The Staff of the Securities and Exchange Commission’s Division of Trading and Markets (Staff) issued a no-action letter to the Financial Industry Regulatory Authority on September 25, 2020 (Letter),1 in which the Staff stated that it would not recommend enforcement action to the SEC under Section 15(c)(3) of the Exchange Act and Rule 15c3-3 thereunder (Customer Protection Rule) against a broker-dealer that operates an alternative trading system (ATS) that trades digital asset securities and complies with the conditions of the Letter with respect to Rule 15c3-3. The Letter provides no-action relief only in instances where the broker-dealer does not guarantee or otherwise have responsibility for settling trades of digital asset securities.
In July 2019, the Office of General Counsel of FINRA and the Staff issued a joint statement (Joint Statement)2 that discussed, among other things, a broker-dealer’s ability to comply with the possession or control requirements of Exchange Act Rule 15c3-3 as such requirements relate to digital asset securities. Paragraph (b) of the Customer Protection Rule generally requires that registered broker-dealers obtain and maintain physical possession or control of all fully-paid and excess-margin securities carried by the broker-dealer for the account of its customers.
The Joint Statement provides much-needed guidance regarding compliance with the Customer Protection Rule for operators of ATSs that trade digital asset securities. Particularly, the Joint Statement provides guidance regarding noncustodial models for digital asset securities, by outlining a four-step process for a broker-dealer operating an ATS to facilitate trades of digital asset securities in a manner that would not involve taking custody of the securities. Under this process: (i) the buyer and seller send their respective orders to the ATS; (ii) the ATS matches the orders; (iii) the ATS notifies the buyer and seller of the matched trade; and (iv) the buyer and seller settle the transaction bilaterally, either directly with each other or by instructing their respective custodians to settle the transaction on their behalf. Accordingly, the securities and funds relating to a “matched” transaction effected by the ATS do not pass through a broker-dealer, and broker-dealers generally would not be subject to the possession/control or reserve requirements of the Customer Protection Rule.
The Letter states that several broker-dealers operating ATS platforms suggested that the four-step process provided for in the Joint Statement increases operational and settlement risks. To reduce such risks, FINRA, on behalf of its broker-dealer members, proposed the following three-step process as an alternative:
- The buyer and seller each send their order to the ATS, notify their respective custodians of the orders they submitted to the ATS, and instruct their custodians to settle transactions in accordance with the terms of their orders when the ATS notifies the custodians of a match on the ATS;
- The ATS matches the orders; and
- The ATS notifies the buyer and seller and their respective custodians of the matched trade, and the custodians carry out the conditional instructions.
As was required under the four-step process, the broker-dealer operator would not guarantee or have responsibility for settling the trades, and would not exercise control over the digital asset securities being sold or the cash being used to make the purchase (for example, the ATS would not place a temporary hold on the seller’s wallet or on the buyer’s cash to ensure that the transaction is completed).
In the Letter, the Staff stated that it would not recommend enforcement action to the SEC with respect to a broker-dealer operating an ATS that trades digital asset securities and follows the three-step process outlined above, as well as the following additional conditions:
- The broker-dealer operator maintains a minimum of $250,000 in net capital;
- The agreements between the broker-dealer operator and its customers clearly state that the broker-dealer operator does not guarantee or otherwise have responsibility for settling the trades;
- The broker-dealer operator has established and maintains procedures reasonably designed to assess whether: a digital asset security was offered and sold initially pursuant to an effective registration statement or an available exemption from registration; and any secondary transactions of the digital asset security on or through the ATS are made pursuant to an effective registration statement or an available exemption from registration; and
- The transactions in digital asset securities otherwise comply with the federal securities laws.
The relief granted in the Letter, along with recent guidance from the Staffs of the SEC and the Office of the Comptroller of the Currency with respect to digital asset custody,3 demonstrate an increased regulatory willingness to support developments in the digital asset space by providing guidance and flexibility to help industry participants navigate regulatory requirements. While the conditions in the Letter impose cumbersome conditions for secondary trading of digital asset securities, the Letter brings the industry closer to fostering secondary market trading of digital asset securities.
1) Financial Industry Regulatory Authority, SEC Staff No-Action Letter (Sept. 25, 2020).
2) Joint Staff Statement on Broker-Dealer Custody of Digital Asset Securities (July 8, 2019).
3) See OCC Interpretive Letter No. 1170, Authority of a National Bank to Provide Cryptocurrency Custody Services for Customers (July 22, 2020); OCC Interpretive Letter No. 1172, OCC Chief Counsel’s Interpretation on National Bank and Federal Savings Association Authority to Hold Stablecoin Reserves, (Sept. 21, 2020); SEC FinHub Staff Statement on OCC Interpretation (Sept. 21, 2020). For further information, please refer to Dechert OnPoint, OCC Allows National Banks to Custody Cryptocurrency and Dechert OnPoint, OCC and SEC Staff Issue Statements on Stablecoin Reserves.