Oct. 30, 2023
To Whom It May Concern, The comments below summarize a number of concerns with the SEC’s proposed rule. Please consider these concerns in evaluating the rule. 1. THE PROPOSED SEC CUSTODY RULE AMENDMENT REGARDING CRYPTO ASSETS WOULD IMPOSE EXCESSIVE COMPLIANCE COSTS ON INVESTMENT ADVISERS. The proposed amendment to the SEC's custody rule under the Investment Advisers Act of 1940 that would expand the definition of "custody" to include crypto assets raises serious concerns about imposing excessive compliance costs on registered investment advisers (RIAs). While the goal of enhancing investor protections is laudable, the proposal goes too far and would create undue financial burdens for RIAs that have or intend to have custody over client crypto assets. Specifically, the requirement in proposed Rule 223-1(c)(1) that a qualified custodian have "exclusive possession or control" over crypto assets sets an unrealistically high standard that few, if any, crypto custody providers can currently satisfy. As noted in the SEC's proposing release, crypto assets differ from traditional securities in that anyone with the private key can transfer the assets (See Proposing Release at 62). This makes demonstrating exclusive possession or control difficult. Yet the proposing release provides no guidance on how crypto custodians could reliably show exclusive control. Without a workable framework for demonstrating exclusive control, RIAs would likely have no choice but to hold crypto assets directly, putting them in violation of the custody rule. According to the SEC, RIAs that currently self-custody crypto assets are already violating the existing rule (See Proposing Release at 49). Forcing RIAs to become the custodian of last resort would impose substantial security, storage, insurance and capital costs that many advisers cannot absorb. It would also increase risks to client assets. In effect, the proposed rule may make it prohibitively expensive for many RIAs to continue holding crypto assets on behalf of clients – harming investor choice. Congress did not intend such an outcome when it enacted the Dodd-Frank Act’s broader “assets” language that the SEC is now relying on. The compliance costs are disproportionate to any increase in investor protection given the significant burdens the rule already imposes on RIAs. Less burdensome alternatives exist. The SEC could provide guidance on existing methods crypto custodians use to demonstrate control, such as SOC reports, custody audits, and other security controls. The SEC could also allow joint control arrangements between RIAs and qualified custodians, as long as a qualified custodian has a right to block unauthorized transfers. This more flexible approach would enable RIAs to comply with the custody rule at a reasonable cost. In sum, the SEC should reconsider its rigid view of "exclusive control" for crypto assets to avoid saddling RIAs with excessive and unnecessary compliance costs.Crypto assets pose unique custody challenges. But the solution is not to make compliance functionally impossible. With the right framework, RIAs can secure client crypto assets consistent with the SEC's investor protection goals without incurring unreasonable expenses. The SEC should revise the proposal accordingly. 2. UNFAIR COMPETITIVE ADVANTAGES The proposed SEC custody rule would unfairly advantage national banks and federally regulated qualified custodians for crypto assets over state-chartered qualified custodians. This violates the principle of functional regulation under the Gramm–Leach–Bliley Act. The GLBA establishes "functional regulation" for the separation of banking and commerce. This means that financial activities should be regulated by the same regulator, regardless of the entity performing the activity (12 U.S.C. § 1843). Crypto custody qualifies as a financial activity. By imposing stricter requirements on state-chartered crypto custodians versus national banks, the SEC custody rule proposal violates functional regulation and unfairly favors national banks. The proposed custody rule should not disadvantage state-chartered custodians relative to national banks. Both perform the same essential function – safeguarding client assets. Any perceived greater risks of crypto custody at state-chartered custodians can be addressed through appropriate regulation by state regulators. Congress affirmed the principle of functional regulation when it defined "qualified custodian" in the Dodd-Frank Act to include a bank, savings association, registered broker-dealer, or futures commission merchant (15 U.S.C. § 80b-6(4)). The SEC should not create artificial obstacles and unfair competitive advantages between different qualified custodian types. Doing so exceeds its authority and contravenes Congressional intent. 