US SEC and FINRA statement on broker-dealer custody of digital asset securities

A recent joint statement by the SEC and FINRA highlights three main areas for broker-dealers to consider—the customer protection rule, books and records requirements, and insolvency protections—but stopped short of providing concrete guidance, instead noting “the Staffs will continue their constructive engagement with market participants . . . so that they may better respond to developments in the market.” 

The current landscape of digital asset security regulation

The joint statement serves as a stark reminder to US-regulated broker-dealers that: 

  1. certain digital assets are susceptible to characterization as securities (see our April 2019 insight)
  2. “[w]hether a security is paper or digital, the same fundamental elements of the broker-dealer financial responsibility rules apply” to custody services for securities; and
  3. these regulators are still coming to terms with exactly how those rules apply to so-called digital asset securities. 

We look at the three main areas for broker-dealers to consider in light of the joint statement.

1. The Customer Protection Rule

Safeguarding customers assets

Rule 15c3-3 under the Exchange Act of 1934 (the customer protection rule) generally requires a broker-dealer to safeguard customer assets in a way that increases the likelihood that, in the event of the broker-dealer’s failure, customers can still access their securities and cash. 

Among other requirements, broker-dealers must physically hold customers’ fully paid and excess margin securities (as such terms are defined in the rule) or maintain them free of lien at a good control location (e.g., the Depository Trust Company).

Joint statement guidance?

While acknowledging that “[t]here are many significant differences in the mechanics and risks associated with custodying traditional securities and digital asset securities”, the joint statement offers no concrete guidance for addressing these differences.

Instead, the joint statement merely highlights some of the risks attendant to custody of digital asset securities. For example, if a broker-dealer holds a “private key” for securities reflected on a distributed ledger, that broker-dealer may not be able to demonstrate the required control under the rule because it may not be able to foreclose the possibility that no other party has a copy of the private key and thereby could transfer the digital asset security without the broker-dealer’s knowledge or consent.

In what is an oft-repeated sentiment, the joint statement provides that:

 “[t]he specific circumstances where a broker-dealer could custody digital asset securities in a manner that the Staffs believe would comply with the Consumer Protection Rule remain under discussion, and the Staffs stand ready to continue to engage with entities pursuing this line of business.

2. The challenge of Books and Records requirements for digital asset securities

Maintaining auditable records

Broker-dealers generally must make and keep current ledgers of all assets and liabilities and must maintain a securities record containing a list of each customer security carried by the broker-dealer.

The nature of digital asset securities, particularly the use of distributed ledgers, could make it difficult for broker-dealers to adequately evidence the existence of digital asset securities in their books, records and financial statements.

Joint statement Guidance?

The joint statement baldly states that broker-dealers “should consider how the nature of the technology may impact their ability to comply with the broker-dealer recordkeeping and reporting rules.” Easier said than done.

3. Securities Investor Protection Act of 1970

First priority claims in insolvency

SIPA gives securities customers first priority claim to securities and cash held by an insolvent broker-dealer.  SIPA protections apply to “securities” as defined in the SIPA statute in a way that is narrower than that of the federal securities laws.

Notably, the SIPA definition does not include the concept of an “investment contract”, so it remains possible that certain digital assets will be securities for purposes of (a) SIPA but not the federal securities laws and rules thereunder (like the customer protection rule), the federal securities laws but not SIPA, or (c) both SIPA and the federal securities laws.  In case (b)—i.e., where a digital asset is not a security under SIPA—a customer would not have a first priority claim against the estate of an insolvent broker-dealer for that asset; instead, a customer would only have a general unsecured creditor claim.

Joint statement guidance?

The joint statement notes in a grand understatement that such an outcome is “likely to be inconsistent with the expectations of persons who would use a broker-dealer to custody their digital asset securities.”

What’s happening next?

It’s possible that the joint statement is a prelude to more comprehensive and constructive guidance.  It’s also possible that the joint statement is intended to release political pressure on the SEC and FINRA by publicly demonstrating that they are on the case.  Indeed, it is even possible that this verbal equivalent of a shrug emoji is an attempt to signal to Congress that the current statutory framework is lacking or that legislative direction is desired.

At a minimum, the many questions raised with few, if any, answers might have the practical effect of scaring off potential broker-dealer entrants to the field of custodying digital assets.  If such a vacuum is created, it remains to be seen whether other non-broker-dealers, such as trust company holders of New York BitLicenses, will fill it.