On July 8, 2019, the SEC’s Division of Trading and Markets and FINRA’s Office of General Counsel (collectively, the Staffs) issued a Joint Statement on Broker-Dealer Custody of Digital Asset Securities. For purposes of the Joint Statement, “digital asset” refers to any asset that is issued and transferred using distributed ledger or blockchain technology, and a “digital asset security” is any digital asset that is also a security for purposes of the federal securities laws. The Joint Statement discusses several provisions of the federal securities laws applicable to registered broker-dealers that may be implicated when such entities custody digital asset securities.
The Joint Statement begins by noting that “digital asset securities and related innovative technologies raise novel and complex regulatory and compliance questions and challenges.” It also observes that there “are many significant differences in the mechanics and risks associated with custodying traditional securities and digital asset securities.” The Joint Statement then discusses a series of risks and regulatory requirements for broker-dealers seeking to maintain custody of digital asset securities, as well as those whose business models do not involve custody.
For broker-dealers whose business models involve custody of digital asset securities, the Joint Statement focuses in particular on the requirements of the SEC’s Customer Protection Rule, which imposes various requirements on broker-dealers to ensure that customer securities and cash are readily available to be returned to customers. The Joint Statement also discusses some of the unique issues that the use of distributed ledger technology may raise in the context of the SEC’s Books and Records and Financial Reporting Rules.
According to the Joint Statement, the Staffs have received inquiries from broker-dealers, including alternative trading systems (ATSs), wishing to utilize an issuer or transfer agent as a proposed “control location” for purposes of the possession or control requirements under the Customer Protection Rule. In general, this arrangement would involve uncertificated securities where the issuer or a transfer agent maintains a traditional single master security holder list, but also publishes as a courtesy the ownership record using distributed ledger technology. While the issuer or transfer agent may publish the distributed ledger, in these examples, the broker-dealers have asserted to the Staffs that the distributed ledger is not the authoritative record of share ownership. To the extent a broker-dealer contemplates an arrangement of this type, the Joint Statement provides that the SEC will consider whether the issuer or the transfer agent can be considered a satisfactory control location pursuant to an application under paragraph (c)(7) of SEC Rule 15c3-3.
Additionally, the Joint Statement includes a discussion of the application of the Securities Investor Protection Act of 1970, or SIPA, which provides up to $500,000 in protection (of which up to $250,000 can be used for qualifying cash claims) on brokerage accounts in the event of the failure and liquidation of a broker-dealer. Importantly, the Joint Statement notes that SIPA coverage may be unavailable for many digital asset securities because such coverage is generally limited only to securities subject to an SEC registration statement under the Securities Act of 1933.
Finally, the Joint Statement notes that various unregistered entities that intend to engage in broker-dealer activities involving digital asset securities are seeking to register with the SEC and have submitted New Membership Applications to FINRA. Likewise, entities that are already registered broker-dealers and FINRA members are seeking to expand their businesses to include digital asset securities services and activities. The Joint Statement points out that under FINRA rules, a registered broker-dealer is prohibited from materially changing its business operations (e.g., engaging in material digital asset securities activities for the first time) without FINRA’s prior approval of a Continuing Membership Application.
In the case of entities that contemplate engaging in broker-dealer activities involving digital asset securities that would not involve custody functions, the Joint Statement observes that to the Staffs, “noncustodial activities involving digital asset securities do not raise the same level of concern,” provided that the relevant legal and regulatory requirements are followed. According to the Staffs, some of the noncustodial business activities that have been presented or described to the Staffs include:
- A broker-dealer sends the trade-matching details (e.g., identity of the parties, price and quantity) to the buyer and issuer of a digital asset security—similar to a traditional private placement—and the issuer settles the transaction bilaterally between the buyer and issuer, away from the broker-dealer. In this case, the broker-dealer instructs the customer to pay the issuer directly and instructs the issuer to issue the digital asset security to the customer directly (e.g., to the customer’s digital wallet).
- A broker-dealer facilitates “over-the-counter” secondary market transactions in digital asset securities without taking custody of or exercising control over the digital asset securities. In this example, the buyer and seller complete the transaction directly and, therefore, the securities do not pass through the broker-dealer facilitating the transaction.
- A secondary market transaction involves a broker-dealer introducing a buyer to a seller of digital asset securities through a trading platform where the trade is settled directly between the buyer and seller. For instance, a broker-dealer that operates an ATS could match buyers and sellers of digital asset securities and the trades would either be settled directly between the buyer and seller, or the buyer and seller would give instructions to their respective custodians to settle the transactions. In either case, the ATS would not guarantee or otherwise have responsibility for settling the trades and would not at any time exercise any level of control over the digital asset securities being sold or the cash being used to make the purchase (e.g., the ATS would not place a temporary hold on the seller’s wallet or on the buyer’s cash to ensure the transaction is completed).
In sum, it would seem that broker-dealers seeking to effect securities transactions without custody of the underlying securities may face fewer regulatory hurdles than entities seeking to do so with full custody.