3. THE PROPOSED RULE IGNORES RELIANCE INTERESTS The proposed amendments to the custody rule fail to account for the substantial reliance interests that have developed around cryptocurrencies. Over the last decade, cryptocurrencies have become a major asset class that is relied on by millions of investors and financial professionals. Ignoring these reliance interests threatens significant disruption and uncertainty. The Supreme Court has long recognized that the interest of justice counsels against upsetting reliance interests to accommodate changed regulatory approaches. When an agency shifts course, it must "be cognizant that longstanding policies may have 'engendered serious reliance interests that must be taken into account.'" Encino Motorcars, LLC v. Navarro, 136 S. Ct. 2117, 2126 (2016) (quoting FCC v. Fox Television Stations, Inc., 556 U.S. 502, 515 (2009)). This doctrine against retroactivity protects the deep-seated desire for fairness and security in the legal system. Here, the SEC's proposed amendments threaten to significantly disrupt the custody ecosystem that has developed around cryptocurrencies. Over the past five years, state-chartered trusts and other platforms have made substantial investments to provide secure custody solutions tailored to the unique properties of cryptocurrencies. The proposal acknowledges that proving "exclusive possession or control" of cryptocurrencies may be challenging, yet it provides little clarity on acceptable custodial models. This ambiguity leaves providers unsure whether their existing operations comply with the proposed standards. The proposed indemnification and insurance requirements could also necessitate significant changes to current business models. Moreover, registered investment advisers (RIAs) have come to rely on these state-chartered platforms to hold client assets in compliance with existing rules. Sudden elimination of these providers' status would force RIAs to urgently shift assets to new custodians. Such disruptive transitions risk the loss or theft of client funds. An agency should not change direction without cogent explanation. Here, the proposal fails to justify imposing potentially significant disruption on market participants who have reasonably relied on prior SEC guidance and approval. The SEC should align any amendments with existing custodial models and provide flexibility for compliance. At minimum, it should grandfather existing crypto custody arrangements to protect justified reliance interests. Ignoring these cautionary principles threatens market stability and investor confidence in regulation of this critical asset class. 4. THE PROPOSED RULE IMPOSES UNREASONABLE REGULATORY BURDENS ON GLOBAL TRADE NETWORKS. The SEC's proposed amendments to the custody rule under the Investment Advisers Act impose unreasonable regulatory burdens on crypto asset custodians that facilitate global trade. This overregulation threatens to stifle innovation and push crypto asset custody to jurisdictions with less onerous regulation, harming US competitiveness. The proposed "exclusive possession or control" standard for crypto custody far exceeds existing standards for traditional asset custody. It is well established that possession of a document conferring title or ownership qualifies as custody, even if the custodian lacks total physical control over the asset. The SEC provides no evidence that crypto assets require greater restrictions. Imposing unique limitations on crypto custody serves no purpose beyond hindering crypto's development. Likewise, the proposed written agreement and assurance requirements impose significant costs without clear benefits. The SEC does not show these measures will meaningfully improve investor protection given existing state licensing frameworks. Absent evidence of necessity, these duplicative regulations contradict the SEC's obligation to consider efficiency, competition, and capital formation under 15 U.S.C. § 80b-2(c). Finally, the SEC's skeptical view of non-bank crypto custodians threatens to concentrate custody in a few federally regulated entities. But as the Supreme Court has noted, diverse and decentralized custodial models often provide greater security and resilience. See Free Enterprise Fund v. Public Company Accounting Oversight Board, 561 U.S. 477 (2010). Suppressing state-regulated alternatives undermines the SEC's own goals of safeguarding assets. In sum, the SEC should reconsider or clarify these provisions to avoid imposing unreasonable burdens on well-regulated crypto custodians. Overregulation of global crypto networks will push activity offshore, depriving US investors of opportunities and undermining US leadership. The SEC can achieve its valid investor protection goals through less invasive means. 5. THE PROPOSED RULE DOES NOT ACCOUNT FOR THE RAPIDLY EVOLVING NATURE OF DIGITAL ASSETS. The proposed rule imposes numerous new obligations on registered investment advisers (RIAs) related to the custody of "digital assets." However, the heterogeneous and rapidly evolving nature of digital assets resists one-size-fits-all regulation. The custody risks and solutions for a decentralized stablecoin like DAI may look very different from those for decentralized NFTs like CryptoPunks. The same crypto asset may even entail different risks and tradeoffs depending on the custody architecture. This complexity challenges prescriptive regulation. The proposed rule's requirement that qualified custodians demonstrate "exclusive possession or control" of digital assets illustrates this problem. While such exclusive control may be feasible for some digital assets, it will be technically infeasible or imprudent for others. For example, multisignature arrangements are commonly used to balance security and convenience for holders of digital assets. But these arrangements necessarily involve shared control, running afoul of the proposed rule's exclusivity requirement. The result may be reduced security, not enhanced protection. Faced with an impossible exclusivity mandate, some RIAs may abandon multisig custody in favor of sole control models that concentrate risks and attack vectors. Others may even hold assets directly, increasing risks for clients. Rather than mandate rigid requirements, a principles-based approach would better account for the diversity and rapid evolution of digital assets. The rule could focus on requiring RIAs to: (1) assess the risks posed by a particular digital asset and custody architecture and (2) implement controls appropriately calibrated to those risks. Replacing prescriptive mandates with thoughtful, context-specific risk management would provide flexibility to adapt to novel assets and architectures while still enhancing protections for investors. 