SEC and FINRA Issue Joint Statement on Broker-Dealer Custody of Digital Asset Securities | Practical Law

SEC and FINRA Issue Joint Statement on Broker-Dealer Custody of Digital Asset Securities | Practical Law

The SEC and FINRA issued a joint statement regarding broker-dealer custody of digital assets. The statement outlines key issues that a broker-dealer transacting in digital assets should consider when determining how to comply with the federal securities laws and FINRA rules.

SEC and FINRA Issue Joint Statement on Broker-Dealer Custody of Digital Asset Securities

by Practical Law Corporate & Securities
Published on 11 Jul 2019 • USA (National/Federal)
The SEC and FINRA issued a joint statement regarding broker-dealer custody of digital assets. The statement outlines key issues that a broker-dealer transacting in digital assets should consider when determining how to comply with the federal securities laws and FINRA rules.
On July 9, 2019, the Securities and Exchange Commission's (SEC) Division of Trading and Markets and the Financial Industry Regulatory Authority's (FINRA) Office of the General Counsel released a joint statement regarding broker-dealer custody of digital asset securities. The statement outlines key issues and considerations for broker-dealers and others who engage in digital asset transactions. The statement notes that broker-dealers and other market participants have raised questions about the applicability of the federal securities laws and FINRA rules to digital asset securities.

Compliance with the Customer Protection Rule

The statement emphasizes that an entity that buys, sells, or otherwise transacts or is involved in effecting transactions in digital asset securities for customers or its own account is subject to federal securities laws and may be required to register as a broker-dealer (for information about broker-dealer registration requirements, see Practice note, Determining Broker-Dealer Status). If an entity is required to be registered as a broker-dealer, it is subject to Exchange Act Rule 15c3-3, known as the Customer Protection Rule. The Customer Protection Rule requires broker-dealers to ensure that customer property is safeguarded and is available to satisfy customer claims in the event that the broker-dealer fails.
The statement indicates that the SEC and FINRA have received many applications requesting approval to engage in businesses involving digital assets. These include both applications to become new broker-dealers and applications from existing broker-dealers (for information on the broker-dealer application and registration process, see Practice Note, Broker-Dealer Registration: Overview).
The statement makes clear that the specific circumstances under which a broker-dealer transacting in digital asset securities could meet the requirements of the Customer Protection Rule are still under discussion by the SEC and FINRA. While final guidance has not been issued, the statement discusses some key considerations regarding different digital asset business models and compliance with applicable rules.

Non-Custodial Broker-Dealers

The statement indicates that the SEC and FINRA will apply less scrutiny to broker-dealer business models that do not involve a custodial function. The statement includes the following examples of business models that are non-custodial:
  • Arrangements similar to the role of a broker-dealer in a traditional private placement transaction, where the customer settles directly with the issuer.
  • Secondary market transactions where the broker-dealer facilitates the transaction between a buyer and seller, but never takes possession of customer funds or securities.
  • Broker-dealers that operate platforms to introduce buyers and sellers of digital assets, but do not take on the obligation to settle the transactions. These include alternative trading systems (for information on alternative trading system broker-dealers, see Practice Note, Determining Broker-Dealer Status).

Custodial Broker-Dealers

The statement makes clear that broker-dealers that take custody of digital asset securities must comply with the Customer Protection Rule. The most difficult aspect of the Customer Protection Rule for broker-dealers to demonstrate compliance with is the requirement to maintain exclusive physical possession or control over customer securities. Most broker-dealers use a third-party depository that has been approved by the SEC as a "good control location" to custody traditional securities. The most commonly used depository is one of the subsidiaries of the Depository Trust Company. Currently, there is no equivalent third-party depository institution for digital asset securities.
The SEC and FINRA state that the way digital asset securities are issued, held, and traded presents greater custody risks than traditional securities because there would be no recourse available to the customer if:
  • A private key is lost or stolen.
  • The broker-dealer accidently transfers funds to the wrong account or digital wallet.
  • A fraudulent transaction occurs.
The statement emphasizes that a broker-dealer must consider these unique risks presented by digital assets when determining how to comply with the Customer Protection Rule. Specifically, the statement indicates the fact that a broker-dealer maintains a private key to a digital wallet may not be sufficient evidence that it has exclusive possession or control over the digital asset securities.

Books and Records

The statement describes the potential issues that digital assets present to the preparation of required book and records (for information on broker-dealer recordkeeping requirements, see Practice Note, Broker-Dealer Recordkeeping). Specifically, the broker-dealer may have difficulty proving the existence of digitial asset securities. This may also create challenges for the broker-dealer's auditor when seeking to independently test management assertions regarding the broker-dealer's financial statements. The statement acknowledges that some broker-dealers are developing specialized methods for complying with the books and records requirements under the Customer Protection Rule. These methods involve allowing quick asset verification by third-parties like auditors and regulators.

Securities Investor Protection Act of 1970

A broker-dealer that fails and is unable to return all customer property that it holds would be liquidated under the Securities Investor Protection Act of 1970 (SIPA). Customer property is only protected to the extent that it is cash or a "security" as defined under SIPA. The statement indicates that the SEC and FINRA believe that many digital assets will not meet the definition of security under SIPA. In addition, where digital assets do meet the definition of security under SIPA, the uncertainty around possession or control may make it difficult to return the securities to customers if the broker-dealer fails. The statement goes further to say that these outcomes are likely inconsistent with investor expectations.

Control Locations

Broker-dealers wishing to treat a particular issuer or transfer agent as a "good control location" for digital assets under the Customer Protection Rule should make an application with the SEC's Division of Trading and Markets.