SEC Outlines Path to Digital Asset Custody for Broker-Dealers
On December 23, 2020, the SEC issued a request for comment regarding the application of the Customer Protection Rule to digital asset securities. With the request for comment, the SEC also issued a statement indicating that, if a broker-dealer operates under specific circumstances set out in the statement, it would not seek enforcement action on the basis that a broker-dealer “deems itself to have obtained and maintained physical possession or control of customer fully paid and excess margin digital asset securities for the purposes of paragraph (b)(1) of Rule 15c3-3”. This position will expire in 5-years. The industry has been waiting for this guidance for some time.
This important development in the regulation of digital asset securities will allow broker-dealers, if they comply with the requirements in the statement, to maintain possession and control of digital asset securities and stay in compliance with the Customer Protection Rule.
This guidance is likely to cause the creation of new, special purpose broker-dealers designed specifically for the custody of digital asset securities.
In earlier guidance, the SEC and FINRA had outlined concerns they had in applying the Customer Protection Rule to digital asset securities. These include the risk that a broker-dealer maintaining custody of digital asset securities:
- could be victimized by fraud or theft,
- could lose a “private key” necessary to transfer a client’s digital asset securities,
- could transfer a client’s digital asset securities to an unknown or unintended address without meaningful recourse to invalidate fraudulent transactions, recover or replace lost property, or correct errors, or,
- (in) the case of a digital asset security that does not meet the definition of a “security” under SIPA, and in the event of the failure of a carrying broker-dealer, SIPA protection likely would not apply and holders of those digital asset securities would have only unsecured general creditor claims against the broker-dealer’s estate.
In the December 23, 2020 statement, the SEC outlines nine requirements that, if met, would allow a broker-dealer to maintain custody of digital asset securities without being subject to a Commission enforcement action for violating the possession and control requirements of the Customer Protection Rule for a period of five years. Each of the nine requirements must be met to take advantage of the relief.
Importantly, one of the requirements is that the broker-dealer limit its business to dealing in, effectuating transactions in, maintaining custody of, and/or operating an alternative trading system for digital asset securities. That means that a broker-dealer that provides custody of digital assets under this guidance would not be able to engage in traditional securities business with limited exceptions. The broker-dealer would also be unable to engage in activities with non-security digital assets. It would stand to reason that as a result, new, limited-purpose broker-dealers would need to be created for this purpose. Expect to see several new member applications to be filed with FINRA to register special purpose digital asset custody broker-dealers.
The SEC’s guidance also requires that such broker-dealers establish, maintain and enforce reasonably designed policies and procedures to conduct and document an analysis of whether the digital assets they custody are securities registered under the Securities Act or exempt from registration. The remaining requirements include that, among other things, firms ensure they provide specific disclosures to customers and be able to demonstrate that they have exclusive control over the digital asset securities held in custody.
This is an exciting development in the evolution of digital asset securities and the use of blockchain technology in the securities industry.
Oyster Consulting can help firms view the opportunities and risks associated with digital assets from a strategic, operational, and compliance standpoint for the emerging digital asset industry and for existing broker-dealers and RIAs. For more information click here.
About the Author: Ed Wegener is an innovative compliance, risk management and supervisory controls expert with deep understanding of Federal Securities Laws and the rules of self-regulatory organizations, as well as technology optimization and risk mitigation. Prior to joining Oyster, Ed held several posts in FINRA, most recently as Senior VP and Midwest Regional Director. While there, he was responsible for the Region’s risk assessment, examination and investigation programs. Ed was a member of the team that developed FINRA’s risk-based examination program and he developed and managed FINRA’s first Digital Asset and Cybersecurity examination programs.