Oct. 30, 2023
To the Securities and Exchange Commission: Please consider the following comments expressing concerns with respect to the proposed rule. LACK OF PREDICTABILITY IN THE PROPOSED CUSTODY RULE. The SEC's proposed amendments to the custody rule lack predictability and fail to provide clear guidance on key issues. This violates basic principles of administrative law and undermines the Commission's policy objectives. The Administrative Procedure Act requires agencies to provide fair notice of what their rules require. If the agency does not provide a particular rule or standard by which conduct can be accurately gauged, fair notice is violated and the regulation cannot be enforced. A regulation must be sufficiently specific and definitive enough to provide those within its reach with notice of the conduct it prohibits or requires. See Freeman United Coal Mining Co. v. Fed. Mine Safety & Health Review Comm'n, 108 F.3d 358, 362 (D.C. Cir. 1997). The proposed amendments to the custody rule fail to provide this requisite clarity and predictability in several key respects: The Commission declined to provide guidance on whether and under what circumstances decentralized exchanges and staking arrangements would comply with the rule. This ambiguity leaves advisers unable to accurately determine if common activities violate the rule. The requirement that custodians demonstrate "exclusive control" of crypto assets is vague and potentially unworkable, providing no standards by which custodians could reliably satisfy the rule's demands. The proposal casts doubt on whether any state-chartered trusts could qualify as custodians under the rule but does not directly address the issue. Again, this deprives advisers of the ability to predict whether current custodial arrangements comply. By declining to provide clear guidance on these critical questions, the Commission adopted a proposed rule that lacks the predictability and fair notice required by administrative law. This undermines the Commission's stated policy aims by making compliance impracticable. The Commission should address these deficiencies by providing concrete standards and guidance in any final rule. THE COMMISSION CANNOT ENGAGE IN WARRANTLESS SURVEILLANCE OF CRYPTOCURRENCY TRANSACTIONS WITHOUT VIOLATING THE FOURTH AMENDMENT. The proposed SEC rule requiring investment advisers to maintain custody of client crypto assets with qualified custodians at all times grants the SEC unprecedented access to real-time transactional data for cryptocurrency transactions. This expansive surveillance capability raises significant Fourth Amendment concerns. The Fourth Amendment protects the right of the people to be free from unreasonable searches and seizures by the government. The Supreme Court has long recognized that the Fourth Amendment's protections extend to people's reasonable expectation of privacy. Individuals have a reasonable expectation of privacy in their financial transactions that is protected by the Fourth Amendment. The proposed SEC rule would require advisers to use only qualified custodians that give the SEC continuous, unrestricted access to all transaction data for client crypto assets. This would allow the SEC to engage in a dragnet, suspicionless search of every cryptocurrency transaction executed on behalf of advisory clients. The SEC could data mine this information without any particularized suspicion of wrongdoing, which is an unconstitutional general warrant. The third-party doctrine, which holds that individuals lack a reasonable expectation of privacy in information voluntarily conveyed to third parties, does not diminish the adviser clients' Fourth Amendment interests here. The adviser clients are mandatorily required under the proposed rule to use SEC-approved third party custodians; they are not voluntarily conveying transactional data to those custodians. And the third party doctrine has been heavily criticized, with several Supreme Court justices recognizing its flaws in the digital age. Warrantless, continuous government surveillance chills expressive and associative freedoms protected by the First Amendment. The SEC should adopt a reasonable, balanced approach that protects investors without enabling sweeping, unconstitutional surveillance. The SEC could require periodic reporting of transactional data based on articulable suspicion of wrongdoing. But the proposed rule goes too far and violates reasonable expectations of privacy in financial transactions, which lie at the historic core of Fourth Amendment protection. THE PROPOSED RULE PROVIDES AN UNREASONABLE TIMELINE FOR COMPLIANCE. The SEC's proposed amendments to the custody rule would impose unreasonable timelines for advisers to come into compliance, particularly for advisers that utilize or invest in crypto assets. Advisers would be required to overhaul longstanding business practices and custody arrangements within 12 to 18 months under the proposal. This abbreviated transition period ignores the complexities of selecting qualified custodians for crypto assets and establishing compliant custody arrangements. The costs and burdens to the investment management industry would be immense. The SEC should extend the transition period to at least two to three years. Section 206(4) of the Advisers Act grants the SEC authority to define and prescribe means reasonably designed to prevent investment advisers from engaging in fraudulent or deceptive conduct. 