6. THE RULE PROVIDES ONLY A LIMITED ABILITY TO ASSESS THE POLICY IMPACT OF THE RULE. The Proposed Rule fails to provide adequate opportunity for the public to review data and research to properly assess the policy rationale and impact. The Administrative Procedure Act requires agencies to provide sufficient details about the factual basis and policy choices embodied in a proposed rule to enable meaningful public comment. FCC v. Fox TV Stations, 556 U.S. 502 (2009). The SEC provides almost no data or analysis to justify its presumption that existing qualified custodians cannot properly secure crypto assets. Without disclosing relevant custodial models and practices, the public cannot properly evaluate the SEC's claims. Nor can the public determine whether less restrictive alternatives exist that equally advance investor protection goals while imposing fewer burdens on regulated entities. Courts have found agency rules arbitrary and capricious where the agency failed to disclose critical data, research and assumptions underlying the proposed rule. Owner-Operator Indep. Drivers Ass'n v. Federal Motor Carrier Safety Admin., 494 F.3d 188 (D.C. Cir. 2007). The SEC should withdraw this proposal, conduct appropriate fact-gathering and research, and re-propose the amendments based on a transparent assessment of relevant data, practices and viable policy options. At minimum, it should extend the comment period to allow sufficient time to gather relevant facts omitted from the proposal. 7. THE EXTERNALITIES OF THE PROPOSED RULE HAVE NOT BEEN ADEQUATELY CONSIDERED. The proposed amendments to Rule 206(4)-2 significantly expand the scope and requirements for investment advisers who have custody of client assets. While the intent of enhancing protections for clients is admirable, the proposed rule does not adequately consider the externalities and unintended consequences that may result. Specifically, the proposed rule does not fully account for the costs and burdens that will be imposed on investment advisers and qualified custodians, particularly those involved with digital assets and other novel asset classes. The prescriptive contractual requirements between advisers and custodians could substantially increase legal and operational expenses without clear evidence that client assets will be materially safer. The proposed limitations on the use of certain custodians, such as state-chartered trust companies prevalent in the digital asset space, could also restrict client choice and access. Furthermore, the proposed rule presents significant challenges for advisers seeking to execute and settle digital asset transactions, given the requirement that qualified custodians demonstrate "possession or control" at all times. Most digital asset platforms are not qualified custodians, so requiring custody by qualified custodians during the entire trade lifecycle may effectively prohibit advisers from accessing digital asset markets on behalf of clients. This could limit investment opportunities without materially improving asset security. While the Commission aims to adapt custody rules to evolving assets and technology, the proposed amendments go too far in prescribing rigid requirements without fully weighing the impacts on market participants and structures. A more principles-based approach would better balance flexibility and strong controls. Therefore, the Commission should reconsider the proposed amendments holistically and seek targeted enhancements that achieve stated policy aims without unduly burdening market participants or limiting client choice and opportunity. The merits and effects of each major component should be evaluated independently to determine what requirements are truly necessary to improve client protections versus imposing excessive externalities. 8. THE PROPOSED RULE WOULD IMPOSE NEW REGULATORY BURDENS THAT WOULD NEGATIVELY IMPACT GLOBAL TRADE IN DIGITAL ASSETS. The SEC's proposed amendments to the custody rule under the Investment Advisers Act seek to expand the definition of "custody" to encompass digital assets such as cryptocurrencies. While the goal of enhanced investor protection is laudable, subjecting digital assets to the full panoply of custody regulations applicable to traditional securities would impose excessive regulatory burdens that could stifle innovation and competition in this nascent marketplace. Rather than take a tailored, risk-based approach to regulating digital asset custody that accounts for the unique properties of blockchain networks, the proposal would categorically impose legacy regulations designed for traditional securities. This overly rigid approach would undermine U.S. leadership in the rapidly evolving global digital asset markets. The SEC proposes to require registered investment advisers ("RIAs") who custody digital assets to use only qualified custodians that demonstrate "exclusive possession or control" over such assets at all times. However, the decentralized nature of blockchain networks makes demonstrating exclusive control difficult, if not impossible. Private keys provide access to digital assets on public blockchains that can be copied or shared in ways that physical securities cannot. While operational controls like cold storage can help custodians secure private