What has happened?
The U.S. Securities and Exchange Commission and the Financial Industry Regulatory Authority (FINRA) have issued a joint statement in response to questions from market participants on the application of the federal securities laws and the rules of FINRA to the potential intermediation of digital asset securities and transactions.
What does this mean?
In the statement, the SEC's Division of Trading and Markets and FINRA's Office of General Counsel said that it should be recognized that the application of federal securities laws, FINRA rules and other laws to digital assets and digital asset securities and other innovative technologies raise "novel and complex regulatory and compliance questions and challenges".
The statement discusses various considerations in respect of the application of the federal securities laws and the rules of FINRA to the potential intermediation of digital asset securities and transactions, especially the SEC's Customer Protection Rule.
In this respect, the statement notes that:
"The ability of a broker-dealer to comply with aspects of the Customer Protection Rule is greatly facilitated by established laws and practices regarding the loss or theft of a security, that may not be available or effective in the case of certain digital assets."
U.S. broker-dealers must comply with broker-dealer financial responsibility rules, including custodial requirements under Rule 15c3-3 under the Securities Act of 1934, which is known as the "Customer Protection Rule".
The statement explains that:
"The Customer Protection Rule requires broker-dealers to safeguard customer assets and to keep customer assets separate from the firm’s assets, thus increasing the likelihood that customers’ securities and cash can be returned to them in the event of the broker-dealer’s failure."
Among its core protections for customers, the Rule requires a broker-dealer to "physically hold customers' fully paid and excess margin securities or maintain them free of lien at a good control location."
The statement adds that, generally, a broker-dealer may custody customer securities with a third-party custodian, and uncertified securities, such as mutual funds, may be held at the issuer or its transfer agent.
In either case, a third party controls the transfer of the securities.
This "traditional" securities infrastructure also has processed to reverse or cancel mistaken or unauthorized transactions.
The statement notes that there are many important differences in the "mechanics and risks associated with custodying traditional and digital asset securities."
For example, the way in which digital asset securities are issued, held, and transferred may create greater risk that a broker-dealer maintaining custody of them could be victim of fraud or theft, lose a "private key" used to transfer a client's digital asset securities or could transfer them to an unknown or unintended address "without meaningful recourse to invalidate the transactions, recover or replace lost property, or correct errors".
Therefore, a broker-dealer must consider how it can hold in possession or control digital asset securities, the statement concludes.
For example, a broker-dealer might find it a challenge proving that it (or its third party) maintains custody of digital asset securities.
A broker-dealer may be able to prove that it (or its third party) keeps a private key, but this by itself is not enough to show that it has "exclusive control" of the digital asset security and it may not be able to show that no one else has a copy of the private key and could transfer the digital asset security without its consent.
Further, holding a private key may not be sufficient for the broker-dealer to reverse or cancel mistaken or unauthorized transactions.
"These risks could cause securities customers to suffer losses, with corresponding liabilities for the broker-dealer, imperiling the firm, its customers, and other creditors," the statement said.
Other considerations
The statement also covers other considerations in respect of non-custodial broker-dealer models for digital asset securities, and around books and records and financial reporting rules. On this second point, the statement notes that:
"The nature of distributed ledger technology, as well as the characteristics associated with digital asset securities, may make it difficult for a broker-dealer to evidence the existence of digital asset securities for the purposes of the broker-dealer’s regulatory books, records, and financial statements, including supporting schedules."
In turn, this may become a challenge for the broker-dealer's auditor when undertaking its annual audit.
The SEC and FINRA said that some firms are considering using distributed ledger technology with some features designed to enable them to meet their record-keeping obligations and help the quick verification of digital asset security positions.
"Broker-dealers should consider how the nature of the technology may impact their ability to comply with the broker-dealer recordkeeping and reporting rules," the statement said.
The SEC and FINRA then turned to the Securities Investor Protection Act of 1970 (SIPA).
SIPA affords certain protections to customers in respect of a "security" and money deposited with the broker-dealer for the purpose of buying securities, such as a first-priority claim to cash and securities held by the firm and up to $500,000 in protection if customer assets go missing.
However, these protections do not apply to other types of assets.
In the case of a digital asset security that does not meet the SIPA definition of a security, and in the event a broker-dealer fails, SIPA protection is unlikely to apply, meaning that anyone holding those digital asset securities would have "only unsecured general creditor claims against the broker-dealer's estate."
In addition, uncertainty as to when and where a broker-dealer holds a digital asset security in its possession creates greater risk that customers' securities will not be returned if the broker-dealer fails.
To finish, the SEC and FINRA said they look forward to continuing their dialogue as market participants develop methodologies for establishing possession over digital asset securities.
Next steps
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