Oct. 30, 2023
1. THE PROPOSED RULE THREATENS REGULATORY FRAGMENTATION. The proposed SEC rule amending the custody requirements for registered investment advisers threatens to fragment regulation of digital asset custodians across federal and state regulators, reducing clarity and increasing compliance costs. The SEC should make clear that properly regulated state-chartered trusts can qualify as custodians under the rule. The SEC's proposed interpretation of "qualified custodian" risks excluding state-chartered trusts that provide digital asset custody services, despite such entities meeting the definition of "bank" under the Investment Advisers Act. This approach ignores that the Act's definition of "bank" encompasses state-chartered trust companies, including those "exercising fiduciary powers similar to those permitted to national banks" under state laws. See 15 U.S.C. §80b-2(a)(2). Fragmenting oversight between federal and state regulators would undermine the certainty and uniformity the SEC aims to provide through its proposed rule. Effective regulation of securities trading is impossible if traders can shift accounts to States with the weakest regulations. Similarly, allowing custody requirements to vary based on a custodian's charter would increase compliance costs without clear benefits. The SEC should avoid arbitrarily limiting "qualified custodians" to federally regulated entities. Instead, it should set clear, uniform standards that permit properly regulated state-chartered trusts to serve as custodians. This will provide clarity to market participants while upholding the SEC's mission of protecting investors. 2. THE PROPOSED RULE CREATES UNWORKABLE CONFLICTS WITH GLOBAL STANDARDS. The Proposed Rule would impose standards of custody and control over crypto assets that conflict with emerging global consensus and recognized international standards. This creates an unreasonable compliance burden for advisers and custodians. The Basel Committee on Banking Supervision published principles in 2021 stating crypto assets should be held in either hot or cold storage, and dual controls should be in place for private key access. See Basel Committee, Prudential treatment of cryptoasset exposures (2021). The International Organization of Securities Commissions (IOSCO) likewise recommended segregation and protection of client assets as sufficient. See IOSCO, Issues, Risks and Regulatory Considerations Relating to Crypto-Asset Trading Platforms (2020). Imposing "exclusive possession or control" over crypto assets is plainly inconsistent with these global standards. The Proposal even seems to acknowledge the impossibility of this by questioning whether exclusive control could be demonstrated at all for crypto assets, given their transferability. See Proposing Release at 62,063. Yet it forges ahead to impose this impractical standard anyway. The exclusive control standard would put advisers and custodians in an untenable position of trying to comply with conflicting regulations. It is simply not possible to comply with recognized global standards for crypto custody while also maintaining "exclusive" control. Congress has directed the SEC to consider efficiency, competition, and capital formation in its rulemaking. 15 U.S.C. § 80b-2(c). Imposing unique U.S. crypto custody standards at odds with international norms fails on all three counts. It will drive advisers and custodians overseas to more welcoming jurisdictions, starving U.S. crypto markets of needed capital. The SEC should abandon the exclusive control standard and instead align its crypto custody requirements with recognized global standards. At a minimum, it should provide flexibility for custodians and advisers to implement controls like multisig wallet configurations that are consistent with international norms yet still robustly protect investors. 3. THE PROPOSED RULE CREATES AN IMPOSSIBLE BURDEN FOR CRYPTOCURRENCY CUSTODY. The proposed rule requires that a qualified custodian demonstrate "exclusive control" over cryptocurrency assets. However, as the SEC notes in the proposing release, it may be technically infeasible for any entity to conclusively prove exclusive control over cryptocurrencies due to their ability to be transferred via private keys. Requiring legally conclusive proof of exclusive control sets an unworkably high standard. There is no evidence that requiring exclusive control in the absolute sense contemplated in the proposal provides material protections for investors beyond existing custody frameworks applied to cryptocurrencies. Leading audit firms have established standards and procedures to verify custody and control over cryptocurrency assets to a reasonable assurance standard. The SEC should clarify that similar standards can satisfy the exclusive control requirement in the context of cryptocurrencies. Requiring absolute proof of exclusivity where none can exist imposes an unnecessary burden without clear benefit. See 15 U.S.C. § 80b-11(a) ("The Commission shall, prior to adopting any rule or regulation . . . consider . . . whether the action will promote efficiency, competition, and capital formation"); Business Roundtable v. SEC, 647 F.3d 1144 (D.C. Cir. 2011) (striking down SEC rule for inadequate economic analysis). 