Oct. 29, 2023
Legal Memorandum on File number S7-04-23, Safeguarding Advisory Client Assets, a Proposed Rule Regarding Custody of Cryptocurrencies and Digital Assets by the Securities and Exchange Commission (SEC) This legal memorandum is in response to your request for a comprehensive analysis of the proposed rule regarding custody of cryptocurrencies and digital assets issued by the SEC. The purpose of this memo is to provide an overview of the potential implications, challenges, and concerns associated with the implementation of such regulations. I. Overview of Proposed Rule: The Securities and Exchange Commission (SEC) has proposed a new rule that would require broker-dealers holding cryptocurrencies or digital assets on behalf of their customers to comply with certain custody requirements. The SEC's proposal is aimed at protecting investors by ensuring the safekeeping and proper handling of these assets, which are often subject to cybersecurity risks due to their digital nature. Under this proposed rule, broker-dealers would be required to maintain physical possession or control over cryptocurrencies held on behalf of customers through either direct custody (where the firm holds the private keys) or indirect custody arrangements with qualified custodians. Additionally, firms must implement robust cybersecurity measures and internal controls to safeguard these assets from potential threats such as hacking attacks or insider fraud. II. Potential Implications of Proposed Rule: A. Increased Costs for Broker-Dealers: Implementing the SEC's proposed rule would likely result in significant additional costs for broker-dealers, particularly those who currently do not maintain direct custody over cryptocurrencies held on behalf of their customers. These firms may need to invest heavily in infrastructure and personnel to meet the new requirements, including hiring specialized staff with expertise in cybersecurity and blockchain technology. B. Reduced Competition: The increased costs associated with complying with the proposed rule could lead to consolidation within the industry as smaller firms struggle to keep up with larger competitors that have greater resources at their disposal. This reduction in competition may ultimately harm consumers by limiting choice and driving up prices for financial services related to cryptocurrencies and digital assets. C. Potential Liability Issues: The SEC's proposed rule could expose broker-dealers to increased liability risks if they fail to comply with the new requirements or experience a breach of their cybersecurity measures resulting in loss or theft of customer funds. This potential exposure may deter some firms from offering services related to cryptocurrencies and digital assets, further limiting consumer choice and access to these emerging asset classes. III. Challenges Associated with Implementation: A. Lack of Clarity on Key Definitions: The SEC's proposed rule contains several ambiguous terms that could lead to confusion among broker-dealers attempting to comply with the new requirements. For example, there is no clear definition provided for what constitutes "qualified custodians" under the rule, leaving firms uncertain about which third parties they can rely on to meet their obligations. B. Difficulty in Obtaining Insurance Coverage: Given the novel nature of cryptocurrencies and digital assets, it may be challenging for broker-dealers to obtain adequate insurance coverage against potential losses resulting from cybersecurity breaches or other risks associated with holding these assets. This lack of available insurance options could further increase costs and limit the ability of firms to comply with the proposed rule. C. Technical Complexity: Implementing robust cybersecurity measures as required by the SEC's proposal may prove difficult for some broker-dealers due to the technical complexity involved in securing digital assets stored on distributed ledger technology (DLT) platforms such as blockchain networks. Firms without sufficient expertise or resources dedicated to this area could struggle to meet these requirements, potentially exposing them to increased liability risks if they experience a breach of their systems. IV. Concerns Regarding the Proposed Rule: A. Potential Impact on Innovation and Growth in Cryptocurrency Market: The SEC's proposed rule could have a chilling effect on innovation within the cryptocurrency market by discouraging new entrants from offering services related to these assets due to increased costs and liability risks associated with compliance. This could ultimately stifle growth in this emerging sector, limiting opportunities for investors seeking exposure to digital currencies and other blockchain-based technologies. B. Lack of Consistency with Existing Regulatory Framework: The SEC's proposed rule appears inconsistent with existing regulations governing traditional securities markets, which do not require broker-dealers holding stock certificates or other physical assets on behalf of customers to maintain direct custody over those items. This disparity could create confusion among market participants and lead to unequal treatment between different types of financial instruments. C. Potential Conflicts with State Laws: The SEC's proposed rule may conflict with existing state laws governing the regulation of cryptocurrencies and digital assets, creating additional compliance challenges for broker-dealers operating across multiple jurisdictions. This could result in a patchwork of inconsistent regulatory requirements that make it difficult for firms to navigate the legal landscape surrounding these emerging asset classes. V. Recommendations: In light of the potential implications, challenges, and concerns outlined above, we recommend several actions be taken by stakeholders in response to the SEC's proposed rule regarding custody of cryptocurrencies and digital assets: A. Engage with Regulators: Broker-dealers should engage directly with regulatory agencies such as the SEC to provide feedback on the potential impacts of the proposed rule, including any unintended consequences that may arise from its implementation. This dialogue can help inform future revisions or modifications to the regulation in order to address stakeholder concerns and ensure a more balanced approach to protecting investors while promoting innovation within the cryptocurrency market. B. Advocate for Clarity on Key Definitions: Industry groups representing broker-dealers should advocate for greater clarity from regulators regarding key definitions contained in the proposed rule, such as "qualified custodians" and other terms related to cybersecurity measures required under the regulation. This will help ensure that firms have a clear understanding of their obligations when implementing these requirements. C. Pursue Alternative Solutions: Broker-dealers should explore alternative solutions for meeting the SEC's proposed custody requirements, such as partnering with third parties specializing in secure storage and management of digital assets or developing internal capabilities to handle these functions directly. This could help mitigate some of the costs associated with compliance while also providing additional assurance that customer funds are being properly safeguarded against potential threats. D. Monitor Developments Closely: Given the rapidly evolving nature of cryptocurrencies and digital assets, it is essential for broker-dealers to closely monitor developments related to this proposed rule as well as any other regulatory actions that may impact their operations in this space. By staying informed about these issues, firms can better prepare themselves for potential changes or challenges ahead while also positioning themselves to take advantage of new opportunities arising from the growth and maturation of the cryptocurrency market. In conclusion, the SEC's proposed rule regarding custody of cryptocurrencies and digital assets raises several important implications, challenges, and concerns that must be carefully considered by all stakeholders involved in this emerging sector. While there is no doubt that investor protection remains a critical priority for regulators, it is equally essential to ensure that any new regulations do not unduly hinder innovation or growth within the cryptocurrency market. By engaging with regulatory agencies, advocating for clarity on key definitions, pursuing alternative solutions, and monitoring developments closely, broker-dealers can help shape a more balanced approach to regulating these emerging asset classes while also protecting their own interests in this rapidly evolving landscape.