On July 8, 2019, the SEC Division of Trading and Markets (the "Joint Statement") and FINRA issued a joint statement highlighting challenges broker-dealers face in complying with SEA Rule 15c3-3 (the "Customer Protection Rule"), and financial recordkeeping and reporting rules with respect to transactions in digital asset securities. The agencies also addressed related issues regarding the application of the Securities Investor Protection Act ("SIPA") to digital asset securities.
Customer Protection Rule. The agencies stated that broker-dealers face unique challenges in complying with the safekeeping (or "possession and control") requirements of the Customer Protection Rule with respect to transactions in digital asset securities. Specifically, the agencies noted the risk of fraud or theft of digital assets, the risk of losing a "private key" necessary to transfer a customer's digital assets, and the inability to cancel erroneous or fraudulent transactions. In addition, the agencies said that holding a private key may not be sufficient for a broker-dealer or custodian to demonstrate that it has exclusive control (and thus "possession and control") of digital asset securities, as a third party may have a copy of the key, and thus may be able to transfer digital assets without the broker-dealer's consent.
Recordkeeping and Reporting. The agencies stated that, due to the nature of distributed ledger technology ("DLT"), it may be difficult for firms to evidence the existence of digital asset securities for purposes of complying with the SEC financial recordkeeping and reporting requirements. The agencies noted that some firms are considering use of DLT features that would enable firms to verify positions in digital asset securities, including use of regulatory nodes and permissioned DLT.
SIPA. The agencies also addressed certain limitations in the scope of coverage afforded by SIPA to customers holding digital asset securities. In particular, the agencies noted that digital asset securities may fall outside the definition of "securities" under SIPA (even though they may be securities for purposes of the Customer Protection Rule). Customers that hold positions in digital asset securities thus may be treated as general creditors in the event of a broker-dealer's bankruptcy. The difficulty of establishing whether a broker-dealer holds a digital asset security in its "possession and control" may create an additional risk in the event of a broker-dealer's bankruptcy.
The agencies stated that they intend to continue their ongoing discussion of these issues with market participants.
Of all the hurdles that stand in the way of acceptance of tokenized assets, operational issues (particularly safe custody) are likely the biggest. While blockchain was supposed to disintermediate the trusted intermediary, it is easier said than done. Regulated custodians continue to serve essential roles in the financial services industry and look to do so going forward.