Oct. 30, 2023
To whom it may concern: Please consider the concerns outlined below in evaluating the Commission’s proposed rule. 1. THE COMMERCE CLAUSE LIMITS FEDERAL REGULATION OVER INTRASTATE CRYPTOCURRENCY TRANSACTIONS. The proposed SEC rule regarding custody of digital assets exceeds the SEC's authority under the Commerce Clause of the U.S. Constitution. The Commerce Clause grants Congress the power to regulate interstate commerce, but not purely intrastate commerce that does not substantially affect interstate commerce. The SEC's proposed regulation of digital asset custody services provided by state-chartered companies to in-state customers constitutes an overreach under the Commerce Clause. The custody and transfer of digital assets within a single state's borders does not inherently constitute interstate commerce merely because the digital assets reside on distributed networks. Constitutional law recognizes that intrastate rail and truck shipments are not interstate commerce simply because they cross state lines en route to their ultimate local destinations. See Baltimore & Ohio Sw. R.R. Co. v. Settle, 260 U.S. 166 (1922). Similarly, custody and transfers of in-state residents' digital assets by state-chartered companies should not be considered interstate commerce based solely on the nature of blockchain networks. In addition, state-level digital asset custody services do not substantially affect interstate commerce under the prevailing aggregation doctrine. The services involve assets and activities that occur solely within one state. See Wickard v. Filburn, 317 U.S. 111 (1942). Any potential impact on interstate commerce via price effects on digital asset markets would result only from the aggregate effect of all states' intrastate custody services. The Commerce Clause does not grant Congress power over local activities merely because, in the aggregate, they have downstream effects on interstate markets. See United States v. Lopez, 514 U.S. 549 (1995). Absent a direct and substantial nexus with interstate commerce, the proposed federal regulation over fully intrastate digital asset custody services exceeds constitutional limits on federal power. The custody rule should exclude state-chartered companies providing bona fide custody services solely to in-state customers using reasonable verification methods. States retain police powers over such intrastate services. The Commerce Clause prohibits federal encroachment into this traditionally state-regulated area absent a direct and material impact on interstate commerce. 2. THE WEAKNESSES IN THE SEC’S PROPOSAL CREATE REGULATORY GAPS THAT COMPROMISE INVESTOR PROTECTIONS. The SEC's proposed amendments to Rule 206(4)-2 would expand the definition of "custody" of client assets to encompass cryptocurrency, but the proposal falls short of providing a comprehensive regulatory framework to protect investors. The proposed rule fails to establish clear custody standards for cryptocurrency that ensure client assets are properly safeguarded. The SEC acknowledges "it may be difficult to actually demonstrate exclusive possession or control of crypto assets." This ambiguity leaves unresolved whether models like multisig wallets meet custody requirements. Without precise guidelines, advisers may custody cryptocurrency in ways that inadequately protect clients from theft or loss. The SEC should establish custody standards tailored to cryptocurrency keys and wallets. The proposal lacks requirements for auditing cryptocurrency held in custody. Unlike with traditional assets, the proposed rule does not compel periodic audits to verify the existence and ownership of cryptocurrency. Regular audits by qualified professionals are essential to confirming assets match books and records. The SEC must mandate rigorous auditing of custodied cryptocurrency. The proposal does not provide oversight protocols for sub-custodians. The rule requires advisers to obtain assurances from qualified custodians, but lacks procedures for evaluating sub-custodians of cryptocurrency. Sub-custodian risk is heightened with cryptocurrency kept in global cold storage vaults. The SEC should implement accreditation and examination programs for sub-custodians of cryptocurrency. The rule does not adequately address insurance for custodied cryptocurrency. The proposal requires qualified custodians to indemnify clients only for "losses caused by the custodian's negligence, recklessness, or willful misconduct." It does not compel custodians to maintain insurance for cyber breaches or employee theft not arising from misconduct. Insurance protections should be strengthened for this asset class. The SEC must address these regulatory gaps to establish a custody framework that provides substantive protections tailored to cryptocurrency. Meaningful standards, oversight, auditing and insurance are needed to safeguard investor assets. The current proposal falls short in implementing robust protections and oversight for this rapidly growing asset class. 