Subject: S7-04-23: Webform Comments from Anonymous
From: Anonymous
Affiliation:

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.