Oct. 29, 2023
1. THE SEC'S PROPOSED AMENDMENTS TO RULE 206(4)-2, ALSO KNOWN AS THE "CUSTODY RULE", REPRESENT AN EGREGIOUS EXAMPLE OF REGULATORY CREEP THAT WILL STIFLE INNOVATION IN THE CRYPTOCURRENCY SPACE WITHOUT PROVIDING MEANINGFUL ADDITIONAL INVESTOR PROTECTIONS. The SEC is vastly expanding the scope of the custody rule, which currently only applies to the custody of client "funds and securities", to encompass the custody of all "crypto assets". This expansive interpretation goes far beyond the SEC's authority under the Investment Advisers Act and disregards the unique attributes of cryptocurrencies. Imposing stringent qualified custodian requirements on cryptocurrency assets exceeds the SEC's rulemaking authority because most cryptocurrencies do not constitute "securities" under federal securities laws. The SEC is relying on a vague reference to "assets" in the Dodd-Frank Act to bypass normal administrative procedure and circumvent judicial review of its authority. The SEC should not be permitted to regulate non-security crypto assets without a formal rulemaking process subject to public notice and comment. See 15 U.S.C. § 80b–4 (granting the SEC authority to prescribe rules only with respect to investment advisers' custody of “securities” or “funds”). In addition, the proposed qualified custodian requirements are ill-suited for cryptocurrency assets given their unique characteristics. The immutability of blockchain transactions makes physical possession of private keys an imperfect proxy for "control" over crypto assets. A prudent regulatory approach would recognize these distinctions rather than impose a one-size-fits-all custody framework designed for traditional securities. Subjecting non-security crypto assets to qualified custodian requirements will choke off market innovation without meaningfully enhancing investor protection. Rather than rely on contorted interpretations of existing statutes, the SEC should work with Congress if it believes heightened custody requirements for cryptocurrencies are warranted. Expanding the custody rule by administrative fiat represents an alarming case of regulatory creep that circumvents proper legislative and administrative procedures. The SEC's proposal should be withdrawn and any further attempts to expand custody requirements beyond the SEC's statutory authority should be pursued through proper rulemaking channels. 2. LEGAL DISPUTE ISSUES WITH DIGITAL ASSET CUSTODY REQUIRE REVISITING THE PROPOSED SEC RULE The proposed amendments to the SEC's custody rule, Rule 206(4)-2, raise significant legal concerns regarding the custody of digital assets that necessitate revisiting the rule. Specifically, the strict "exclusive possession or control" standard creates legal disputes regarding digital asset custody models and fails to account for digital asset characteristics. The proposed rule also conflicts with existing caselaw and interpretations of the custody definition. The Exclusive Possession or Control Standard Conflicts with Digital Asset Properties The proposed rule requires demonstrating "exclusive possession or control" of digital assets, which conflicts with the transferability property of these assets. As noted in SEC v. Shavers, digital assets like Bitcoin are transmitted directly between users without an intermediary through their transaction histories stored on a decentralized public ledger or blockchain. This peer-to-peer transferability conflicts with custodians proving "exclusive" control when clients retain private keys. Additionally, the proposed rule does not consider technical digital asset custody models involving sharding or multisignature arrangements that provide qualified custodians participation in transactions without exclusive control. Imposing an "exclusive possession" standard creates legal disputes around determining custody and control for digital asset segregation and transaction authorization models inherently designed not to grant any single entity exclusive unilateral authority. The proposed SEC custody rule raises significant legal issues concerning the custody of digital assets. Revisiting the exclusive control requirement and adhering to custody principles established through caselaw will resolve legal disputes and allow developing compliant custody models tailored to digital assets' technical properties. This revision is imperative to enable digital asset custody consistent with securities laws. 3. INADEQUATE CONSIDERATION OF ENVIRONMENTAL IMPACTS The proposed amendments to SEC Rule 206(4)-2 fail to adequately consider the potential environmental consequences of imposing stricter regulations on digital asset custody and transactions. As drafted, the proposal would make it exceedingly difficult for registered investment advisers to execute and settle digital asset trades in compliance with the rule. This could have the unintended effect of inhibiting mainstream adoption of digital assets and their underlying blockchain technologies. Blockchain-based systems have the potential to greatly reduce energy consumption and carbon emissions across many industries. A 2021 Galaxy Digital report found that the Bitcoin network consumes less than half the energy of legacy financial systems. See https://protect2.fireeye.com/v1/url?k=31323334-50bba2bf-3132d782-4544474f5631-45b831c09726ed30&q=1&e=8bf51a82-f784-49f3-9af1-4bac13c2bcec&u=https%3A%2F%2Fdocsend.com%2Fview%2Fadwmdeeyfvqwecj2. Further research indicates that transitioning payments systems and other financial infrastructure to blockchain could yield significant efficiency improvements and emissions reductions. By hampering digital asset innovation, the proposed custody rule amendments may obstruct these promising environmental benefits. At a minimum, a thorough environmental impact assessment is needed before imposing regulations that could stifle growth in this emerging sector. The SEC should conduct or commission a study quantifying the proposal's marginal effects on blockchain adoption, financial system efficiency, and net emissions. Without further analysis of these critical issues, the proposal risks thwarting climate progress and runs counter to the Biden Administration's climate agenda. I urge the SEC to reconsider the amendments until environmental impacts can be properly evaluated. Climate policy considerations should be integral to financial regulatory decisions. 