3. THE PROPOSED RULE FAILS TO ADEQUATELY INCORPORATE STAKEHOLDER PERSPECTIVES. The SEC's proposed amendments to the custody rule, Rule 206(4)-2, fail to adequately incorporate stakeholder perspectives. While the proposal states it will "strengthen and modernize the Custody Rule," the proposal does not provide evidence that the SEC meaningfully engaged with industry stakeholders to understand current practices, concerns, and potential unintended consequences. The Administrative Procedure Act (APA) governs the regulatory process for federal agencies like the SEC. Under the APA, agencies must provide notice of proposed rules and give interested parties an opportunity to participate in the rule making through submission of written comments. See 5 U.S.C. § 553. The APA also requires the agency to consider and respond to significant comments received. See Perez v. Mortg. Bankers Ass'n, 575 U.S. 92, 96 (2015) ("An agency must consider and respond to significant comments received during the period for public comment."). While the SEC provided the requisite notice and comment period, the proposal itself does not reflect meaningful consideration of industry concerns or current market realities. This suggests the SEC failed to adequately engage with stakeholders as part of the rulemaking process. The crypto asset industry is most directly impacted by the proposed amendments. However, the proposal does not indicate that the SEC sufficiently considered the perspectives of market participants like crypto exchanges and custody providers. For example, the proposal casts doubt on whether any crypto custody provider could meet the "exclusive possession or control" requirement, without citing evidence this concern was raised by industry. The proposal also repeatedly references "new entrants" in the custody space without describing efforts by the SEC to learn about their existing controls and protections. Additionally, the proposal leaves critical questions about staking unanswered and fails to solicit stakeholder input on staking through the comment process. This suggests the SEC did not make reasonable efforts to understand current staking market practices before proposing amendments that could significantly disrupt the industry. 4. THERE IS A LACK OF CLEAR GUIDANCE ON QUALIFIED CUSTODIAN STATUS FOR STATE-CHARTERED TRUST COMPANIES CUSTODYING CRYPTO ASSETS. The SEC's proposed amendments to the custody rule fail to provide clear guidance on whether state-chartered trust companies that custody crypto assets can qualify as "qualified custodians" under the rule. While the proposal leaves open the technical possibility for state-chartered trusts to serve as qualified custodians, statements by SEC Chair Gensler cast serious doubt on this. The lack of clear guidance raises concerns under the Administrative Procedure Act. Under the APA, an agency must provide sufficient factual detail and rationale for its rules to permit interested parties to comment meaningfully. See Home Box Office v. FCC, 567 F.2d 9, 35 (D.C. Cir. 1977). By failing to directly address whether state-chartered crypto custodians could qualify under the rule, despite their prevalent role in the market, the SEC has denied interested parties a meaningful opportunity to comment as required by the APA. See id. at 35-36. While agencies have discretion in framing their proposed rules, they abuse that discretion by omitting critical details needed for informed comment. See Horsehead Res. Dev. Co. v. EPA, 130 F.3d 1090, 1095 (D.C. Cir. 1997). Here, the lack of clarity on state-chartered crypto custodians precludes informed comment on a significant issue under the rule. The SEC should provide clear guidance on this issue in any final rule. 5. LIMITED STAKEHOLDER ENGAGEMENT REGARDING CRYPTO ASSETS. The SEC's proposed amendments to the custody rule fail to adequately engage with impacted stakeholders regarding the custody of crypto assets. While the SEC requested general comments on the proposed rule, it did not put forth any specific questions related to crypto custody models, qualifications for crypto custodians, or unique considerations for crypto assets. This lack of stakeholder engagement is concerning given that applying the custody rule to crypto assets raises novel issues that differ fundamentally from the custody of traditional securities. The Administrative Procedure Act (APA) requires agencies to publish notice of proposed rules in the Federal Register and provide interested parties an opportunity to comment (5 U.S.C. § 553(b)-(c)). The purpose is to obtain informed responses and feedback from impacted stakeholders before finalizing a rule. While the SEC published the proposed amendments, it failed to provide meaningful opportunities for engagement specifically regarding crypto custody. The D.C. Circuit has held that agencies violate the APA when they do not disclose critical information underlying a proposed rule, impeding stakeholders' ability to comment meaningfully. See Owner-Operator Indep. Drivers Ass'n v. Fed. Motor Carrier Safety Admin., 494 F.3d 188, 199 (D.C. Cir. 2007). Here, by not