The staffs of the Financial Industry Regulatory Authority (“FINRA”) and the U.S. Securities and Exchange Commission’s Division of Trading and Markets (the “Staffs”) issued the Joint Statement on Broker-Dealer Custody of Digital Asset Securities (the “Joint Statement”) on July 8, 2019. The Joint Statement helps to clarify how a broker-dealer may be able custody digital securities, which are securities issued on a blockchain, in compliance with the so-called customer protection rule, Rule 15c3-3 under the Securities Exchange Act of 1934.
The Staffs note that broker-dealers’ digital securities activities may not involve custody. For example, broker-dealers may facilitate over-the-counter secondary market transactions in such securities in which the buyers and sellers complete the transaction directly with each, or may match buyers and sellers of digital securities by operating an alternative trading system (“ATS”) with respect to which matched transactions settle outside of the ATS. The Staffs state that noncustodial activities do not raise the same level of concern as custodial activities do.
Custodial brokerage activities are subject to Rule 15c3-3, as noted above. That rule requires a broker-dealer that holds customer securities either to take physical possession of those securities or to hold them free from liens at a so-called control location. A broker-dealer cannot take physical possession of digital securities. The physical possession provision historically applied to broker-dealers holding customers’ certificated securities in the broker-dealers’ vaults, for example.
Broker-dealers establish control over securities by holding those securities at control locations specified in paragraph (c) of Rule 15c3-3, such as a securities depository. At present, none of the control locations set out in paragraph (c) offer control of customer securities.
Paragraph (c)(7) of the Rule 15c3-3 allows the SEC, upon application, to designate other control locations for the securities of a broker-dealer’s customers. The Division of Trading and Markets has delegated authority to designate such control locations, upon application, on behalf of the SEC.
The Division has designated a number of control locations for uncertificated securities under paragraph (c)(7), including transfer agents. The Joint Statement indicates that the Staffs (1) views digital securities as uncertificated securities, and (2) would consider designating transfer agents as control locations for such securities upon application for such designation under paragraph (c)(7). The Joint Statement also suggests that other solutions for custodying securities, such as holding those securities in a wallet controlled by the broker-dealer through private keys, face a more difficult path to Division approval under paragraph (c)(7).
Failed broker-dealers are liquidated under the Securities Investor Protection Act of 1970 (“SIPA”), which protects the custodial function of broker-dealer. The SIPA regime seeks to return customer funds and securities upon a broker-dealer and provides compensation, subject to specified limits, if customer funds and/or securities cannot be returned in a SIPA liquidation. The Staffs note that a digital security must be a “security” within the meaning of that term under SIPA in order for SIPA protections to apply to such securities in a broker-dealer liquidation. The Staffs take the position that holding digital securities that are not securities under SIPA would not be consistent with customer expectations with respect to protection of their securities holdings.
The Joint Statement also notes that broker-dealers must keep records of customers’ digital securities in their possession and control in compliance with Rules 17a-3 and 17a-4 under the Exchange Act, and must prepare and file financial reports with respect to such holdings in compliance with Rule 17a-5 under the Exchange Act.
The Joint Statement does not address how a broker-dealer could establish custody of digital securities on the blockchain, for example, by holding digital securities in wallets, for purposes of complying with Rule 15c3-3. Nevertheless, the Joint Statement is important because it is the first public statement by securities regulators recognizing that a broker-dealer could establish control of customers’ digital securities for purposes of complying with Rule 15c3-3.
Blockchain technology utilizes a distributed digital ledger to record and track information, and can be leveraged to gain transparency and certainty in transactions ranging from cryptocurrency to supply chain tracking. This blog provides information on the legal developments surrounding implementation of blockchain technology, with an initial focus on the financial services sector.