Responding to questions from market participants, the Securities and Exchange Commission and the Financial Industry Regulatory Authority released a joint statement Monday clarifying broker-dealers’ custody of digital asset securities.
Market participants, the SEC’s Division of Trading and Markets and FINRA state, have raised questions concerning the application of the federal securities laws and FINRA rules to the potential intermediation — including custody — of digital asset securities and transactions.
Their Monday statement draws upon key principles from both entities’ approach to broker-dealer regulation and investor protection and articulate various considerations relevant to many of these questions.
“As a threshold matter, it should be recognized by market participants that the application of the federal securities laws, FINRA rules and other bodies of laws to digital assets, digital asset securities and related innovative technologies raise novel and complex regulatory and compliance questions and challenges,” the statement said. For 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, that may not be available or effective in the case of certain digital assets.”
Among other guidance, the joint statement sets out that a broker-dealer seeking to custody digital asset securities must comply with the SEC’s Customer Protection Rule.
The Customer Protection Rule safeguards customer securities and funds held by a broker-dealer, prevents investor loss or harm in the event of a broker-dealer’s failure, and enhances the SEC’s ability to monitor and prevent unsound business practices.
“Put simply, the Customer Protection Rule requires broker-dealers to safeguard customer assets and to keep customer assets separate from the firm’s assets, thus increasing the likelihood that customers’ securities and cash can be returned to them in the event of the broker-dealer’s failure,” the statement said.
Various unregistered entities that intend to engage in broker-dealer activities involving digital asset securities are seeking to register with the commission and have submitted New Membership Applications to FINRA, according to the statement.
Also, various entities already registered broker-dealers and FINRA members are seeking to expand their businesses to include digital asset securities services and activities. “Under FINRA rules, a firm is prohibited from materially changing its business operations (e.g., engaging in material digital asset securities activities for the first time) without FINRA’s prior approval of a Continuing Membership Application,” the statement said.
The NMAs and CMAs before FINRA are diverse: “Some of the NMAs and CMAs cover proposed business models that would not involve the broker-dealer engaging in custody of digital asset securities. On the other hand, some NMAs and CMAs include the custodying of digital asset securities, and therefore implicate the Customer Protection Rule, among other requirements.”
Nicolas Morgan, a partner at the global defense firm Paul Hastings in Los Angeles, told ThinkAdvisor in a Monday email that the joint statement “is a step in the right direction by the SEC staff and FINRA’s Office of General Counsel regarding some of the thornier issues for broker-dealers who participate in the digital assets space.”
The statement “makes clear that custody issues are at the top of the regulators’ concerns,” Morgan said. “Perhaps the most helpfully specific advice was to describe BD roles in digital asset transactions that avoid custody altogether.”
The statement, however, “is far less helpful in advising how to comply with the custody requirements themselves, simply noting that a BD ‘must consider’ certain things and ‘may face challenges’ complying with the requirements,” Morgan added. “In essence, the statement appears to be more of an invitation to have further dialogue rather than any sort of firm guidance or final word.”