On July 8, 2019, the staffs of the U.S. Securities and Exchange Commission’s Division of Trading and Markets and the Financial Industry Regulatory Authority (“FINRA”) issued a joint statement articulating various considerations relevant to questions they had received concerning the application of the federal securities laws and the rules of FINRA to the potential intermediation—including custody—of digital asset securities and transactions. At the outset, the Statement made clear that novel issues have been raised. It gave the following example: 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, but these practices might not be available or effective in the case of certain digital assets.
Among its core protections for customers, SEC Rule 15c3-3 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. Generally, a broker-dealer may custody customer securities with a third-party custodian. The manner in which digital asset securities are issued, held, and transferred may create greater risk that a broker-dealer maintaining custody of them could be victimized by fraud or theft, could lose a “private key” necessary to transfer a client’s digital asset securities, or 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. Consequently, a broker-dealer must consider how it can, in conformance with Rule 15c3-3, hold in possession or control digital asset securities.
The Statement also commented on recordkeeping and reporting rules, such as those requiring a broker-dealer, among other things, to make and keep current ledgers reflecting all assets and liabilities, as well as a securities record reflecting each security carried by the broker-dealer for its customers. 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. Thus, broker-dealers should consider how the nature of the technology may impact their ability to comply with the broker-dealer recordkeeping and reporting rules.
SIPA (Securities Investor Protection Act of 1970) raises other concerns. Generally, a broker-dealer that fails and is unable to return the customer property that it holds would be liquidated in accordance with SIPA. Customers are eligible for up to $500,000 in protection (of which up to $250,000 can be used for cash claims) if the broker-dealer is missing customer assets. These SIPA protections apply to a “security” as defined in SIPA. They do not, however, apply to other types of assets, including, importantly, assets that are securities under the federal securities laws but are excluded from the definition of “security” under SIPA. There is, accordingly, a potential gap in coverage for holders of such digital asset securities.
The practical upshot of the Statement is that it identifies for the public some of the novel issues that the regulators are grappling with before they feel ready to approve crypto companies’ applications to become broker-dealers.
