investment Advisers Act of 1940 present a significant shift in regulatory oversight for digital assets. While the intent to enhance investor protection is commendable, the rule inadvertently neglects the unique considerations of underrepresented communities, which often leverage digital assets as a means to financial inclusion and empowerment. This comment challenges the SEC to consider the broader implications of its proposal on these marginalized groups. Barrier to Financial Inclusion: For many underrepresented communities, especially those with limited access to traditional banking systems, digital assets offer an alternative financial solution. The strict custodial requirements of the Proposed Rule may increase the costs for advisory services and, in turn, could price out marginalized communities from accessing these services. Such an effect would be contrary to the spirit of the Dodd-Frank Wall Street Reform and Consumer Protection Act, which aims to promote financial stability by improving accountability and transparency, thereby ensuring that all Americans have access to fair and transparent financial services. Inadvertent Exclusion of Grassroots Initiatives: Many grassroots initiatives within underrepresented communities leverage digital assets to fund projects, businesses, and even educational opportunities. The Proposed Rule’s broad definition of “assets” and the stringent requirements for qualified custodians may inadvertently stifle these community-driven initiatives by placing undue burdens on them, especially when they may not have the resources to comply. This could be seen as inconsistent with the principles of the Jumpstart Our Business Startups (JOBS) Act, which seeks to encourage funding of small businesses by easing securities regulations. Limiting Access to Innovative Investment Opportunities: Digital assets represent an innovative investment avenue, which, for many in underrepresented communities, is an entry point into the investment world. The Proposed Rule, by intensifying the regulatory landscape, may deter these individuals from exploring these new investment horizons. This is contrary to the principles of the Securities Act of 1933, which seeks to provide investors with material information concerning securities being offered for public sale while prohibiting misrepresentation, deceit, and other fraud in the sale of securities. Potential for Unequal Enforcement: As the Proposed Rule emphasizes the role of qualified custodians, there is a risk that enforcement might disproportionately impact smaller advisory firms that cater to underrepresented communities. Historically, smaller entities have faced challenges in navigating complex regulatory landscapes, often due to limited resources. This could inadvertently create a system where larger firms continue to dominate, further sidelining advisors who specifically cater to marginalized groups. Such an outcome would be inconsistent with the intent of the Investment Advisers Act of 1940, which seeks to protect investors by ensuring that investment advisers act in their clients' best interests. In conclusion, while the SEC’s intent to bolster investor protection, especially in the rapidly evolving digital asset space, is praiseworthy, it is crucial to ensure that regulations do not inadvertently sideline underrepresented communities. It is imperative that the SEC strike a balance between investor protection and ensuring that regulations do not stifle financial inclusion, grassroots initiatives, and access to innovative investment opportunities for these communities. 8. THE RULE PROVIDES INADEQUATE FEEDBACK MECHANISMS FOR NEW TECHNOLOGY. The SEC's proposed rule regarding cryptocurrency custody arrangements overlooks existing technological solutions and fails to provide adequate mechanisms for industry feedback on emerging custodial technologies. By mandating singular control standards that do not accommodate multiparty cryptographic security, the rule risks stifling financial innovation. The SEC should amend the proposal to provide a more flexible framework that allows qualified custodians to demonstrate effective control and formally solicits industry input on appropriate technical standards. The SEC's insistence on "exclusive possession or control" does not align with existing cryptocurrency custodial practices that utilize sophisticated multiparty cryptographic controls. As one example, Fireblocks' multi-party computation technology allows assets to be sharded across multiple parties in a mathematically provable way, such that no single party has unilateral control. Similarly, uses of multiparty threshold signatures - where transactions require approval by a defined subset of participants - are common among cryptocurrency custodians. These solutions provide effective control and security while avoiding singular points of failure. By mandating exclusive control, the proposed rule fails to accommodate custodial innovation and forces reliance on potentially less-secure single party models. Rather than take an overly prescriptive approach, the SEC should establish a principles-based framework that allows qualified custodians to demonstrate effective control through a variety of means. This aligns with Congress' intent under the Securities Acts Amendments of 1975 to provide flexibility in custody requirements. It would also enable ongoing innovation in custody technology. To ensure emerging solutions provide adequate investor protections, the SEC could require notice and review of new custodial architectures, as well as industry input on appropriate control standards through mechanisms like pilot programs or advisory committees. Overall, the proposed custody rule does not provide adequate feedback channels to address new technological developments. By mandating singular control standards, the SEC risks stifling beneficial innovation in cryptocurrency custody. The Commission should take a more flexible, collaborative approach that accommodates emerging multiparty security models. This will further the SEC's mission of facilitating capital formation while appropriately safeguarding investor assets. 