15 U.S.C. § 80b-6(4). However, the proposed transition period is not reasonably designed to achieve the SEC's stated goal of enhanced investor protection. The abbreviated timeline would likely lead to rushed decision-making and hastily constructed compliance frameworks, undermining protections for advisory clients. Moreover, Section 206(4) requires the SEC to consider whether its rules will impose an undue burden on competition. 15 U.S.C. § 80b-6(4). The proposed transition period ignores the competitive burdens it would impose, particularly on smaller advisers that lack the resources to quickly establish compliant crypto custody arrangements. THE TENTH AMENDMENT RESERVES POWERS TO THE STATES TO REGULATE CRYPTOCURRENCY TRANSACTIONS WITHIN THEIR BORDERS. The proposed SEC rule regarding regulation of cryptocurrencies overreaches the federal government's power and infringes on states' rights protected under the Tenth Amendment. The Tenth Amendment provides that ";the powers not delegated to the United States by the Constitution, nor prohibited by it to the States, are reserved to the States respectively, or to the people." The Constitution does not grant the federal government general police powers or the power to regulate all commercial activity. Regulation of financial transactions and markets has historically been an exercise of states' police powers. Cryptocurrency transactions within a state do not necessarily implicate interstate commerce to justify federal regulation under the Commerce Clause. The SEC fails to provide evidence that intrastate cryptocurrency transactions have a substantial effect on interstate commerce. Absent such evidence, the proposed federal regulation infringes on the states' powers reserved by the Tenth Amendment. Furthermore, states have already begun exercising their powers to regulate cryptocurrency transactions within their borders through legislation and enforcement actions. Over 20 states have enacted laws regarding cryptocurrency regulation, licensing requirements, or promotion of blockchain technology and cryptocurrency businesses. State regulators have also brought enforcement actions against fraudulent cryptocurrency schemes. This state regulation demonstrates that the states have acted pursuant to their reserved powers to regulate local cryptocurrency activity. The SEC should not adopt a rule that exceeds the federal government's constitutional authority and displaces states' efforts to regulate cryptocurrency transactions within their jurisdictions. The Tenth Amendment reserves the general police power over local financial transactions to the states. The SEC should acknowledge the states' regulatory authority over intrastate cryptocurrency activity under the Tenth Amendment. THE RULE IMPOSES INCREASED COSTS FOR QUALIFIED CUSTODIANS AND MARKET PARTICIPANTS. The SEC's proposed amendments to the custody rule would impose substantial costs on qualified custodians and market participants seeking to comply with the new requirements, which may ultimately reduce services and investment options available to retail investors. Most notably, the proposed rule's heightened requirements surrounding "exclusive possession or control" of digital assets present significant technological and operational hurdles for qualified custodians. As the release acknowledges, demonstrating exclusive possession or control of cryptocurrencies may be challenging due to their ability to be transferred simply by anyone with access to the private keys. While some custodians are developing proprietary solutions to establish exclusive control, these systems are extremely expensive to build and maintain. The costs associated with developing this specialized technology would inevitably be passed down to asset managers and advisory clients in the form of higher fees, reducing access to digital asset investments. In addition, the proposed required assurances between advisers and qualified custodians impose impracticable contractual obligations given the novelty and risks inherent in cryptocurrency custody. The broad indemnification requirements fail to account for the nascency of digital asset custody solutions and the difficulties in preventing loss due to cyberattacks, technological