Oct. 29, 2023
1. LIMITED STAKEHOLDER ACCESS UNDERMINES PROPOSED SEC SAFEGUARDING RULE The proposed amendments to the SEC's custody rule, while well-intentioned, suffer from a lack of meaningful input from relevant stakeholders. The prescriptive requirements around qualified custodians and mandatory contractual provisions do not adequately account for operational realities in dynamic areas like digital asset custody. Imposing standardized conditions without fully engaging with the impacted industries threatens to stifle beneficial innovation and impose unnecessary costs that undermine investor protection. Before moving forward, the SEC must expand its outreach to ensure its policy choices reflect current market practices. This should include, at minimum, convening public roundtables with custodians, advisers, exchanges, investors and other parties. While the public comment process allows some feedback, interactive discussions are needed on technical topics like custody of digital assets and trade settlement mechanics. Direct dialogue will surface more constructive alternatives than the proposed rule's rigid mandates. The SEC's goals of strengthening controls and reducing risk are valid. But rules crafted without access to those they impact most risk being ineffective or counterproductive. The Commission should slow down, open its doors to more stakeholders, and recalibrate its proposal based on what it learns. Good policy requires good process. This rulemaking would benefit greatly from more inclusive development before adoption. 2. THE PROPOSAL RELIES ON FLAWED ASSUMPTIONS ABOUT CRYPTO ASSETS AND CUSTODY MODELS The Proposed Rule relies on flawed assumptions about the nature of crypto assets and crypto custody models that do not reflect technological realities. The Proposal suggests crypto assets cannot be securely held in custody by crypto-native custodians. However, crypto custody models utilizing advanced cryptography and decentralized security protocols can provide client asset protections on par with or superior to traditional custodians. The Proposal incorrectly assumes crypto custodians cannot demonstrate “exclusive possession or control.” But crypto custodial models using multi-party computation and decentralized validation enable exclusive control of private keys without a single point of compromise. These models should be recognized as meeting the exclusive possession standard. The Proposal further assumes that the irrevocable nature of crypto transactions necessitates heightened custody requirements. But the use of whitelists, transaction limits, and other controls can prevent unauthorized transactions without limiting advisers’ ability to trade. The SEC should reconsider flawed assumptions underlying the Proposal and craft a final rule that accommodates the unique technological attributes of crypto assets. The final rule should enable advisers to utilize crypto-native custodians and security protocols tailored to digital assets rather than impose a one-size-fits-all approach. Doing so will foster innovation and provide clients access to the most secure and efficient custody solutions. 3. UNFAIR TREATMENT OF SMALL BUSINESSES The SEC's proposed amendments to the custody rule under the Investment Advisers Act would place disproportionate burdens on small RIAs that currently custody crypto assets, effectively prohibiting most small RIAs from engaging in activities involving digital assets that larger RIAs would still be able to undertake. This unfairly disadvantages small RIAs in violation of the Regulatory Flexibility Act. Under the Regulatory Flexibility Act, agencies must analyze the impact of proposed rules on small entities and consider less burdensome alternatives. See 5 U.S.C. §§ 601-612. The SEC's analysis falls short, only briefly mentioning the compliance costs for small advisers without providing meaningful alternatives. For example, the SEC acknowledges that under the proposal, "small advisers would likely experience larger relative increases in compliance costs" but does not sufficiently quantify the costs and in particular it fails explore less burdensome approaches. 