On February 15, 2023, the Securities and Exchange Commission (SEC) proposed amendments to rule 206(4)-2 (the custody rule) of the Investment Advisers Act of 1940 and provided a fact sheet for reference — we previously provided a high-level summary of the Proposed Safeguarding Rule.
The comment period expired May 8, 2023, and the SEC received over 150 comment letters. Many institutions expressed concern that the limited 60-day comment period was insufficient to properly evaluate the proposal. Highlighted below are some of the common or important critical comments that the SEC received. This is intended to highlight a few important issues from important industry voices and is not intended to be a comprehensive summary of the comments or of any individual comment letter.
Inadequate SEC Review and Proposed Working Group
- BNY Mellon: “…we suggest that the Commission coordinate an interagency working group with federal and state banking regulators and the Department of Treasury in order to promote regulatory coordination and alignment… we recommend that the Commission either re-propose the Proposal in its entirety, or, at the very least, provide supplemental information and re-open the comment period.”
- American Bankers Association: “In light of the significance of the topic and the proposed number and magnitude of far-reaching changes, we are concerned that the existing comment deadline will not provide us with sufficient time to perform the level of analysis that this proposal warrants. We are also concerned that the Commission is not taking into account that the pace and complexity of its simultaneous rulemaking ultimately may harm, rather than benefit, investors.”
- US Chamber of Commerce: “The Commission has rushed the rulemaking and short-changed its due diligence process. The Commission failed to analyze the impact of the Proposal on various markets, or even consider how the rule could be applied to important asset classes. The economic analysis itself is deficient and massively understates the costs to advisers and their clients… We also remain concerned about the limited amount of time the public has to submit meaningful and thoughtful comments on such a consequential rulemaking proposal…”
Burden on Qualified Custodians
- Association of Global Custodians: “The Proposal would… substantially increase the cost of providing custody services to the clients of investment advisers without any corresponding reduction in custody risk.”
- Kraken: “The Proposed Rule… imposes an SEC federal regulatory scheme without regard to well-established federal and state bank custody law or related regulatory and supervisory principles… The proposed indemnification and insurance requirements of the Proposed Rule are unnecessary and would hamper the adoption of digital assets.”
Whether State-Chartered Trust Companies are “Qualified Custodians”
- Fidelity: “New York trust companies offering custody of digital assets continue to be subject to even more demanding requirements than national banks… Limiting qualified custodians to federally chartered institutions… would artificially and unnecessarily shrink the market for, and quality of, custodial services without generating safety benefits for clients.”
- Equity Trust Company: “…not recognizing the ability of state-chartered trust companies to serve as qualified custodians likely would harm investors by substantially narrowing the pool of entities that may serve this critical function thereby making it more expensive for investors. Because the Safeguarding Proposal proposes to broaden the types of assets under the SEC’s purview, it would also needlessly prevent state-chartered trust companies from continuing to serve and protect investors where those trust companies now have expertise with these asset classes.”
- BitGo: “States that have chartered trust companies to conduct digital asset custodial services… require those trust companies to act as a fiduciary… Consistent with those principles, the OCC has repeatedly affirmed that state-chartered trust companies who provide digital asset custodial services as a fiduciary under applicable state law… could also provide those services as a fiduciary after becoming a national bank.”
Overbroad Expansion of Definition of Assets
- American Investment Council: “The Proposal… is overbroad and includes provisions that do not accurately reflect current or even realistic market practices. The Proposal does not reflect a consideration of the relative risks of misappropriation of different asset classes in light of the significant new costs that it would impose on investment advisers, qualified custodians and advisory clients.”
- JP Morgan Chase: “The Proposed Rule inappropriately expands the concept of custodial obligations to markets where compliance would not be possible and/or costly for investors.”
- National Venture Capital Association: “Both digital assets and privately offered securities are being appropriately safeguarded under fiduciary principles and the basic requirements of the current custody rule… The proposed custody requirements for digital assets are unworkable and… may make it impractical for venture capital funds to self-custody any assets.”
Asset Segregation Requirements Will Harm Institutions and Clients
- NY DFS: “The Proposed Rule poses challenges to the entire banking industry because the application of the asset segregation provision to deposit accounts could impact a bank’s use of cash on its balance sheet, upsetting the time-tested safety and soundness measures banks have traditionally relied upon to operate.”
- Northern Trust: “Demands for active cash management and same-day funds availability have accompanied increasingly complex investment strategies and expanding global markets… It will not be possible for custody banks to provide these types of intraday and overnight advances or contractual settlement if, as the Proposed Rule requires, cash must be segregated by client. Instead, such unused cash will be siloed for use by the affected client, leaving custody banks with insufficient liquidity to provide these necessary advances.”
- BNY Mellon: “This segregation condition within the Proposal does not distinguish client cash from client securities and other assets. If this segregation condition applies to client cash, this would mark a fundamental shift in how bank custodians treat client cash, reshape the balance sheets of bank custodians, and have significant micro and macro implications.”
‘Possession or Control’ Requirement Has Far-Reaching Consequences
- Coinbase: “The Commission uses the requirement to justify banning RIA client trades on crypto exchanges that are not qualified custodians and require pre-funding to execute transactions. This restriction on crypto asset trading does not account for why crypto exchanges pre-fund transactions or the benefits of pre-funding such as real-time settlement.”
- Ropes & Gray LLP: “The Commission… would be asking advisers to completely uproot the ways in which they currently maintain and protect these types of assets for the benefit of their clients – while the Commission has cited (and we know of) no instance in which those current processes have proven to be inappropriate or insufficient to protect such client assets… This requirement would effectively prohibit advisers with custody over client assets… from investing in a broad range of assets.”
- Binance: “…digital asset platforms generally operate under a business model that would be inconsistent with the “possession and control” standard required of qualified custodians under the Proposed Rule. As a result, the Proposed Rule would, as a practical matter, remove registered investment advisers from participating on many, if not all, digital asset platforms.”
Safeguarding
- PricewaterhouseCoopers: “Digital assets… are usually similar to bearer assets in that whoever has access to the private key… has the ability to claim ownership of the digital asset. Therefore, access to and management of the private key are critical to safeguarding digital assets. This would include safeguarding practices over the full private key lifecycle, including key generation, access management, segregation of duties, key backups, and other practices to prevent misappropriation or loss of assets. The current custodial environment for digital assets… is not yet fully developed and is the subject of significant regulatory enforcement activity. The current regulatory regime over custody does not address these unique characteristics and risks of digital assets.”
- Ernst & Young: “…we recommend that the Commission add control objectives that (1) private keys are safeguarded from loss and/or misappropriation, (2) new digital asset onboarding is authorized and considers key requirements and risk factors, and (3) existing digital assets are monitored for potential forks.”
SEC Lacks Authority
- American Bankers Association: “The Proposed Rule exceeds the Commission’s authority. The Commission does not have authority to regulate custody banks. The [Advisers Act] contains no provision that delegates to the Commission the authority to alter sensitive aspects of the operations of custody banks, such as balance sheet structure and risk management, and courts have made clear an agency cannot regulate indirectly through rules governing private contracts where it lacks the authority to regulate directly.”
All comments to the proposed rule can be found here. This post might be updated as the SEC uploads additional comment letters.