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

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.