87 Fed. Reg. 1685. Higher relative costs alone can violate the RFA if they do not meet the stated goals of a regulation. See, e.g., Cement Kiln Recycling Coal. v. EPA, 255 F.3d 855, 869 (D.C. Cir. 2001) (finding violation of RFA where rule imposed disproportionate costs on small businesses). Here, the SEC does not provide evidence to justify the burdens, which effectively bar small RIAs from crypto activities. The SEC's cursory analysis runs afoul of its obligations under the RFA. We urge the SEC to more meaningfully assess and mitigate the proposal's impact on small entities as required by the RFA. 4. THE PROPOSED RULE FAILS TO IMPLEMENT EFFECTIVE MECHANISMS FOR EVALUATING COMPLIANCE RISK MANAGEMENT TOOLS The Securities and Exchange Commission's proposed amendments to the custody rule under the Investment Advisers Act negatively impact crypto assets by failing to implement effective mechanisms for evaluating compliance risk management tools. The Commission should reconsider this approach, as it undermines investor protections and stifles responsible innovation in the digital asset space. The proposed rule does not provide clear guidance on how compliance risk management systems can demonstrate possession or control over crypto assets. Unlike traditional securities, crypto assets rely on private keys and public keys that enable transferability by anyone with access. However, transferability alone should not preclude a determination of exclusive possession or control. Qualified custodians of traditional securities also have the ability to transfer assets on a book-entry basis, but this does not negate their exclusive possession or control. Rather than categorically dismissing crypto's unique transferability feature, the Commission should consider reasonable guidelines for evaluating compliance tools like multisig wallets, whitelists, and cold storage that mitigate risks and strengthen control. Clarifying how crypto custodians can prove exclusive possession or control would provide regulatory certainty and allow responsible innovation in this area to flourish. In addition, the proposed rule suggests that advisers who currently custody crypto assets are likely violating custody requirements. However, definitive guidance is needed regarding which specific crypto assets constitute "securities" subject to custody rules. Without clearer parameters, advisers face regulatory uncertainty and heightened liability for innovating in the crypto space. The Commission should clarify which crypto assets are categorized as securities and evaluate compliance tools case-by-case, rather than automatically penalizing custody of all crypto assets. Overall, the proposed amendments undermine investor protection by chilling responsible crypto innovation. The Commission should reconsider implementing more nuanced, effective mechanisms for evaluating compliance risk management tools in the crypto space. Doing so would provide regulatory clarity, enable crypto custody services to responsibly evolve, and strengthen protections for investors navigating this innovative landscape. See SEC v. W.J. Howey Co., 328 U.S. 293 (1946). 5. THE PROPOSED RULE CREATES UNJUSTIFIED REGULATORY BURDENS ON GLOBAL ECONOMIC COMPETITIVENESS AND CONNECTIVITY. The Commission's proposed amendments regarding custody of digital assets by registered investment advisers create unnecessary and unjustified regulatory burdens. While the Commission undoubtedly has legitimate interests in protecting investors, the proposal goes too far and risks severely hampering innovation and US competitiveness in the rapidly evolving digital asset sector. Such overregulation violates the Commission's mandate under the National Securities Markets Improvement Act of 1996 to consider efficiency, competition, and capital formation in its rulemaking. 15 U.S.C. § 77b(b). As multiple Commissioners have noted, the proposal seems designed less to protect investors and more to outright prohibit investment advisers from participating in digital asset custody. This blanket prohibition ignores critical distinctions among different models and providers. It also disregards the many benefits of digital assets, including enhancing efficiency, competition, and connectivity in global financial markets. The Commission justifies the proposal by citing the risks of loss from theft or unauthorized transactions involving digital assets. But these risks are not unique to digital assets. As Commissioner Peirce observed, traditional financial assets face risks too, and regulators have addressed those risks through standards of care and other tailored measures rather than outright prohibitions. The Commission can and should take the same tailored approach here, by setting appropriate standards of care and control for digital asset custody without imposing unreasonable burdens amounting to a de facto prohibition. The Commission's overly broad approach will undermine US leadership and competitiveness in digital asset technology. As leading organizations like the Chamber of Digital Commerce have explained, digital assets present major opportunities for the US financially and technologically. But overly restrictive policies will cause activity to shift overseas. Indeed, one Commissioner cited data showing that 90% of digital asset custody already occurs outside the US. The proposal seems destined to accelerate that trend. Rather than reflexively prohibit, the Commission should foster responsible digital asset custody and leadership by US firms. This will protect investors far better than forcing custody activity offshore or underground. The Commission can achieve its legitimate policy aims while supporting innovation, connectivity, and competitiveness. But the current proposal misses that balance. The Commission should go back to the drawing board and take a more tailored, risk-based approach. 