including questions or requesting feedback on crypto custody, the SEC has inhibited informed comments from crypto custodians, investors, and other stakeholders. Further, Executive Order 13563 directs agencies to seek participation from those impacted before imposing new costs through regulation. The amendments would impose significant new burdens on RIAs and custodians dealing in crypto assets. By not directly engaging with these parties, the SEC has acted counter to the Order's requirements. The unique attributes of crypto assets necessitate industry participation before imposing prescriptive custody requirements. The SEC should re-propose the amendments with specific questions tailored to crypto custody and provide adequate time for informed responses before moving forward. 6. THE SEC FAILED TO CONDUCT SUFFICIENT ECONOMIC ANALYSIS AND OVERSIGHT IN PROPOSING AMENDMENTS TO RULE 206(4)-2, RESULTING IN A RULE THAT INTRODUCES UNNECESSARY BURDENS AND AMBIGUITY. The SEC is required by law to consider the economic consequences of its rules and evaluate alternatives before adopting regulations. However, the SEC has failed to conduct this analysis sufficiently for its proposed amendments to Rule 206(4)-2 under the Investment Advisers Act. Specifically, the SEC neglected to adequately assess the costs and benefits of the proposed rule and failed to properly consider reasonable alternatives. The SEC must conduct an economic analysis under the National Securities Markets Improvement Act of 1996 (NSMIA). NSMIA amended the Securities Act, the Securities Exchange Act and Investment Company Act to require the SEC to consider efficiency, competition, and capital formation whenever it engages in rulemaking. It must also evaluate the impact a new rule would have on competition and publish its analysis. See National Securities Markets Improvement Act of 1996, Pub. L. No. 104-290, 110 Stat. 3416 (1996); 15 U.S.C. § 77b(b). Additionally, the Administrative Procedure Act requires agencies to consider costs and benefits before proposing regulations. It states that an agency must examine "the problem at which the regulation is directed," explore "alternative approaches" and weigh "the costs and benefits of the proposed regulation." Perez v. Mortg. Bankers Ass'n, 575 U.S. 92, 96 (2015). Here, the SEC's analysis falls short on both fronts. Its 222-page proposal includes just two pages discussing costs and benefits. The analysis is cursory and lacks substantive evidence to support the SEC's claims. For example, the SEC speculates the rule could spur more qualified custodians to enter the market but provides no data to back up this assertion. The SEC also fails to adequately explore alternatives. Its discussion of alternatives amounts to three short paragraphs broadly summarizing other approaches. This lack of economic analysis means the SEC is proposing a rule without fully understanding its impacts. The proposal would extend custody requirements to all digital assets and impose a strict "control" test without analyzing the costs and benefits. The SEC even acknowledges implementing exclusive control over cryptocurrencies may not be possible. Yet it provides no evidence showing existing custody models are inadequate or clients are being harmed. Imposing rigid requirements without proper oversight will stifle innovation and impose unnecessary burdens on advisers. The SEC must conduct further economic analysis consistent with its statutory obligations. This includes rigorously examining costs and benefits, exploring alternatives, and avoiding ambiguity that will prove unworkable. Doing so will lead to a better rule that meets regulatory objectives without undue burden. The SEC should withdraw this proposal until it can complete a thorough oversight process. 7. THE RULE’S LACK OF DEFINED TERMS WILL RESULT IN UNCERTAINTY AND IMPLEMENTATION CHALLENGES FOR INVESTMENT ADVISERS. The proposed amendments to the custody rule lack clear definitions of key terms, which will lead to uncertainty and impede investment advisers' ability to understand and implement the revised requirements. Specifically, the proposed rule does not adequately define “exclusive possession or control,” “crypto assets,” or “staking,” which are critical for determining when an investment adviser has custody and what assets must be held by a qualified custodian. This ambiguity leaves advisers without sufficient notice of what is required for compliance. The proposed rule states that custody turns on "possession or control" of client assets, which requires the ability to effect a change in beneficial ownership. However, "exclusive possession or control" is undefined. The proposing release describes crypto assets as having unique characteristics that may make exclusive control difficult or impossible to demonstrate. Without defining exclusive control, advisers are left to guess whether commonly used crypto custodial arrangements like sharding meet the standard. The proposed rule covers "crypto assets," also undefined. Thousands of crypto assets exist, with