4. LIMITING QUALIFIED CUSTODIANS TO FEDERALLY REGULATED BANKS HARMS COMPETITION AND INNOVATION. The proposed rule strongly suggests that state-chartered trusts and other non-bank custodians will not be deemed qualified custodians for purposes of the custody rule, limiting this status in practice to federally regulated banks. However, this approach harms competition and innovation in the cryptocurrency custody market. State-chartered trusts and specialty custodians have developed cutting-edge technological solutions for safeguarding cryptocurrency assets. Excluding them as qualified custodians based purely on charter status does not clearly serve investor protection and deprives RIAs and clients of access to specialized expertise. If the SEC has particular concerns with security protocols at some entities, it should address those specifically rather than categorically excluding broad classes of custodians from qualifying based solely on charter status. Such categorical exclusions violate the SEC's duty to consider effects on efficiency, competition and capital formation. See 15 U.S.C. § 80b-11(a); Business Roundtable v. SEC, 647 F.3d 1144 (D.C. Cir. 2011). 5. THE PROHIBITION ON PREFUNDED TRADING ACCOUNTS IMPOSES UNNECESSARY LIMITS ON TRADING VENUES. The proposed rule appears to prohibit RIAs from maintaining prefunded trading accounts at centralized cryptocurrency exchanges, which are the primary venues for liquid cryptocurrency trading. However, the risks posed by prefunded trading accounts, which apply equally to securities trading, have not been shown to justify excluding the dominant trading venues for cryptocurrencies. Imposing such a disproportionate burden on access to cryptocurrency trading venues does not clearly enhance investor protection and arbitrarily restricts access to these markets for advisory clients. The SEC should reconsider this prohibition in light of its costs to efficiency and capital formation. 6. THE RULE’S TRANSITION PERIODS SHOULD BE EXTENDED TO MATCH OPERATIONAL REALITY. The proposed rule allows only a 1-1.5 year transition period until compliance is required. However, operationally implementing novel cryptocurrency custody frameworks, onboarding with new qualified custodians, and restructuring long-established business practices will require substantially more time. A 3-5 year transition period would be more consistent with the operational realities of evolving custody arrangements across various new asset classes. The artificially truncated period imposed by the proposal does not appear justified by investor protection needs. 7. THE RULE PROVIDES INEFFECTIVE COMPLIANCE INCENTIVES AS APPLIED TO STATE-CHARTERED CRYPTO CUSTODIANS. The SEC’s proposed rule amendment unfairly disadvantages state-chartered crypto custodians and provides ineffective compliance incentives compared to national banks. The proposed rule should be revised to provide a level playing field for state and national crypto custodians. Section 206(4) of the Investment Advisers Act and the SEC’s rules thereunder require investment advisers to maintain client assets with a “qualified custodian.” State-chartered trusts that provide custodial services for crypto assets potentially meet the definition of a “qualified custodian” under Section 202(a)(26) of the Advisers Act, which includes certain state-chartered banks and trust companies. However, statements by SEC officials cast doubt on whether state-chartered crypto custodians could ever meet the “qualified custodian” requirements in practice. This discourages state-chartered institutions from developing compliant custody arrangements, harming competition and innovation. The SEC should clarify how state-chartered crypto custodians can comply, rather than arbitrarily favoring national banks. The SEC’s position also inappropriately treats physically settled crypto assets as more risky than traditional securities from a custody perspective. Crypto assets do not inherently pose greater custodial risks if properly secured, such as through cold storage of private keys. The SEC should evaluate custody arrangements based on their effectiveness, not the asset class involved. In sum, the SEC should provide equal opportunities for state and national crypto custodians to demonstrate effective controls and procedures to secure client assets. This will encourage greater competition and access to custody services, benefiting investors. The SEC should avoid disadvantaging state-chartered institutions absent concrete risks, rather than theoretical differences between asset classes. 8. THE PROPOSED SAFEGUARDING RULE PROVIDES AN UNFAIR DISTRIBUTION OF BENEFITS. The SEC's proposed safeguarding rule risks unfairly distributing benefits to large financial institutions at the expense of smaller fintech companies and investors. The proposed rule expands the definition of "qualified custodian" to include large banks and broker-dealers, but does not provide a pathway for emerging crypto-native companies to potentially qualify. This unfairly favors traditional financial institutions and stifles innovation in the crypto custody market. Smaller companies have developed novel technical solutions for securing digital assets, but would be barred from serving as qualified custodians under the rule. In addition, the proposed required contractual provisions impose significant legal and insurance costs that established institutions are better equipped to bear. The indemnification and insurance requirements could prevent fledgling crypto custody providers from competing. While