6. INADEQUATE EDUCATION: THE PROPOSED AMENDMENTS OVERREACH DUE TO LACK OF INDUSTRY EXPERTISE The SEC's proposed amendments to the investment adviser custody rule demonstrate a fundamental lack of understanding of the technical complexities involved in crypto asset custody. As evidenced by the proposing release, the SEC has inadequate expertise regarding the varied custody models utilized in this rapidly evolving industry. The proposed rule relies on flawed assumptions about exclusive possession and control of private keys that do not reflect the real-world operational practices of qualified crypto custodians. Moreover, the requirements outlined in the amendments exceed what is reasonably necessary to accomplish the SEC's stated goal of enhanced investor protection. Before imposing stringent regulations on an emerging industry, the SEC must take steps to educate itself on crypto asset technology and custody solutions. Per the Administrative Procedures Act, federal agencies have an obligation to engage in reasoned decision-making that relies on substantial evidence when enacting binding rules. As multiple federal courts have held, rules premised on speculation, exaggeration or unwarranted assumptions are arbitrary and capricious. The crypto custody amendments clearly fail that test. Given the SEC's admitted lack of understanding of the technical nuances involved in the proposed rule, the prudent course is for the SEC to solicit additional industry feedback and work collaboratively with market participants to craft balanced regulations that truly enhance investor protections. 7. LIMITED OPPORTUNITY FOR COMMENT VIOLATES THE ADMINISTRATIVE PROCEDURE ACT The Securities and Exchange Commission's proposed amendments to the investment adviser custody rule, Rule 206(4)-2 under the Investment Advisers Act of 1940, and redesignation as Rule 223-1, provide insufficient opportunity for public comment in violation of the Administrative Procedure Act. Section 553 of the APA requires that a general notice of proposed rulemaking be published in the Federal Register and that "interested persons be afforded an opportunity to participate in the rule making through submission of written data, views, or arguments." The APA's notice and comment procedures are designed to "assure fairness and mature consideration of rules of general application" (NLRB v. Wyman-Gordon Co., 394 U.S. 759, 764 (1969)). Here, the Commission has allowed insufficient time for public comment on expansive amendments that implicate complex issues regarding cryptocurrency custody and fundamentally alter the obligations of registered investment advisers. The proposing release itself acknowledges that these are "novel" issues meriting careful consideration (Proposing Release at 20). Providing just 60 days for public input undermines the APA's goals of fairness, transparency, and deliberation. More time is necessary. Comprehensive comments necessitate extensive internal and external consultation. Investment advisers, custodians, cryptocurrency platforms, state regulators, and other stakeholders require more time to thoughtfully respond to the Commission's broad solicitation of comment. The courts have made clear that agencies must provide a meaningful opportunity to comment, which requires a comment period that allows for differing viewpoints to be fully aired (see Rural Cellular Assoc. v. FCC, 588 F.3d 1095, 1101 (D.C. Cir. 2009)). By truncating the process here, the Commission has failed to meet the APA's procedural requirements. 8. UNFAIR COMPETITION The SEC's proposed custody rule amendments place an undue burden on state-chartered trusts and unfairly advantage federally regulated qualified custodians in violation of fair competition principles under the Investment Advisers Act. Specifically, the proposed rule's conditions, assurances, and ambiguity around demonstrating "exclusive possession or control" over crypto assets make it prohibitively difficult for state-chartered trusts to maintain "qualified custodian" status. This both undermines Congressional intent in defining "bank" under the Advisers Act to include certain state-chartered trusts and violates principles of fair competition by creating significant barriers to entry and unfairly advantaging federally regulated qualified custodians. The SEC should modify the proposal to provide greater clarity around how