Keyword: Distributed ledger technology

SEC/FINRA Joint Statement on Digital Asset Securities Does Not Address Regulatory Log Jam

Last week, the Staffs of the Securities and Exchange Commission (SEC) and the Financial Industry Regulatory Authority (FINRA) (collectively, the Staffs) released a Joint Statement concerning the application of the SEC’s Customer Protection Rule and other federal laws and regulations to transactions in digital asset securities. The Joint Statement is the result of months of dialogue among the Staffs and industry participants regarding the practical application of the federal securities laws to emerging digital technologies. Nonetheless, it gives no indication as to when FINRA expects to begin working down its backlog of applications from broker-dealers seeking to facilitate markets in digital asset securities.

The Customer Protection Rule

The Joint Statement primarily addresses the application of SEC Rule 15c3-3, the Customer Protection Rule, to federally registered broker-dealers taking custody over their customers’ digital asset securities. The Customer Protection Rule requires broker-dealers to segregate customer assets in specially protected accounts, thereby increasing the likelihood that customers will be able to withdraw their assets even if the broker-dealer becomes insolvent. To comply with the rule, broker-dealers must either physically hold customers’ fully paid and excess margin securities or deposit them at the Depository Trust Company, a clearing bank, or other “good control location” free of any liens or encumberments. This infrastructure additionally protects customers by allowing mistaken or unauthorized transactions to be reversed or canceled.

While the Customer Protection Rule applies to both traditional and digital asset securities, the Staffs advised that broker-dealers taking custody over digital asset securities may need to take additional precautions to respond to unique risks presented by these emerging technologies. For instance, there may be greater risk that a broker-dealer maintaining custody of digital asset securities could become the victim of fraud or theft or could lose the “private key” required to transfer a client’s digital asset securities. Further, another party could hold a copy of the private key without the broker-dealer’s knowledge and transfer the digital asset security without the broker-dealer’s consent. The Staffs noted that an estimated $1.7 billion worth of digital assets was stolen in 2018, of which approximately $950 million resulted from cyberattacks on bitcoin trading platforms. These risks could cause customers to suffer losses and create liabilities for the broker-dealer and its creditors.

The Staffs noted that broker-dealer activities that do not involve custody functions do not trigger the Customer Protection Rule. Examples of such activities include the facilitation of bilateral transactions between buyers and sellers similar to traditional private placements or “over the counter” secondary market transactions. These transactions do not “raise the same level of concern among the Staffs” as do transactions in which the broker-dealer assumes custody over the securities.

Other Federal Regulations

The Staffs advised broker-dealers to consider how distributed ledger technology may impact their ability to comply with broker-dealer recordkeeping and reporting rules. Because transactions in digital asset securities are recorded on distributed ledgers such as blockchains rather than traditional ledgers, broker-dealers may find it more difficult to evidence the existence of these digital asset securities on financial statements and to provide sufficient detail about these assets to independent auditors.

Finally, the Staffs discussed the application of the Securities Investor Protection Act (SIPA) to broker-dealers exercising custody over digital assets. In the event a broker-dealer is liquidated, SIPA gives securities customers first-priority claims to securities and cash deposited with the broker-dealer. However, the Joint Statement notes that SIPA’s definition of “security” is different than the federal securities laws definitions. For example, the definition in SIPA of “security” excludes an investment contract or interest that is not the subject of a registration statement with the Commission pursuant to the provisions of the Securities Act of 1933. Consequently, customers whose digital assets are subject to the Customer Protection Rule and other federal regulations may only have an unsecured general creditor claim against their broker-dealer’s estate in the event their broker-dealer fails. The Staffs found that such outcomes are likely inconsistent with the expectations of investors in digital assets that do not qualify for SIPA protection.

Waiting Game

Absent from the Joint Statement is a clear answer to the question at the forefront of many industry participants’ minds: When will FINRA begin approving the dozens of applications of existing broker-dealers and new registrants seeking authority to offer a variety of custodial and non-custodial services with respect to digital assets? Applicants seeking to engage only in non-custodial activities, such as market-making, may be encouraged that the Staffs have indicated that those activities pose the least concern to federal regulators, and, presumptively, may be more readily approved. Nonetheless, the Staffs have given no indication that FINRA will prioritize processing applications seeking authority to provide only non-custodial services currently in its backlog, or when such applications will once again be approved.