the goal of better safeguarding client assets is laudable, the rule should not handicap certain business models and advantage entrenched players. A more technology-neutral approach could allow different types of crypto custody arrangements to emerge and compete based on their technical merits. Investors would benefit from such market-driven innovation. The SEC should revise the proposed rule to establish a pathway for emerging crypto custody providers to potentially qualify, provided they meet strict security standards. The rule should also take a more flexible, principles-based approach to required contractual protections, rather than mandating standardized terms. This would enable a diversity of custody solutions to flourish and avoid concentrating control in a few dominant institutions. Fair competition and decentralized control better serve investors and industry growth. The SEC should recalibrate the proposed rule to foster market-wide innovation, not benefit established players at the expense of upstarts. This would lead to the best crypto custody solutions rising to the top and the widest possible distribution of benefits. 9. THE PROPOSED RULE WOULD EXACERBATE THE FRAGMENTED REGULATORY LANDSCAPE FOR DIGITAL ASSETS. The Securities and Exchange Commission's proposed amendments regarding custody of digital assets by registered investment advisers would further fragment the already disjointed regulatory landscape for digital assets. By imposing stringent custodial requirements for digital asset custody that few existing custodians could satisfy, the proposed rule would Balkanize custody solutions and reduce access to digital asset investments for retail investors. Fragmented oversight creates market inefficiencies, stifles innovation, and frustrates policy objectives. See Hall v. Geiger-Jones Co., 242 U.S. 539, 557-58 (1917). The SEC should exercise its authority judiciously and avoid Balkanizing digital asset custody between state and federally regulated entities. Imposing rigid custody standards could have the unintended effect of entrenching a handful of legacy financial institutions as the only viable qualified custodians. Less stringent requirements than those proposed may adequately protect investors given the SEC's simultaneous proposal to enhance disclosure requirements. As the Supreme Court has observed, disclosure can be a more precise regulatory tool than blanket prohibitions. See Va. State Bd. of Pharm. v. Va. Citizens Consumer Council, 425 US. 748, 770 (1976). The SEC should consider allowing advisers to maintain custody of digital assets using technological safeguards like multisignature wallets. Technological protections like multisignature transactions, when coupled with enhanced disclosure requirements, may sufficiently protect investors. Imposing disparate regulatory regimes on functionally similar custodial services offered by state and nationally chartered institutions would undermine policy objectives like financial inclusion, consumer choice, and democratized finance. See 12 U.S.C. § 5381 (identifying these objectives for the Consumer Financial Protection Bureau). Less restrictive custody standards coupled with enhanced disclosure requirements could foster those goals while adequately protecting investors. The SEC should decline to exacerbate fragmented oversight of digital asset custody and carefully tailor its regulations to avoid creating an anti-competitive landscape. 10. THE RULE REFLECTS INEFFECTIVE COMMUNICATION BY THE SEC. The SEC's proposed amendments to Rule 206(4)-2 regarding the custody of crypto assets fail to provide clear guidance to commenters on key issues and reflect ineffective communication by the SEC. Specifically: The proposal does not adequately define "possession or control" of crypto assets. The SEC acknowledges "it is possible for a custodian to implement processes that seek to create exclusive possession or control of crypto assets." However, it then questions whether exclusive control can be demonstrated at all due to crypto’s “specific characteristics,” without elaborating on what those characteristics are. This vagueness leaves commenters guessing as to what processes could satisfy the custody rule (See 15 U.S.C. § 80b-6(4)). The proposal sends mixed messages on whether certain entities could be qualified crypto custodians. On one hand, the SEC does not amend the definition of “bank” under the Advisers Act, leaving room for state-chartered trusts to potentially meet the qualified custodian requirements. On the other hand, statements by SEC leadership indicate hostility toward “crypto platforms” serving as qualified custodians. This dichotomy leaves commenters uncertain as to the SEC’s position (See 15 U.S.C. § 80b-2(a)(2)). The release poses open questions without soliciting public input. The SEC asks how RIAs should handle crypto assets unsupported by qualified custodians but does not request comment on potential solutions. The SEC also declines to seek input on the application of the rule to staking activities, again leaving commenters in the dark (See 15 U.S.C. § 80b-2(b)). Overall, the SEC’s ineffective communication in the proposal inhibits meaningful public commentary, failing to meet the Administrative Procedure Act's requirements for reasoned decision-making (See 5 U.S.C § 553(c)). The SEC should clarify these ambiguities in a transparent dialogue with commenters before adopting amendments. 