4. LACK OF FLEXIBILITY IN PROPOSED SEC RULE REGARDING CUSTODY OF CLIENT ASSETS The proposed SEC rule regarding custody of client assets by investment advisers does not provide enough flexibility for companies to adjust to changing market conditions. By expanding the definition of "assets" to include cryptocurrencies and other digital assets, and by imposing strict requirements on qualified custodians, the proposed rule limits the ability of advisers and custodians to adapt as new technologies and asset classes emerge. The SEC should revisit the proposed rule to build in more flexibility on several fronts: Definition of assets - The proposed rule's inclusion of cryptocurrencies and potentially other digital assets in the definition of "assets" subject to custody requirements may be premature. These new asset classes are still evolving, and more time is needed to determine the most appropriate custodial models. The SEC should leave room for adjustments to the definition of covered assets as the market matures. Qualified custodian requirements – The proposed assurance requirements for custodians, such as the ability to demonstrate “exclusive possession or control” of digital assets, could disqualify existing crypto custodians operating under various models. The requirements should focus on functional capabilities to secure assets rather than prescribing custodial models, giving firms flexibility to innovate. Subcustodial arrangements – The proposed rule requires advisers to obtain assurances from custodians that client assets will not be subject to claims of a subcustodian's creditors. While important, this prescriptive requirement does not account for various forms of segmented or partial custody. The rule should allow flexibility for specialized custody arrangements. Insurance – The SEC proposal specifies required insurance coverage for different types of assets held in custody. Insurance markets for novel asset classes like crypto are still developing, so coverage requirements could be premature. The rule should provide flexibility on insurance pending market maturation. In summary, while the SEC aims to enhance protections for advisory clients, the prescriptive requirements in the proposed custody rule could have unintended consequences in constraining market innovation and evolution. The SEC should revisit the proposal to build in more flexibility so that advisers and custodians can adjust models and protections as market conditions change, while still safeguarding client assets. This comments urges the SEC to adopt a custody rule that protects clients while better accommodating a dynamic 21st century marketplace. 5. INCONSISTENT REGULATORY TREATMENT OF CRYPTO ASSETS CREATES UNCERTAINTY The SEC's proposed amendments to the custody rule evidence inconsistent regulatory treatment of crypto assets that fails to provide clear guidance and predictability to market participants. While the SEC asserts crypto assets are within the custody rule's scope, its lack of consistent classification of crypto assets as securities continues to create uncertainty. This frustrates consistent application of the custody rule to crypto assets. The SEC classifies some crypto assets as securities while declining to provide clear guidance on the status of major crypto assets. This inconsistent treatment leaves ambiguity around which crypto assets fall under the custody rule. The SEC itself acknowledges difficulty demonstrating "exclusive possession or control" of crypto assets, given their intangible nature. This complicates requirements for RIAs to maintain qualifying custody of crypto assets classified as securities. Uniform classification of crypto assets as securities, or issuance of clear guidance on factors determining whether a crypto asset is a security, would enable consistent application of the custody rule. Subjecting crypto assets definitively classified as securities to the full protections of the custody rule would provide confidence to market participants. Crypto assets not classified as securities could remain outside the rule's scope. The SEC should pursue consistent classification of crypto assets to facilitate uniform regulatory treatment. 6. THE SEC'S ACTIONS ENCROACH UPON STATE SOVEREIGNTY: The SEC's proposed amendments to the Custody Rule would impermissibly encroach upon the sovereign authority of states to regulate entities created under their laws. The proposed rule would make it difficult, if not impossible, for state-chartered trust companies to continue serving as qualified custodians for digital assets like cryptocurrencies. By imposing stringent federal standards on these state-created institutions, the rule would undermine states' ability to oversee businesses operating within their borders. The regulation of state-chartered trusts falls squarely within the police power reserved to the states under the Tenth Amendment. The proposed amendments improperly infringe upon this core state power by imposing federal standards that could functionally eliminate state-chartered trusts from the digital asset custody market. Although the SEC certainly has authority to regulate investment advisers under the Advisers Act, it