more created daily, and it is unclear which fall under the custody rule. Defining crypto assets by reference to existing securities law definitions would provide needed clarity. Finally, "staking" is not defined. Staking services and protocols vary, so guidance is needed on whether staking keys alone constitute control and when validator actions could result in custody by the validator. Undefined, advisers cannot evaluate when staking triggers custody rule obligations. The lack of definitions violates an agency's obligation under the Administrative Procedure Act to provide notice of proposed rule changes, inhibiting the ability to comment meaningfully. Courts have found ambiguity in proposed rules arbitrary and capricious. See, e.g., Housing Study Group v. Kemp, 736 F. Supp. 321 (D.D.C. 1990). The SEC should provide clear definitions in any final rule. 8. THE PROPOSED RULE DUPLICATES OTHER REGULATIONS GOVERNING QUALIFIED CUSTODIANS AND IMPOSES ADDITIONAL RULES THAT ARE UNNECESSARY. Qualified custodians like banks and broker-dealers are already subject to strict regulations regarding custody of client assets. For example, Rule 15c3-3 under the Securities Exchange Act requires broker-dealers to safeguard customer securities and cash. Rule 15c3-3 mandates segregation and periodic accounting of customer assets. Similarly, the Customer Protection Rule requires banks to implement controls and segregate accounts to protect customer assets. These existing regulations provide significant protections without the need for additional requirements under the custody rule. Subjecting qualified custodians to overlapping regulations governing custody and asset segregation creates redundancies without meaningfully enhancing protections. As the SEC itself has recognized, qualified custodians are heavily regulated institutions subject to registration, oversight and examination by regulators. The proposed rule would require advisers to obtain specific written assurances from qualified custodians regarding standards of care, liability, and other matters. However, regulations like SIPA already provide assurances regarding broker-dealer liability. Subjecting qualified custodians to additional, overlapping requirements under the custody rule provides little incremental benefit while increasing costs and uncertainty. The SEC should not add obligations indirectly through the custody rule that have already been considered and rejected in the directly applicable context. Imposing additional regulations on qualified custodians indirectly through the custody rule undermines regulatory efficiency and consistent standards. 9. THE NINTH AMENDMENT PROTECTS UNENUMERATED RIGHTS RELATED TO CRYPTOCURRENCY TRANSACTIONS NOT SPECIFICALLY MENTIONED IN THE CONSTITUTION. The proposed SEC rule requiring registered investment advisers to use qualified custodians that have exclusive possession and control of client cryptocurrency assets contravenes the spirit of the Ninth Amendment. While the Constitution does not specifically mention cryptocurrency transactions, the Ninth Amendment states: "The enumeration in the Constitution, of certain rights, shall not be construed to deny or disparage others retained by the people." The people have an unenumerated right to engage in cryptocurrency transactions and use novel methods to control their own digital assets. Requiring advisers to only use qualified custodians that maintain exclusive possession and control of private keys would prevent clients from using multi-signature or social recovery wallets, which allow clients to maintain backup access to their own assets. This violates the Ninth Amendment by denying clients their retained right to exercise direct control over their cryptocurrency wallets and keys. The Constitution was designed to protect fundamental liberties and restrict only specific, limited powers to the federal government. The Ninth Amendment guards against a latitude of interpretation that would allow the government to claim unchecked powers not delegated to it. The SEC should narrowly interpret its authority under the Advisers Act in a manner that respects the people's Ninth Amendment right to freely transact in cryptocurrency and control their own digital assets without excessive government interference. Rather than mandate exclusive custodial possession of private keys, the SEC should adopt a principles-based approach that allows advisers flexibility to use novel cryptocurrency controls that serve clients' best interests. This would comport with both the Ninth Amendment and the SEC's mission to protect investors. 