Meanwhile, the Joint Statement underscores that considerable uncertainty remains regarding the application of existing laws and regulations to broker-dealer activities involving the custody of digital assets. While the Staffs invite broker-dealers and other industry participants to continue to engage with federal regulators to develop workable methodologies for securely carrying customers’ digital assets, industry participants hoping to get a firm answer as to when secondary market trading in digital asset securities will gain federal regulators’ seal of approval will have to keep waiting.

 

The Beat Goes On: Division of Investment Management Seeks Input on the Impact of the Custody Rule on Digital Currency – and Vice Versa

As part of its ongoing examination of the Custody Rule, the SEC’s Division of Investment Management is seeking views from the securities industry members and the public on two issues regarding the Custody Rule: (1) the application of that rule to trading that is not handled on a delivery versus payment basis, and (2) the application of the rule to digital assets. In a March 12, 2019 letter to the President and CEO of the Investment Adviser Association published on the SEC’s website (“the Custody Release”), the Division seeks input to expand on its Guidance Update from early 2017. Both issues are important in view of the increasing complexity of types of securities that registered investment advisers are purchasing on behalf of their customers and, as discussed below, the issues overlap in a way that might predict an important use case for blockchain technology.

The Custody Rule

The Custody Rule under the Investment Advisers Act of 1940 provides that it is a fraudulent, deceptive or manipulative act, practice or course of business for a registered investment adviser to have “custody” of client funds or securities unless they are maintained in accordance with the requirements of the Custody Rule. The definition of custody includes arrangements where the adviser has authority over and access to client securities and funds.

By way of context, we note that although the Custody Rule applies only to registered investment advisers, its concepts are relevant for non-registered advisers and other intermediaries as well, since their clients or customers have a practical interest in assuring that: managed assets are appropriately safeguarded; and the absence of appropriate custody arrangements may preclude a client from investing with a particular adviser.

Also, as the Custody Release notes, the Division previously issued a letter inviting engagement on questions relating to the application of the Investment Company Act of 1940, including the custody provisions of that Act, to cryptocurrencies and related products.

The Custody Rule and DVP Arrangements

The Custody Release points out that when an investment adviser manages funds pursuant to delivery versus payment arrangements – that is, when transfers of funds or securities can only be conducted together with a corresponding transfer of securities or funds – then it provides certain protections to customers from misappropriation by the adviser. The Release seeks to assist the Division in gathering information on payment practices that do not involve delivery versus payment, seeking input on, among other things: the variety of instruments that trade on that basis; the risk of misappropriation or loss associated with such trading; and how such trades appear on client accounts statements.

The Custody Rule and Digital Assets

The Custody Release also asks about the extent to which evolving technologies, such as blockchain/distributed ledger technology, provide enhanced client protection in the context of non-delivery versus payment trading. That question presents a good lead-in to the second part of the Custody Release, which seeks to learn “whether and how characteristics particular to digital assets affect compliance with the Custody Rule.” These characteristics include:

– the use of distributed ledger technology to record ownership;

– the use of public and private cryptographic keys to transfer digital assets;

– the “immutability” of blockchains;

– the inability to restore or recover digital assets once lost;

– the generally anonymous nature of DLT transactions; and

– the challenges posed to auditors in examining DLT and digital assets.

With these characteristics in mind, the Division asks are fairly open-ended about the challenges faced by investment advisers in complying with the Custody Rule with respect to digital assets, including:

– to what extent are investment advisers construing digital assets as funds or securities?

– are investment advisers including digital assets in calculating regulatory assets under management in considering with they need to register with the SEC?

– how can concerns about misappropriation of digital assets be addressed?

– what is the process for settlement of digital asset transactions, either with or without an intermediary?

The most forward-looking question asked in the Release is whether digital ledger technology can be used for evidencing ownership of securities. The answer to this question – which could represent a direct application of the blockchain’s ability to record ownership and its immutability – could pave the way to resolving custody concerns with respect to any asset class transacted in by investment advisers on behalf of their clients. It certainly points the way to an important possible use of blockchain technology – to demonstrate custody in a way that is immutable, anonymous and auditable. Technologists, get to work!

The Custody Release’s questions are a significant next step in drawing digital assets into the embrace of investment adviser regulation, but a positive step nonetheless.

Could Digital Assets Be Considered Securities? A Perspective From Regulators

Earlier this year, two key SEC officials shared their views on digital assets under federal securities laws. While an ultimate determination will be dependent upon the specific facts and circumstances in a given situation, and these views do not constitute official policy, they are nonetheless helpful in understanding the SEC’s perspectives and considerations for potential future direction.

Learn more about key takeaways from this recent article published by one of our cross-practice teams.