FINRA and the SEC's Division of Trading and Markets comment on BD Custody of Digital Assets

Updated: Aug 29, 2019

July 19th | 2019

On Monday, July 8, 2019, the Financial Industry Regulatory Authority (“FINRA”) released a joint statement with the Division of Trading and Markets (the “Division”) regarding Broker-Dealer custody of Digital Asset Securities.

The release defines digital asset securities as assets issued or transferred using distributed ledger or blockchain technology. The release comments on the relationship between digital asset securities and the SEC’s Customer Protection Rule and Securities Investor Protection Act of 1970 (“SIPA”). It highlights “significant differences in the mechanics and risks associated with custodying traditional securities and digital asset securities.” Among these are the threat of theft, fraud, loss of a key to transfer a client’s digital assets, and the inability to grant meaningful recourse for fraudulent transactions or errors.

Broker-Dealers are required to safeguard securities in a manner compliant with the SEC’s Customer Protection Rule. Digital assets securities raise a unique problem regarding custody in that the broker-dealer cannot physically hold digital assets or safeguard them in a central control location. In addition, if a broker-dealer fails, digital asset securities would not necessarily be readily available to be returned to customers. Combine those requirements with current recordkeeping and reporting obligations, and broker-dealers have quite a puzzle to solve regarding their engagement with digital asset securities.

SIPA requires that a broker-dealer liquidate and return the customer property that it holds in the event of its failure. The Securities Investor Protection Corporation (“SIPC”) was created under SIPA and protects against the loss of cash (up to $250,000) and securities (up to $500,000) when a brokerage firm fails. SIPC, however, only protects the custody function of the broker dealer, which means that SIPC works to restore to customers their securities and cash that are in their accounts when a brokerage firm liquidation begins. This protection excludes digital asset securities that meet the definition of a security under Federal securities laws but not under SIPA.

FINRA is open to a continued conversation about what actions could be considered satisfactory compliance. The staff has shown in their release that they are willing to survey innovative options for compliance given that those options satisfactorily meet existing regulatory requirements. Consult with your compliance professional to discuss what options could be right for you. #tradeuptotitan

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