failures, or human error. Forcing qualified custodians to make overly expansive guarantees could discourage participation and competition in digital asset custody markets to the detriment of investors. Finally, the proposed amendments may lead custodians to exit the digital asset custody business entirely due to heightened compliance burdens, decreased profit margins, and increased legal risks. A reduction in the number of qualified custodians focused on digital asset custody would concentrate assets in a few select providers, reducing redundancy and increasing systemic risks. Ultimately, the complexities and costs associated with compliance will constrain development and availability of digital asset custody services. Rather than impose prescriptive technological mandates, the SEC should take a principles-based approach that allows qualified custodians flexibility to demonstrate possession and control commensurate with the risks of particular digital assets. This would encourage further innovation and allow custodians to tailor solutions that expand investor access to digital asset markets while appropriately safeguarding assets. The SEC should reconsider overly burdensome requirements of the proposed rule that would stifle competition and raise costs for market participants. THE PROPOSED RULE LACKS CLARITY ON WHAT CONSTITUTES “CUSTODY” AND “QUALIFIED CUSTODIAN” STATUS FOR DIGITAL ASSETS. The proposed rule lacks clarity on what constitutes "custody" and "qualified custodian" status for digital assets. The proposing release states that custody turns on "possession or control" of client assets, which is defined as "holding assets such that the qualified custodian is required to participate in any change in beneficial ownership of those assets." However, it is unclear how this standard would apply to digital assets, where "possession or control" differs fundamentally from traditional securities. Must a custodian hold the private keys to demonstrate "exclusive control"? Can multi-party arrangements like sharding meet the control test? The lack of guidance on these critical questions leaves both investment advisers and potential qualified custodians in an untenable position. Relatedly, the proposing release questions whether proof of "exclusive control" over digital assets is even possible, again without providing meaningful guidance on what specific custody models or controls would satisfy regulators. This lack of clarity is compounded by Chairman Gensler's accompanying statement casting doubt on whether crypto platforms could ever serve as qualified custodians. State-chartered trusts are not technically prohibited under the proposed rule, but without further guidance on satisfying control requirements, they are effectively precluded from qualifying. Finally, the proposing release suggests that investment advisers who custody any digital assets may already be in violation of the custody rule, since most crypto trading platforms do not meet the qualified custodian definition. However, the current rule only applies to funds and securities, not all digital assets. This expansive interpretation again leaves advisers without fair notice of their compliance obligations. While the goals of enhanced investor protection are laudable, this lack of clarity effectively makes compliance with the proposed rule impossible. I urge the Commission to provide additional guidance on the issues outlined above before moving forward with amendments, so investment advisers have a workable framework for safeguarding client assets. The public interest is best served by clear, workable regulations, not broad mandates without implementation specifics. I welcome the opportunity to further discuss these concerns. AMBIUTITY IN THE PROPOSED RULE UNDERMINES CLARITY AND CERTAINTY, WHICH IS DETRIMENTAL TO THE GROWTH AND REGULATION OF CRYPTO ASSETS. The proposed amendments to Rule 206(4)-2, redesignated as Rule 233-1, under the Investment Advisers Act of 1940 by the Securities and Exchange Commission (SEC), harbor substantial ambiguities that critically undermine the objective of clear and precise regulation necessary for the growth and proper functioning of the crypto assets space. As shown below, the vagueness encapsulated in the proposed rule may result in unintended consequences, misinterpretations, and regulatory overreach, which could stifle innovation and hamper the burgeoning crypto industry. Definition and Scope of "Custody": The proposed amendments expand the definition of "custody" to encompass a broader spectrum of assets, notably including crypto assets. However, the notion of “possession or control” as outlined is ambiguous in the context of crypto assets, which inherently possess unique characteristics dissimilar to traditional assets. This ambiguity undermines the certainty necessary for Registered