cannot exercise that power in a way that eviscerates states' sovereign prerogative to charter and regulate financial institutions. The custody rule amendments would do just that by making it impracticable for state-chartered trusts to serve as qualified custodians. The proposed limitations are also inconsistent with the Dodd-Frank Act, which left states' powers over financial institutions intact. As the Supreme Court has noted, the Dodd-Frank Act reflects Congress's judgment that states should continue regulating the financial entities they create. By hindering state-chartered institutions from participating in digital asset custody services, the proposed amendments contradict the Act's preservation of states' authority in this area. The SEC should not adopt an interpretation of the Advisers Act that risks clashing with Congress's more recent affirmation of states' powers under Dodd-Frank. In addition, the proposed custody requirements lack justification under the Necessary and Proper Clause given their intrusion into the states' sovereign sphere. The federal government's power under that clause is limited when, as here, a proposed regulation reaches into an area of traditional state authority. Bond v. United States, 572 U.S. 844, 873-74 (2014). The SEC has not adequately demonstrated why such an intrusion is necessary to reasonably effectuate its power to regulate investment advisers. Less disruptive alternatives, like letting states regulate the adequacy of custodial services provided by institutions they charter, could reasonably protect investors. The extraordinary nature of the proposed requirements makes them improper under the Necessary and Proper Clause. For these reasons, the SEC should refrain from finalizing amendments that would severely undermine the ability of state-chartered trusts to serve as qualified custodians for digital assets. The proposed rule impermissibly trenches upon the sovereign authority of states over the financial institutions they create. The SEC should modify the amendments to avoid unnecessarily curbing the states' established powers in this area. 7. REGULATORY OVERLAP REGARDING CUSTODY OF CRYPTO ASSETS The SEC's proposed amendments to Rule 206(4)-2 would impose overlapping and potentially contradictory regulations regarding custody of crypto assets. Existing regulations already provide adequate protections, and expanding SEC authority over crypto custody would create confusion, uncertainty, and unnecessary compliance burdens. The SEC should refrain from expanding custody regulations into an area already addressed by other regulators. The Office of the Comptroller of the Currency (OCC) has already authorized national banks to provide crypto asset custody services, following a thorough review process.[1] Subjecting these OCC-approved crypto custodians to a new, overlapping SEC regulatory regime would be duplicative and create uncertainty. As the Supreme Court has held, "[A]n agency may not exercise its authority 'in a manner that is inconsistent with the administrative structure that Congress enacted into law.'"[2] Congress divided jurisdiction over the financial system between different regulators.[3] The SEC should adhere to this framework and avoid overextending its reach into areas properly overseen by banking regulators. Imposing SEC custody regulations on OCC-regulated institutions would undermine the OCC’s validly enacted standards for crypto asset custody. It would also discourage crypto asset custody services, harming innovation in an emerging sector of the economy. [1] Interpretive Letter #1170, Authority of a National Bank to Provide Cryptocurrency Custody Services for Customers (July 22, 2020). https://protect2.fireeye.com/v1/url?k=31323334-50bba2bf-3132d782-4544474f5631-c11f59fcd31846f1&q=1&e=8bf51a82-f784-49f3-9af1-4bac13c2bcec&u=https%3A%2F%2Fwww.occ.gov%2Ftopics%2Fcharters-and-licensing%2Finterpretations-and-actions%2F2020%2Fint1170.pdf [2] FDA v. Brown & Williamson Tobacco Corp., 529 U.S. 120, 125 (2000). [3] See 12 U.S.C. § 1818 (empowering OCC to regulate national banks); 15 U.S.C. § 80b-4 (empowering SEC to regulate investment advisers). 8. THE PROPOSED RULE LACKS FAIR NOTICE BY FAILING TO DEFINE KEY TERMS AND STANDARDS FOR CRYPTO CUSTODY AND QUALIFICATION. The Proposed Rule lacks fair notice by failing to adequately define key terms and standards necessary for regulated entities to understand whether they can comply with the new crypto custody requirements. The Proposed Rule would expand the definition of "custody" to include crypto assets and impose stricter requirements on firms that custody crypto. However, the Proposed Rule does not provide fair notice of what specifically qualifies as "custody" of crypto assets or who can serve as a "qualified custodian." The Proposed Rule states that "exclusive possession or control" is required over crypto assets for a firm to have "custody," but does not elaborate on what constitutes "exclusive possession or control" for cryptographic keys and assets on a blockchain. The SEC acknowledges "it may be difficult actually to demonstrate exclusive possession or control of crypto assets due to their specific characteristics." Without more guidance on what satisfies "exclusive possession or control," firms cannot reasonably determine if their crypto asset storage systems would meet the custody requirement. The lack of notice violates due process principles that regulations must "give the person of ordinary intelligence a reasonable opportunity to know what is prohibited." Grayned v. City of Rockford, 408 U.S. 104, 108 (1972). Similarly, the Proposed Rule does not provide fair notice of which entities can serve as "qualified custodians" for crypto assets. Under 15 U.S.C. §80b-2(a)(26), state-chartered trusts satisfying certain fiduciary requirements can be "qualified custodians." However, SEC statements imply that "crypto platforms" and "new entrants" to crypto custody may not qualify, without specifying how these terms are defined. Again, the lack of notice does not give regulated entities reasonable opportunity to know if they can qualify as "qualified custodians." Without defining key terms like "custody" and "qualified custodian" as applied to crypto assets, the Proposed Rule violates due process requirements for fair notice under the Fifth Amendment. The SEC should clarify the standards and definitions for crypto custody to provide reasonable opportunity for regulated entities to understand their compliance obligations. See generally Connally v. General Construction Co., 269 U.S. 385, 391 (1926) (regulations must provide adequate warning of proscribed conduct). 