10. THE PROPOSED RULE WOULD LEAD TO INEFFICIENT RESOURCE ALLOCATION. The SEC's proposed amendments to the custody rule under the Investment Advisers Act would lead to inefficient allocation of resources and impose unnecessary costs on registered investment advisers (RIAs). The proposed rule is overly restrictive and fails to recognize the ability of qualified custodians to safely custody cryptocurrency using novel solutions such as multi-signature arrangements. By imposing prescriptive requirements for "exclusive" possession or control of cryptocurrency assets, the rule would limit the emergence of diverse and competitive custody models. This runs counter to the SEC's mission to facilitate capital formation and foster innovation in financial markets. Rather than taking a technology-neutral approach focused on safeguarding client assets, the proposal mandates outdated custody models that are ill-suited for digital assets. This restricts capital flows into novel crypto-networks and discourages further blockchain innovation. The costs of compliance will also fall disproportionately on smaller RIAs, reducing competition in the investment advisory industry. As noted in comment letters, the SEC should take a more flexible, principles-based approach that does not disadvantage new entrants or favor legacy institutions. Rigid requirements that fail to consider practical realities of cryptocurrency custody will impede development of crypto markets to the detriment of investors and the broader economy. The proposed rule conflicts with SEC v. W.J. Howey Co., 328 U.S. 293 (1946), which held that substance over form should govern when determining whether an instrument is a security. Similarly, Section 2(a)(36) of the Investment Company Act defines "security" broadly to include any interest commonly known as a security. Rather than classify crypto assets based on their underlying substance and risks, the proposal indiscriminately regulates all cryptocurrency, diverting resources away from true investment contracts requiring SEC oversight. This expansive approach departs from past SEC guidance taking a case-by-case approach to analyzing cryptocurrency. See SEC Release No. 81207 (July 25, 2017). Congress enacted the Investment Advisers Act to mitigate conflicts of interest and prevent fraud -- not to dictate rigid custody models. 15 U.S.C. § 80b-2(a). Absent further evidence that existing qualified custodians cannot safely custody crypto assets, the proposed amendments lack basis in the Advisers Act and will hinder development of the digital asset market. The SEC should reconsider its prescriptive approach to crypto custody and take a more technology-neutral stance focused on safeguarding client assets. This will promote efficient capital allocation, foster innovation, and further the agency's mission to protect investors. 11. THE PROPOSED RULE CREATES UNFAIR TREATMENT DUE TO REGULATORY INCONSISTENCY ACROSS COUNTRIES. Global regulatory inconsistency of cryptocurrency has resulted in unfair treatment and confusion for market participants. The Proposal's imposition of “exclusive possession or control” and overly stringent qualified custodian requirements fails to account for reasoned approaches taken by other jurisdictions and imposes unreasonable burdens. International coordination and recognition of reasoned global regulatory efforts is needed to provide fair treatment, clarity, and consistency. The Proposal disregards more flexible approaches adopted by major jurisdictions. The UK's Financial Conduct Authority recognizes “joint control” custody models where both the custodian and client hold keys. The European Union's regulatory regime permits qualified custodians to demonstrate controls through a range of methods. Rather than coordinate, the Proposal creates inconsistent obligations and unfair burdens. Global regulatory coordination has proven effective in other contexts and should be pursued here. The Basel Committee's supervision standards for internationally active banks are applied reasonably consistently across jurisdictions. The International Organization of Securities Commissions' (IOSCO) Objectives and Principles of Securities Regulation provide a framework for cooperative regulation internationally. IOSCO has already undertaken efforts to identify issues posed by crypto-assets, but its findings urge flexible, proportional regulation. The SEC should pursue engagement with IOSCO to develop consistent international regulatory approaches before unilaterally imposing rigid rules. The SEC cannot regulate the entire global crypto market alone. Imposing inflexible rules out of step with worldwide regulatory efforts will only cause confusion and needlessly unfair burdens on U.S. market participants. The SEC should instead pursue regulatory coordination and flexibility, recognizing qualified custodians that demonstrate substantial control protections without requiring unrealistic “exclusive possession.” Only through internationally coordinated efforts can fair treatment and effective oversight be achieved. The SEC should revise its proposal accordingly. For more information, see: 1 UK FCA PS19/22 Guidance on Cryptoassets Feedback and Final Guidance to CP 19/3 (July 2019). 2 EU Pilot Regime Regulation 2020/1503 Art. 4. 3 Basel Committee on Banking Supervision, Core Principles for Effective Banking Supervision (Sep. 2012). 4 IOSCO, Objectives and Principles of Securities Regulation (May 2017). 5 IOSCO Research Report on Financial Technologies (Fintech) (Feb. 2017).