11. THE PROPOSED RULE CREATES OVERLY COMPLEX AND BEAUREUCRATIC PROCESSES. The SEC's proposed amendments to the custody rule create overly complex and bureaucratic processes that will hinder innovation in the digital asset space without meaningfully enhancing investor protections. While the SEC's goal of safeguarding client assets is laudable, the prescriptive requirements in the proposal are impractical given the nascent nature of digital asset custody solutions. Rigidly defining "possession and control" and mandating specific contractual terms fail to account for the dynamism of the digital asset industry. Rather than stifle progress with bureaucratic red tape, the SEC should take a principles-based approach that allows for flexibility and adaptability as custody standards evolve. The proposing release states that "proving exclusive control of a crypto asset may be more challenging" due to crypto's ability to be transferred by anyone with the private key. However, "exclusive control" is an inherently subjective standard not found in the Advisers Act. As the Supreme Court has noted, Congress does not "alter the fundamental details of a regulatory scheme in vague terms or ancillary provisions" but instead speaks "directly" to make major changes. Whitman v. Am. Trucking Ass'ns, 531 U.S. 457, 468 (2001). Absent clear Congressional intent, the SEC should not impose novel obligations like "exclusive control" through rulemaking. Rather, it should stick to the Advisers Act's focus on whether client assets are properly "maintained" with qualified custodians. Imprecisely defining "control" and layering on prescriptive custody requirements will sow confusion and stifle beneficial market developments. The SEC also proposes mandating specific contractual terms between advisers and custodians, including open-ended assurances and broad indemnities. But Congress declined to dictate how advisers and custodians should allocate liability when it passed the Advisers Act. See 76 Fed. Reg. 37,969 (proposed June 29, 2011) (noting Advisers Act does not require indemnification). By imposing rigid requirements, the SEC would undermine the ability of sophisticated counterparties to negotiate custodial relationships tailored to digital assets. This overreach conflicts with the SEC's mission of facilitating "capital formation." 15 U.S.C. § 77b(b). Rather than prescribe contract terms better left to the market, the SEC should focus on requiring functionally equivalent investor protections without handcuffing industry participants. Imposing bureaucratic requirements that ignore market realities will only drive crypto innovation overseas while doing little to protect investors. The SEC should adhere to statutory limits and take a flexible, principles-based approach. This will foster continued progress on digital asset custody solutions while still achieving the SEC's objectives. 12. THE PROPOSED RULE LACKS CLEAR GUIDELINES FOR ENFORCEMENT PROGRAM MODERNIZATION IN RESPONSE TO EVOLVING TECHNOLOGIES. The proposed amendments seek to modernize the investment adviser custody rule to account for evolving technologies like cryptoassets. However, the proposed rule lacks clear guidelines for how the SEC plans to modernize its enforcement program in response. While the custody rule updates aim to enhance investor protections for new assets, the enforcement regime must also be clarified to effectively regulate emerging technologies. The SEC has broad enforcement authority under the Securities Exchange Act to investigate potential violations of the federal securities laws. See 15 U.S.C. § 78u. This includes violations of SEC rules like the custody rule. However, as the proposing release acknowledges, cryptoassets have unique properties that complicate custody and may require novel enforcement strategies: "proving exclusive control of a crypto asset may be more challenging than for assets such as stocks and bonds." 87 Fed. Reg. 1685. To adequately protect investors in light of cryptoasset adoption, the SEC should clarify how it plans to utilize its enforcement toolkit for digital asset violations. For example, will the SEC provide guidance on applying Howey to different cryptoassets to determine if they are investment contracts and therefore securities? See SEC v. W.J. Howey Co., 328 U.S. 293 (1946). How will the SEC adapt its technology to identify suspicious on-chain activity indicative of misconduct? Without transparency into these issues, market participants lack clarity on if and how the enforcement regime will modernize alongside the custody rule. The SEC's principles-based enforcement approach has benefits, but lacks specificity for emerging technologies. See Report of Investigation Pursuant to Section 21(a) of the Securities Exchange Act of 1934: The DAO, Exchange Act Release No. 81207 (July 25, 2017). While avoiding formulaic enforcement has advantages, cryptoassets require more concrete guidance given their novelty. Leaving enforcement plans opaque could allow problematic activity to slip through the cracks. Therefore, alongside custody rule changes, the SEC should detail how it will modernize enforcement policies, procedures, systems, and cooperation with other regulators. This will ensure investor protections keep pace with market evolutions. The SEC has requested comment on all aspects of the proposed amendments. The Commission should thus provide additional details on envisioned enforcement modernization per Topic II.C of the proposing release. Clarifying enforcement plans will allow industry participants to comply with rules in good faith while giving investors confidence in oversight. 