9. THE SEC UNDERESTIMATES IMPLEMENTATION CHALLENGES ASSOCIATED WITH APPLYING TRADITIONAL CUSTODY CONCEPTS TO CRYPTO ASSETS. The proposed amendments to the Custody Rule underestimate the implementation challenges associated with applying traditional custody concepts to crypto assets. Crypto assets have unique technological attributes that make exclusive possession or control difficult to achieve and demonstrate in practice. Strict application of traditional custody requirements fails to accommodate the novel technological characteristics of crypto assets. Unlike traditional securities, crypto assets rely on blockchain technology and public-private key cryptography for asset validation, transaction execution, and custody. Crypto asset transactions occur and settle on decentralized blockchain networks. While the blockchain provides a secure immutable record, the assets themselves exist in cryptographic form. This makes crypto assets fundamentally different from traditional securities for which custody implies physical possession or book entry control on the books of a centralized intermediary. For cryptographic assets, possession equates to control of the private keys needed to authorize transactions and movement of the assets. However, unlike physical securities certificates, crypto asset private keys do not have a single physical manifestation or represent a singular source of ownership control. Crypto private keys can be generated and stored in various formats, both physical and digital, across multiple locations. This inherently decentralized nature makes demonstrating exclusive possession or control of private keys more challenging compared to centralized securities intermediaries with exclusive book entry control. In practice, it may not be feasible to implement custody models for crypto assets that fully satisfy the proposed exclusive possession or control requirements, such as split key encryption schemas that eliminate single points of failure. Rigid application of traditional custody concepts fails to accommodate these technological differences. Strict compliance could severely inhibit development of custody solutions that leverage the unique benefits of blockchain technology to enhance security, transparency, and client protection. Rather than outright prohibit crypto asset custody absent exclusive control, the Commission should adopt flexible, principles-based requirements that allow models optimized for the distinctive technological attributes of digital assets. With thoughtful guidance grounded in the technological realities of blockchain systems, firms can develop reliable and secure crypto custody solutions that satisfy the Commission's policy aims without stunting beneficial market innovations. Imposing traditional custody constructs without accounting for the novel technological characteristics of crypto assets sets the bar unrealistically and prohibitively high. 10. AMBIGUITY IN PROPOSED SEC CUSTODY RULE AMENDMENT HARMS INNOVATION AND INVESTOR PROTECTION The proposed amendments to the SEC custody rule create significant ambiguity around how crypto assets can be custodied in compliance with the rule. By failing to provide clear guidance on critical issues, the proposal harms rather than protects investors and chills responsible innovation in the crypto asset space. The proposal requires "exclusive possession or control" over crypto assets but provides little clarity on how this standard can be met. The release suggests proving exclusive control may not even be possible for crypto assets due to their ability to be transferred by anyone with the private key. This ambiguity leaves the entire crypto custody ecosystem in limbo. Can federally regulated banks that already custody crypto assets for clients meet this exclusivity test? What about state-chartered trusts with robust controls and strict segregation of client assets? The proposal ominously warns that "new entrants" may not provide necessary protections but refuses to clarify how they could potentially satisfy the rule. This ambiguity will push crypto custody to less regulated off-shore entities, harming US leadership. Equally troubling is the lack of guidance around crypto assets that are not supported by any qualified custodian. The proposal asks whether advisers would effectively be prohibited from holding these assets but provides no resolution, leaving advisers in the dark. Ambiguity around staking arrangements and treatment of hard forks and airdrops creates further uncertainty. By raising more questions than it answers, the proposal chills responsible crypto custody arrangements that would protect investors. It also harms US crypto leadership by driving innovative firms overseas. The SEC must provide greater clarity regarding crypto custody standards to avoid an enforcement-by-ambush approach. Clear rules of the road will let firms innovate responsibly and give investors confidence.