Cryptocurrency and Digital Asset Issues for Broker-Dealers

Transactions involving cryptocurrency and other digital assets are relatively new and evolving, with many unsettled legal and public policy issues. Despite these unknowns, the Securities and Exchange Commission (SEC) and FINRA have released guidance to help broker-dealers transacting in cryptocurrency and other digital assets navigate these dealings.

On July 8, 2019, the SEC’s Division of Trading and Markets and FINRA’s Office of the General Counsel released a joint statement outlining key issues and considerations for broker-dealers and others who engage in digital asset transactions. The joint statement notes that broker-dealers and other market participants have raised questions about the applicability of US federal securities laws and FINRA rules to digital assets. (SEC: Joint Staff Statement on Broker-Dealer Custody of Digital Asset Securities (July 8, 2019).) FINRA has also published several regulatory notices that advise broker-dealers to report their digital asset activities to regulators.

This article discusses the guidance contained in these limited releases and the implications for broker-dealers and unregistered entities that are considering engaging in cryptocurrency and other digital assets activities.

(For more on cryptocurrency and digital asset regulation, see Regulation of Crypto-Asset Securities in USA and Cryptocurrency and Virtual Currency Regulatory Tracker on Practical Law; for a collection of resources on cryptocurrencies and digital assets, see Crypto Toolkit on Practical Law.)

Requirement to Register as a Broker-Dealer

An unregistered entity that engages in any activities that involve cryptocurrency or other digital assets may have to register as a broker-dealer. The joint statement emphasizes that an entity is subject to federal securities laws and may need to register as a broker-dealer if it buys, sells, or otherwise transacts or is involved in effecting transactions in digital asset securities for customers or for its own account (for more on broker-dealer registration requirements, see Broker-Dealer Registration: Overview and Determining Broker-Dealer Status on Practical Law).

Requirement to File a Continuing Membership Application

A broker-dealer engaging in activities involving cryptocurrencies and other digital assets likely must file a continuing membership application (CMA). FINRA has provided guidance (in the form of several regulatory notices) to remind firms of their obligation to file a CMA if they decide to:

While this list is not meant to be exhaustive, it indicates that FINRA’s position is that nearly any activity involving cryptocurrencies or other digital assets requires a CMA. (For more on the requirement to file a CMA, see FINRA Continuing Membership Application Checklist on Practical Law.)

A firm requesting a determination on whether engaging in a particular activity triggers the requirement to file a CMA should consider seeking a materiality consultation with FINRA. This is a brief process that concludes with a written decision from FINRA about whether a CMA is required. (For more on materiality consultations, see FINRA Continuing Membership Application Checklist on Practical Law.)

Compliance with the Customer Protection Rule

All broker-dealers are subject to Rule 15c3-3 of the Securities Exchange Act of 1934, known as the Customer Protection Rule. The Customer Protection Rule requires a broker-dealer to ensure that customer property is safeguarded and is available to satisfy customer claims in the event that the broker-dealer fails.

The joint statement clarifies that the SEC and FINRA are still determining the specific circumstances under which a broker-dealer transacting in digital asset securities could meet the requirements of the Customer Protection Rule. While final guidance has not been issued, the joint statement discusses some key considerations regarding different digital asset business models and compliance with applicable rules.

Non-Custodial Broker-Dealers

The joint statement indicates that the SEC and FINRA will apply less scrutiny to broker-dealer business models that do not involve a custodial function. The joint statement includes examples of non-custodial business models, such as:

Custodial Broker-Dealers

The joint statement indicates that broker-dealers that take custody of digital asset securities must comply with the Customer Protection Rule. The most difficult aspect of the Customer Protection Rule for broker-dealers is the requirement to maintain exclusive physical possession or control over customer securities. Most broker-dealers use a third-party depository that the SEC approved as a good control location for the custody of traditional securities. The most commonly used depository is one of the subsidiaries of the Depository Trust Company. There is currently no equivalent third-party depository institution for digital asset securities.

The SEC and FINRA state that the way digital asset securities are issued, held, and traded presents greater custody risks than traditional securities because there would be no recourse available to the customer if:

The joint statement emphasizes that a broker-dealer must consider these unique risks related to digital assets when determining how to comply with the Customer Protection Rule. For example, the joint statement indicates that a broker-dealer maintaining a private key to a digital wallet may not be able to sufficiently demonstrate that it has exclusive possession or control over the digital asset securities.

December 2020 SEC Statement

In December 2020, the SEC released a statement describing a five-year no-action position under which broker-dealers that limit their business to digital asset securities and operate under certain other circumstances can deem themselves to have obtained and maintained physical possession or control of digital asset securities for purposes of the Customer Protection Rule. The concepts in this release could also be instructive on best practices for maintaining possession or control over digital assets. (For more information, see SEC Issues Statement and Requests Comment on Broker-Dealer Custody of Digital Asset Securities on Practical Law.)

Books and Records

The joint statement describes the potential issues that digital assets present to the preparation of required books and records (for more information, see Broker-Dealer Recordkeeping on Practical Law). A broker-dealer may have difficulty proving the existence of digital asset securities. This may also create challenges for the broker-dealer’s auditor when seeking to independently test management assertions regarding the broker-dealer’s financial statements.

The joint statement acknowledges that some broker-dealers are developing specialized methods for complying with the books and records requirements under the Customer Protection Rule. These methods involve allowing quick asset verification by third parties such as auditors and regulators.

Securities Investor Protection Act of 1970 (SIPA)

A broker-dealer that fails and cannot return all customer property that it holds would be liquidated under SIPA. Customer property is only protected to the extent that it is cash or a security as defined under SIPA. The joint statement indicates that the SEC and FINRA believe that many digital assets will not meet the definition of security under SIPA. Even where digital assets do meet the definition of security, the uncertainty around possession or control may make it difficult to return these securities to customers if the broker-dealer fails. The joint statement further emphasizes that these outcomes are likely inconsistent with investor expectations.

Control Locations

Broker-dealers wanting to treat a particular issuer or transfer agent as a good control location for digital assets under the Customer Protection Rule should make an application with the SEC’s Division of Trading and Markets.