Investment Advisers (RIAs) and other stakeholders in adapting to the new regulatory framework. The rule's expanded definition could potentially encompass novel custody arrangements like key sharding or multi-signature arrangements, yet the lack of clear guidance on these arrangements leaves a void of uncertainty which is detrimental to compliance and innovation. Exclusive Possession or Control Dilemma: The proposed rule necessitates an exclusive “possession or control” over crypto assets by qualified custodians. The uniqueness of crypto assets, particularly the irretrievability of assets in the absence of private keys, presents a quandary in defining and demonstrating exclusive control. The rule does not sufficiently address how this exclusive control should be demonstrated, especially in instances where both the custodian and the client hold copies of private keys. Qualified Custodian Status for State-Chartered Trust Companies: The rule ambiguously impacts state-chartered trust companies' status as "qualified custodians," which is critical for entities that custody crypto. The vagueness could potentially marginalize state-chartered trust companies, skewing the market in favor of federally regulated national banks and stifling competition. Compliance Roadmap for Unsupported Crypto Assets: The rule vaguely addresses the compliance pathway for RIAs wishing to invest in crypto assets unsupported by qualified custodians. The lack of clear guidelines might inadvertently prohibit RIAs from holding certain crypto assets on behalf of clients, thereby limiting investment opportunities. Staking and Other Blockchain Mechanisms: The rule's application to staking remains unclear, leaving RIAs in a regulatory grey area. The ambiguity surrounding whether the staking arrangements, either custodial or non-custodial, satisfy the rule's requirements is a glaring oversight given the popularity of staking as a means of earning passive income on crypto assets. Clarity on Crypto Trading Platforms: The rule's impact on the use of centralized and decentralized crypto trading platforms by RIAs remains unclear, potentially pushing markets onto decentralized exchanges without addressing the associated risks. Foreign Financial Institutions Compliance: The rule introduces onerous requirements for foreign financial institutions, however, it does not provide clear guidance on how these institutions can achieve compliance, particularly in the context of crypto assets custody. This proposed rule, in its current form, lacks the requisite clarity and precision, which is fundamental to fostering a regulatory environment conducive for innovation, compliance, and growth within the crypto assets sector. It's imperative that the SEC revisits these ambiguities to provide clear, unambiguous guidelines that will ensure a balanced regulatory framework for crypto assets. The ambiguities, if unaddressed, may inadvertently stifle the burgeoning crypto industry, thwart innovation, and deter the engagement of traditional financial institutions in the crypto space, which is contrary to the broader objectives of fostering transparency, competition, and innovation in financial markets. RESTRICTING THE USE OF TECHNOLOGICALLY ADVANCED CUSTODIAL MODELS MAY ENCOURAGE FRAUD. The proposed restrictions on the use of digital asset custodians would encourage fraudulent practices by forcing advisers to rely on less secure legacy custodial models. The immutability and transparency of distributed ledgers combined with innovations like multi-party computation provide unparalleled security compared to existing qualified custodians. By inhibiting the use of digital asset native custodians, the proposed rule creates incentives to custody assets in ways more susceptible to fraud, theft, and loss. True investor protection requires embracing custodial innovation, not restricting it. The proposed rule should allow any custodian demonstrating technologically superior security and controls over private keys, even where advisers or clients hold encrypted shards, to qualify. The Commission should work with industry to establish appropriate frameworks recognizing these advances rather than relying on outdated notions of exclusive possession and control. Its role is not to pick winners and losers among custodial models but to encourage those that best safeguard client assets against fraud and loss. The proposed rule fails that test. THE PROPOSED RULE IMPEDES THE ADOPTION OF INNOVATIVE CRYPTO CUSTODIAL SOLUTIONS. The SEC's proposed amendments to the custody rule fail to provide a clear pathway for innovative crypto custodial solutions to achieve "qualified custodian" status. This impedes the timely adoption of custodial best practices tailored to crypto assets, depriving investors of protections optimized for this new asset class. The custody rule should