state-chartered trusts can comply with the qualified custodian requirements. The SEC should not impose conditions through rulemaking that functionally eliminate state-chartered trusts as qualified custodians absent clear Congressional intent. Doing so undermines principles of fair competition that Congress codified under the Advisers Act. The legislative history of the Advisers Act shows that Congress intended to promote fair competition by ensuring that federal securities laws do not create unreasonable barriers to entry or unfairly advantage SEC-registered advisers over state-registered advisers. The proposed rule violates these principles by creating significant barriers to entry and unfairly advantaging federally regulated qualified custodians over state-chartered institutions. The SEC should modify the proposal to mitigate these anti-competitive effects and more closely align with Congressional intent regarding promoting fair competition. 9. DIFFICULTY DETERMINING CRYPTO ASSET REGULATORY CLASSIFICATIONS CREATES APPLICABILITY ISSUES The proposed amendments to the custody rule create significant difficulties in determining the applicability and requirements of the rule because of uncertainties around the regulatory status of different crypto assets. Crypto assets have widely varying characteristics, designs and use cases that make regulatory classifications unpredictable. As a result, investment advisers face substantial challenges understanding whether particular crypto assets are "securities," "commodities" or something else entirely for purposes of the custody rule. The Supreme Court has long held that the question of whether an instrument is a "security" turns on the economic realities underlying the transaction. SEC v. W.J. Howey Co., 328 U.S. 293 (1946). Courts examine the substance of the transaction, not its form. United Housing Found., Inc. v. Forman, 421 U.S. 837 (1975). This highly fact-specific analysis resists generalization and makes it difficult for advisers to determine if a crypto asset is a "security." As the SEC itself has acknowledged, whether a crypto asset is a security is not always clear. SEC Framework for 'Investment Contract' Analysis of Digital Assets, April 3, 2019. The Commodity Futures Trading Commission (CFTC) has also indicated that crypto assets may be commodities in certain circumstances based on facts and circumstances. See CFTC v. McDonnell, 287 F. Supp. 3d 213 (E.D.N.Y. 2018). This ambiguity further complicates analysis of which regulatory regime applies. Without clear guidance on the classifications of crypto assets, advisers cannot reasonably determine whether particular assets fall under the custody rule's requirements. The proposing release requests comments on this issue but does not provide the clarity needed for advisers to understand their obligations. The final rule should explicitly address the requirement’s applicability to major crypto asset categories and provide guidelines for advisers to follow in analyzing assets that do not fall squarely within an established class. Clearer rules regarding crypto asset classifications are needed for advisers to comply with the custody rule’s mandates. 10. THE PROPOSED RULE VIOLATES THE FIFTH AMENDMENT. The Fifth Amendment of the U.S. Constitution states that no person shall "be deprived of life, liberty, or property, without due process of law." The proposed amendments violate due process in two key ways. First, the proposed rule presumes that all cryptocurrencies are "securities" subject to SEC jurisdiction and custody requirements. However, the SEC has not formally determined that any specific cryptocurrency is a security through official agency rulemaking processes. Cryptocurrencies have unique properties as decentralized digital assets built on blockchain technology. Imposing custody requirements on all cryptocurrencies without determining their legal status deprives investors of constitutionally guaranteed due process. Second, the proposed qualified custodian requirements make it functionally impossible for most existing cryptocurrency custodians to qualify. This deprives investors who currently use those custodians of their chosen property arrangements without due process. It is an unconstitutional "taking" to forcibly separate investors from their chosen custodians before there has been an official determination that those custodial relationships pose undue risks. The SEC simply does not have legal authority to unilaterally impose binding rules depriving investors of their cryptocurrency property rights and arrangements. That authority properly lies with Congress and the courts, not appointed agency officials. In summary, while the SEC may have valid investor protection goals, the proposed custody rule amendments clearly violate due process rights guaranteed under the Fifth Amendment. I urge the SEC to withdraw the custody rule proposal and instead work with Congress on crafting solutions that balance innovation and investor protection while respecting all constitutional rights. Investors deserve an open and fair process, not regulatory overreach imposed by administrative fiat. Thank you for the opportunity to comment on this important issue. 