In a joint statement issued by FINRA and the SEC Division of Trading and Markets (the "Joint Statement"), the agencies highlighted challenges broker-dealers face in complying with SEA Rule 15c3-3 (the "Customer Protection Rule"), and financial recordkeeping and reporting rules with respect to transactions in digital asset securities. The agencies also addressed related issues regarding the application of the Securities Investor Protection Act ("SIPA") to digital asset securities.
Customer Protection Rule. The agencies stated that broker-dealers face unique challenges in complying with the safekeeping (or "possession and control") requirements of the Customer Protection Rule with respect to transactions in digital asset securities. Specifically, the agencies noted the risk of fraud or theft of digital assets, the risk of losing a "private key" necessary to transfer a customer's digital assets, and the inability to cancel erroneous or fraudulent transactions. In addition, the agencies said that holding a private key may not be sufficient for a broker-dealer or custodian to demonstrate that it has exclusive control (and thus "possession and control") of digital asset securities, as a third party may have a copy of the key, and thus may be able to transfer digital assets without the broker-dealer's consent.
Recordkeeping and Reporting. The agencies stated that, due to the nature of distributed ledger technology ("DLT"), it may be difficult for firms to evidence the existence of digital asset securities for purposes of complying with the SEC financial recordkeeping and reporting requirements. The agencies noted that some firms are considering use of DLT features that would enable firms to verify positions in digital asset securities, including use of regulatory nodes and permissioned DLT.
SIPA. The agencies also addressed certain limitations in the scope of coverage afforded by SIPA to customers holding digital asset securities. In particular, the agencies noted that digital asset securities may fall outside the definition of "securities" under SIPA (even though they may be securities for purposes of the Customer Protection Rule). Customers that hold positions in digital asset securities thus may be treated as general creditors in the event of a broker-dealer's bankruptcy. The difficulty of establishing whether a broker-dealer holds a digital asset security in its "possession and control" may create an additional risk in the event of a broker-dealer's bankruptcy.
The agencies stated that they intend to continue their ongoing discussion of these issues with market participants.
Commentary / Mark Highman
The Joint Statement is an important contribution to the ongoing dialogue between the securities industry and regulators as to how to apply existing regulatory requirements to transactions involving digital assets. In this vein, the Joint Statement highlights certain key challenges faced by broker-dealers in complying with custody, recordkeeping and reporting requirements without prescribing how firms should comply with these requirements. Rather, the agencies acknowledge that the industry is in the process of developing technological solutions to these issues, noting that this may require firms to put in place "significant technological enhancements and solutions unique to digital asset securities." The safekeeping of digital assets is a key concern to both regulators and customers, and the ability of the industry to create robust solutions to these challenges is likely to be one of the key determinants as to ongoing viability of this asset class.
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