encourage, not hinder, innovation that protects investors. While the Proposal enumerates important custodial safeguards, it establishes opaque criteria for demonstrating "exclusive possession or control" over crypto assets that few, if any, existing custodians likely satisfy. This vagueness casts doubt on even prudent custodians who segregate client assets and maintain stringent protocols. Rather than categorically questioning whether any crypto platform could become a qualified custodian, the Commission should engage with industry stakeholders to develop workable frameworks. The Commission could, for instance, issue transitional relief or no-action assurances to crypto custodians adopting specified controls, as it has to facilitate innovation in other novel areas. Congress designed the Advisers Act to empower the Commission with flexibility to adapt rules to changing markets. See SEC v. Capital Gains Research Bureau, Inc., 375 U.S. 180, 186 (1963). Rather than ossifying custodial requirements that inhibit crypto-tailored solutions, the Commission should allow dynamic innovation that safeguards consumers. See Prohibition of Fraud by Advisers to Certain Pooled Investment Vehicles, 72 Fed. Reg. 44756, 44757 (Aug. 9, 2007) ( opted not to tightly prescribe specific controls to "maintain flexibility" given quickly evolving markets). Established law permits the Commission to take a flexible, collaborative approach to enabling innovation. The Commission should invoke that flexibility here to encourage crypto custodians to implement best practices, not construct opaque obstacles that only entrench less-secure status quo options. THE PROPOSED RULE ERODES PUBLIC TRUST IN CRYPTO ASSETS AND THE COMMISSION. The proposed SEC rule regarding custody of crypto assets is overly broad, exceeds the SEC's authority, and will erode public trust in both crypto assets and the SEC. The rule proposes to regulate all "assets," including crypto assets that are not securities. This overreach exceeds the authority granted to the SEC by Congress in the Dodd-Frank Act, which amended the Investment Advisers Act. The legislative history indicates Congress did not intend to expand the types of assets subject to custody rules or grant the SEC new authority over custodial practices. By attempting to regulate non-security crypto assets, the SEC is improperly asserting jurisdiction beyond what Congress intended. The proposed qualified custodian requirements also impose unreasonable burdens that will discourage participation by crypto-native custodians. This will reduce protections for advisory clients, directly contradicting the SEC's stated goals. The requirements ignore unique technical aspects of crypto assets that enable advanced security features not available for traditional assets. Imposing legacy frameworks designed for traditional assets harms innovation and deprives investors of opportunities. Rather than take a balanced approach that accommodates crypto's novel technological aspects, the proposal takes an overly restrictive view that lacks nuance. This blanket skepticism suggests a bias against crypto assets that is at odds with the SEC's mission to maintain fair, orderly, and efficient markets. Imposing excessive limitations out of distrust for new technologies erodes public confidence in both crypto markets specifically and the SEC generally. Investors may view the SEC as opposed to innovation. And by exceeding its authority, the SEC undermines its own legitimacy as a regulator. This overreach may spur protracted litigation that further hampers market clarity. The SEC should act within the scope of authority granted by Congress and take a technology-neutral approach. The unique properties of crypto can strengthen protections when accommodated appropriately. Working collaboratively with industry will lead to more balanced policies that allow innovation while effectively achieving the SEC's objectives. This inspires greater public trust in emerging technologies and the SEC itself. THE PROPOSED RULE SLOWS INNOVATION AND ADAPTATION TO CHANGING CONSUMER PREFERENCES. The SEC's proposed rule changes threaten to stifle innovation and fail to adapt to changing consumer preferences surrounding cryptocurrencies. While the goal of enhanced investor protection is laudable, the rigid requirements imposed may prevent state-chartered trusts from qualifying as custodians even when utilizing proper security protocols. This conflicts with legislative intent to include state-chartered trusts as qualified custodians under the Advisers Act's definition of "bank." 15 U.S.C. §80b-2(a)(2). Further, the proposed requirements for "exclusive possession or control" over crypto assets do not account for current custody models utilized by federally regulated custodians. Rather than adopt a technology-neutral approach focused on security