11. THE PROPOSED SEC CUSTODY RULE MAY STIFLE INNOVATION IN THE DIGITAL ASSET SPACE The proposed amendments to the SEC’s custody rule for investment advisers, while well-intentioned, may have the unintended consequence of stifling innovation in the nascent digital asset space. By imposing strict qualified custodian requirements on digital assets, the proposed rule would disadvantage emerging crypto-native custodians and limit investor choice. This could dampen technological progress, reduce competition, and prevent investment advisers from accessing novel digital asset investment opportunities. Several aspects of the proposed rule imply significant barriers for crypto custodians. The requirement that qualified custodians demonstrate “exclusive” possession and control of crypto assets fails to account for emerging custodial models utilizing novel technological safeguards like multiparty computation. Similarly, the expectation that custodians provide broad insurance protections does not accommodate the cybersecurity practices common to crypto custody. While traditional custodians already provide these features for conventional assets, applying a rigid framework to digital asset custody could preclude new entrants with innovative approaches. Limiting investor choice of custodian, especially for newer asset classes like crypto, could deprive them of advantages offered by specialized providers more attuned to the novel risks and opportunities of the space. It may also lead advisers to avoid crypto investments altogether, eliminating client access to this rapidly evolving asset class. Overly prescriptive crypto custody regulations could incentivize innovation overseas instead of in the United States. The SEC should reconsider strict qualified custodian requirements for digital assets in the final rule. More flexibility accommodating developing custody models and allowing clients and advisers to judge novel crypto custodians may stimulate further technological improvement. It would also provide clients with greater choice in securing cutting-edge services tailored to crypto’s unique attributes. With thoughtful adjustments to enable crypto custody innovation, the SEC can achieve meaningful investor protections while still promoting progress and competitiveness in this critical economic sector. 12. THE SEC CANNOT PUNISH DIGITAL ASSET INNOVATION AND ADOPTION THROUGH EXCESSIVE REGULATION The SEC’s proposed amendments to the custody rule threaten to impose excessive burdens on digital asset companies and users that would severely restrict innovation and adoption of this new technology. While the SEC may have legitimate interests in protecting investors, the proposed rule goes too far and would violate the Eighth Amendment's prohibition on cruel and unusual punishment. Imposing stringent qualified custodian requirements on digital asset companies that custody assets would impose excessive fines and penalties. The proposed rule sets a near-impossible standard for demonstrating “exclusive possession or control” over digital assets that few, if any, companies can realistically meet due to the nature of blockchain technology. This would effectively cut off digital asset companies from serving as qualified custodians. It would also deprive investors of choices in custodians tailored to digital assets. The proposed rule would also severely restrict the ability of registered investment advisers to provide digital asset services to clients. The custody requirements would prohibit many common uses of digital assets, like staking and decentralized finance protocols, despite the potential benefits they offer investors. This blanket prohibition is excessive and fails to account for clients’ individual risk tolerances. While the SEC may have valid interests in protecting advisory clients, the proposed rule’s overbroad requirements violate the Eighth Amendment. The SEC should pursue a more balanced approach that accommodates the unique features of digital assets. Outright prohibitions that stifle innovation and consumer choice qualify as excessive fines or penalties. The SEC must craft a custody rule that enables continued development of digital asset technology, provides flexibility to advisers and investors, and targets specific harms in a proportional way. A principles-based rule rather than prohibition better aligns with the Eighth Amendment.