9. THE NECESSARY AND PROPER CLAUSE DOES NOT EXPAND FEDERAL AUTHORITY BEYOND ENUMERATED POWERS. The proposed amendments to the SEC's investment adviser custody rule, Rule 206(4)-2, represent an unwarranted expansion of federal power that exceeds the SEC's statutory authority under the Investment Advisers Act. While the SEC may have legitimate concerns about protecting advisory clients' digital assets, the proposed rule relies on an overbroad interpretation of the Necessary and Proper Clause to regulate areas outside of Congress' enumerated powers. Under our constitutional framework, the federal government is one of limited, enumerated powers. As James Madison emphasized in Federalist No. 45, the powers delegated to the federal government by the Constitution are "few and defined," while the powers remaining with the states are "numerous and indefinite." The Necessary and Proper Clause allows Congress to enact legislation that is necessary and proper for carrying into execution its enumerated powers, but it does not grant Congress a broad police power to legislate on matters traditionally reserved to the states. As Chief Justice Marshall explained in McCulloch v. Maryland, the Necessary and Proper Clause does not enlarge the scope of federal power: "Let the end be legitimate, let it be within the scope of the constitution, and all means which are appropriate, which are plainly adapted to that end, which are not prohibited, but consist with the letter and spirit of the constitution, are constitutional." Here, the SEC is relying on an overexpansive interpretation of the Necessary and Proper Clause and Section 206 of the Advisers Act to regulate digital assets in a manner that exceeds its statutory authority. The proposed amendments would expand the custody rule to cover "assets" beyond just "funds and securities," encompassing digital assets that likely fall outside the scope of federal securities laws. This proposed expansion exceeds the SEC's power, which is limited to regulating securities, not other types of assets. Congress has not delegated general authority over digital asset custody practices to the SEC. The SEC cannot point to any enumerated power, much less a necessary and proper power ancillary to an enumerated power, that would authorize federal regulation of non-security digital asset custody. The custody of digital assets does not substantially affect interstate commerce so as to justify regulation under the Commerce Clause. Nor do digital assets in custody fall under any other enumerated federal power. The regulation of non-security asset custody is a matter traditionally left to state law. The proposed amendments are therefore not "consist[ent] with the letter and spirit of the constitution." The SEC should adhere to the limits of its delegated authority and avoid regulatory overreach. Accordingly, the custody rule amendments should be limited to SEC-regulated securities and not expanded to encompass digital assets more broadly. 10. THE SEC HAS FAILED TO PROVIDE THE PUBLIC ADEQUATE OPPORTUNITY TO MEANINGFULLY PARTICIPATE IN THE RULEMAKING PROCESS AS REQUIRED BY LAW. The Administrative Procedure Act (APA) requires federal agencies to publish notice of proposed rules in the Federal Register and "give interested persons an opportunity to participate in the rule making through submission of written data, views, or arguments." 5 U.S.C. § 553(c). While the APA does not specify a minimum period for comment, public participation is one of the APA's central purposes. Prometheus Radio Project v. F.C.C., 652 F.3d 431, 449 (3d Cir. 2011). The notice and comment period must therefore provide a meaningful opportunity to comment on proposed regulations. The custody rule amendments drastically expand the scope of assets deemed to be in an RIA's custody and impose material new qualified custodian requirements. These changes require careful review by the public. By providing only two 60-day comment periods on the 200+ page proposal, the SEC has failed to adhere to its own practices and afford sufficient public input on this highly consequential rulemaking. Given the custody rule amendments' expansive scope and potentially significant effects on the digital asset market and participants, the SEC should reopen public comment period consistent with its historical practices for major rulemaking initiatives. The limited comment periods falls short of the meaningful public participation required by the APA and undermines the legitimacy of this rulemaking. The SEC must reopen the public comment period for an additional reasonable period of time before moving forward with finalizing the proposed amendments. Only then can the public have a full and fair opportunity to analyze the complex implications of the SEC's proposal and provide informed feedback. This serves the public interest by creating better regulatory policy and adhering to principles of open government. 11. THE PROPOSED RULE HINDERS INVESTMENT OPPORTUNITIES IN THE EMERGING CRYPTO MARKET. The proposed amendments to the SEC's custody rule for investment advisers would hinder the ability of investors to access promising investment opportunities in the emerging crypto market. By imposing onerous requirements on crypto custodians and treating crypto assets as presumptively securities, the rule would severely restrict the development of crypto custody services tailored to digital assets and limit the ability of advisers to provide crypto investment options. This contradicts the SEC's mission of facilitating capital formation and ignores the unique technological characteristics of crypto assets. The proposed "exclusive possession or control" standard for crypto custody seems near impossible to satisfy and fails to accommodate crypto-native custody models like multi-party computation. Holding crypto assets in ways that allow investors to realize their unique benefits should not disqualify a custodian. The SEC should embrace crypto-native custody solutions that advance beyond traditional models rather than hindering innovation. The proposed assurances required of custodians also seem intended to steer advisers to federally regulated banks over specialized crypto custodians. However, lower costs, greater efficiencies, and innovative offerings from digital asset companies benefit investors and facilitate capital formation. Further, by presuming most crypto assets to be securities, the rule would severely limit the ability of advisers to provide clients exposure to decentralized networks and crypto assets that do not constitute securities. This contradicts principles-based regulation under the Advisers Act, which respects an adviser's judgments in structuring portfolios suitable for a client's objectives. The SEC should not impose its views of appropriate investments but rather focus on preventing fraud and facilitating responsible access to emerging technologies. Investors stand to benefit greatly from diversification into crypto assets, and the SEC should not hinder these opportunities. In sum, the SEC should reconsider aspects of the proposed amendments that seem intended to restrict rather than responsibly expand investor access to crypto markets. With appropriate guardrails against fraud, investors can realize the technological promises of digital assets within the remit of the SEC's mission to protect investors, maintain fair markets, and facilitate capital formation. The SEC should craft a balanced rule that accomplishes these goals without hindering investment in emerging technologies.