outcomes, the proposal rigidly mandates physical possession of private keys. This ignores the reality that exclusive control can be demonstrated even when private keys are not solely held by the custodian. The demand for crypto assets has skyrocketed in recent years, with consumers entrusting over $100 billion to crypto custodians. This growth reflects changing consumer preferences which regulations should accommodate, not restrict. The proposed rule's hurdles for state-chartered trusts contrast with the OCC's more innovation-friendly approach of allowing national banks to custody crypto assets. That model provides a template for appropriately balancing innovation and security. Indeed, the OCC has supervisory authority to ensure national banks implement proper protocols like cold storage and encryption. The SEC should take a similar functional approach focused on security outcomes rather than physical possession of keys. Moreover, the proposed assumption that existing crypto custody likely violates the custody rule is overbroad. The custody rule applies only to securities, so individualized analysis is required to determine if a particular token is a security. Categorical assumptions ignore the nuances of how crypto assets are utilized. For example, the SEC itself has acknowledged Ether is not a security based on its decentralized network. In sum, the SEC should modify the proposal to provide flexible avenues for state-chartered trusts to demonstrate they can securely custody crypto assets in a manner that adapts to changing consumer preferences and technological innovation. This includes omitting prescriptive key possession mandates and clarifying how state trusts can satisfy "qualified custodian" requirements. Such an approach would align with legislative intent while still achieving the SEC's goals of enhancing investor protection. THE PROPOSED RULE CREATES DIFFICULTY ENSURING CONSISTENCY IN INTERNATIONAL REGULATORY ALIGNMENT. The SEC's proposed amendments to the custody rule create significant difficulty in ensuring consistency between U.S. and international crypto asset regulations. Differing regulations across jurisdictions increase costs and uncertainty for market participants, and undermine global harmonization efforts. The SEC should modify the proposal to avoid conflict with established international standards. International alignment is vital to efficient cross-border crypto asset activity. Disparate rules increase costs as firms attempt to comply with conflicting requirements. See Morrison v. Nat'l Australia Bank Ltd., 561 U.S. 247, 255 (2010). Moreover, contradictory regulations create uncertainty that chills beneficial market activity. See Central Bank of Denver v. First Interstate Bank of Denver, 511 U.S. 164, 190 (1994) (Stevens, J., dissenting) (noting how regulatory uncertainty deters valuable commerce). Here, the proposal's "possession or control" requirement for custodians of crypto assets diverges from international norms. The Financial Action Task Force (FATF), an international standard-setting body, takes a functional approach that examines whether the custodian performs core custody functions like transaction verification without mandating exclusive possession of private keys. See FATF Report, Regulation of Virtual Asset Service Providers (2020), at 59. Imposing stricter requirements out of step with FATF guidance will hamper international consistency. Further, the proposal's assurance requirements may conflict with data privacy laws in other jurisdictions. See Commission Interpretive Release; Request for Comments on Application of Investment Advisers Act Custody Rule to Cryptocurrency, Release No. IA-5930 (Dec. 12, 2022), at 236-37 (acknowledging potential foreign law barriers). Forcing custodians to violate local regulations threatens international coordination. Finally, the proposal introduces uncertainty by questioning whether "new entrants" like state-chartered trusts can serve as qualified custodians. However, entities like Anchorage Digital Bank have secured state trust charters specifically to provide crypto custody services consistent with FATF's framework. See OCC Approves Anchorage Digital Bank to Operate as a National Digital Asset Bank, NR 2022-98 (Nov. 18, 2022). Casting doubt on these entities' custodian status jeopardizes international consistency. Accordingly, the SEC should reconsider aspects of its proposal that conflict with international standards and inhibit global coordination of crypto asset oversight. The SEC could require functional compliance with core custody duties instead of mandating exclusive private key control. It could also clarify that properly regulated state-chartered custodians qualify, provided they satisfy FATF's guidance. Such changes would promote crucial international consistency for crypto asset regulation.