13. THE PROPOSED CUSTODY RULE POSSESSES INADEQUATE SAFEGUARDS. The SEC's proposed amendments to the custody rule raise significant concerns regarding inadequate safeguards for both advisers and investors. The amendments would impose impractical requirements on advisers, particularly regarding cryptocurrency assets, without meaningfully enhancing protections. Moreover, the proposal fails to provide clarity on critical issues, leaving advisers uncertain about compliance. This lack of clarity undermines the stated goal of safeguarding assets. The proposed "exclusive control" standard for cryptocurrencies is unworkable and risks leaving assets unprotected. Requiring "exclusive control" of cryptocurrency assets is inconsistent with the nature of blockchain technology, as private keys can theoretically be duplicated. Advisers cannot definitively prove no other party possesses a private key, creating uncertainty around compliance. Rather than enhance protections, an impossible exclusive control standard could perversely incentivize non-compliance or discourage advisers from holding cryptocurrencies, leaving assets unsupervised. A more reasonable control standard should be adopted. See SEC v. Fife, 311 F.3d 1 (1st Cir. 2002); Chamber of Commerce v. SEC, 412 F.3d 133 (D.C. Cir. 2005). Failure to address treatment of unsupported assets leaves critical assets unprotected. The proposal prohibits advisers from holding assets on behalf of clients that are not supported by qualified custodians. However, the SEC fails to provide guidance on how advisers can protect unsupported but potentially valuable assets like airdropped tokens. Forcing advisers to abandon these assets contradicts the goal of safeguarding all assets. The SEC should clarify treatment of unsupported assets. See SEC v. Chenery Corp., 332 U.S. 194 (1947) (agency must provide reasoned basis for rules); SEC v. Capital Gains Research Bureau, Inc., 375 U.S. 180 (1963) (SEC rules must be reasonably designed to prevent fraud) 14. AMBIGUOUS TREATMENT OF STAKING ACTIVITIES CREATES UNCERTAINTY AND RISK. Staking has become an important crypto asset management strategy, but the proposal lacks any specific guidance on staking. This omission leaves critical compliance questions unanswered, creating ambiguity that undermines asset security. The SEC must directly address staking activities to enable advisers to identify arrangements that adequately safeguard assets. See 5 U.S.C. § 706(2)(A) (agency action may be overturned where arbitrary or capricious); United States v. Nova Scotia Food Prods. Corp., 568 F.2d 240 (2d Cir. 1977) (agency has duty to explain basis for rules) In sum, the proposed custody rule amendments fall short in providing clear, workable requirements for safeguarding investor assets. The SEC must address these inadequacies before adoption. 15. THE PROPOSED RULE WOULD IMPEDE ECONOMIC GROWTH BY CREATING UNDUE BARRIERS FOR QUALIFIED CRYPTO CUSTODIANS. The proposed amendments create onerous barriers that impede economic growth by limiting qualified crypto custodians. As the Supreme Court stated in Edgar v. MITE Corp., 457 U.S. 624 (1982), “the Commerce Clause also precludes the application of a state statute to commerce that takes place wholly outside of the State's borders, whether or not the commerce has effects within the State.” Requiring crypto custodians to demonstrate “exclusive possession or control” over crypto assets in a way that no other custodians are required to demonstrate exclusive control over traditional securities imposes an undue burden on interstate commerce. Similarly, in Bibb v. Navajo Freight Lines, 359 U.S. 520 (1959), the Court struck down a state law requiring curved mudflaps on trucks as violating the Commerce Clause by placing an undue burden on interstate commerce. Like the mudflap requirement in Bibb, the SEC’s proposed “exclusive possession or control” requirement for crypto custodians singles out and disadvantages crypto custodians relative to traditional securities custodians without sufficient justification. This disparate treatment inhibits the economic growth of this emerging industry. The proposed rule should allow crypto custodians to demonstrate exclusive possession or control using methods comparable to traditional securities custodians. For example, 15 U.S.C. § 80a-17(f) requires investment company custodians to hold "all securities and similar investments...in its possession or control." Crypto custodians should be able to show exclusive possession or control through private key access controls, multi-party computations, or other custody methods that provide protections reasonably equivalent to traditional custodians. Imposing disproportional requirements on crypto custodians violates principles of technological neutrality and impedes further growth of the cryptocurrency industry. Laws imposing unjustified, disparate burdens on new technologies violate the First Amendment. The proposed rule similarly threatens to disadvantage crypto relative to traditional finance. The SEC should modify the proposal to minimize regulatory burdens on crypto custodians and foster the continued growth of this burgeoning industry.