keys, the SEC's absolutist control test could preclude qualified custodians from emerging to serve the institutional digital asset markets. In addition, the proposal would impose prescriptive requirements concerning specific representations, assurances and contractual provisions between RIAs and qualified custodians. While appropriate for traditional custodial relationships, these regimented requirements lack flexibility to accommodate evolving custody solutions for digital asset markets. Imposing such rigid regulations before industry standards have time to develop would stifle further innovation in crypto-asset custody technology. Rather than take this overly restrictive approach, the SEC should consider more flexible regulations that set general standards without dictating technological solutions. For example, the OCC has allowed national banks to provide digital asset custody services, provided they implement robust security policies and procedures tailored to managing risks unique to crypto-assets. This flexible approach has enabled regulated financial institutions to develop crypto-custody services, fostering innovation and competition while still protecting consumers. Overly rigid crypto-asset custody regulations could cede leadership of this emerging global industry overseas. Regulators in jurisdictions like Singapore, Switzerland and the U.K. have taken more accommodating approaches to digital asset custody solutions, which could attract activity away from the U.S. Stifling crypto-innovation would be contrary to U.S. interests in maintaining leadership in global financial services. It would also undermine the SEC's mission of facilitating capital formation. Therefore, the SEC should reconsider imposing legacy custody regulations in a rigid, uniform manner across different asset classes. The SEC has supported the emergence of tailored alternative trading systems to facilitate capital formation; custody requirements for digital assets should likewise be tailored and flexible. Blanket application of prescriptive custody regulations designed for traditional securities would ignore the nuances of crypto-assets, stifle innovation and push activity offshore. More flexible, risk-based standards are needed to enable regulated entities to develop secure, regulated crypto-custody services that promote capital formation while protecting investors and maintaining U.S. global leadership in financial services. 9. IMPROPER PROCEDURES IN THE PROPOSED RULE WILL LIMIT CRYPTO INNOVATION. The SEC's proposed amendments to the custody rule create inefficient procedures that will negatively impact innovative crypto asset managers without providing meaningful additional investor protection. The rule should be revised to clarify that advancements in crypto custody arrangements involving multi-signature and sharding with qualified custodians satisfy possession and control requirements. Under Section 206(4) of the Advisers Act, the SEC may only prescribe rules that are "necessary or appropriate" to prevent fraudulent practices by advisers. 15 U.S.C. § 80b-6(4). To meet that standard, the SEC must show that the rule addresses a real problem, and the costs imposed by the rule are proportionate to the problem's significance. Here, the SEC has not demonstrated that existing custody controls are inadequate to safeguard crypto assets. Rather than clarify how qualified custodians can utilize technical advancements like multi-sig and sharding, the proposal creates uncertainty and inefficiency by suggesting exclusive control in all instances. This ignores market realities. Excluding these arrangements fails to strike the right balance between protecting investors and facilitating responsible innovation. The proposal should be revised to provide workable guidance to custodians and advisers. 10. THE PROPOSED RULE EXCEEDS THE COMMISSION’S CONSTITUTIONAL AUTHORITY UNDER THE TENTH AMENDMENT. The Tenth Amendment states: “The powers not delegated to the United States by the Constitution, nor prohibited by it to the States, are reserved to the States respectively, or to the people.” The SEC’s proposed expansion of its authority over all “assets,” including digital assets that may not be securities, represents an overreach of federal power not authorized by the Constitution. Regulation of digital assets and crypto currencies has traditionally been an area reserved to the states under their police powers to regulate local economic activity. The SEC’s proposed rule displaces this traditional state authority in an area not delegated to the federal government. Congress did not clearly authorize the SEC to expand its jurisdiction to non-security digital assets when it amended the Investment Advisers Act in the Dodd-Frank Act. The rule therefore exceeds the SEC's constitutional authority. Furthermore, the proposed qualified custodian requirements place significant burdens on companies seeking to provide digital asset custody services. States have regulated these local businesses appropriately under their police powers. The federal government lacks constitutional authority to preempt these valid exercises of state power over local economic activity. In conclusion, the proposed SEC rule regarding digital asset custody overreaches into the province of the states without clear constitutional authorization. Under the Tenth Amendment, regulation of digital assets and related economic activity are powers reserved to the states. The SEC should refrain from finalizing any rule that would improperly expand federal power over digital assets and displace traditional state authority in this area.