Custody of Cryptocurrency: Considerations for Broker-Dealers

It is evident that the U.S. Securities and Exchange Commission (SEC) and Financial Industry Regulatory Authority (FINRA) are constantly putting efforts forward to navigate the unchartered waters of cryptocurrency. Just days before Blockstack’s Reg A+ token offering received SEC approval, the SEC and FINRA issued a joint statement to provide guidance and encourage innovation and ongoing discussions with market participants on the idea of the custody of cryptocurrency for broker-dealers.

This comes amid industry requests for clarity on whether they can hold such assets under federal securities laws. It also could potentially prepare a way for more traditional investors to hold digital asset securities.

The Customer Protection Rule

According to the statement, the organizations have yet to discover a set of circumstances in which a crypto custodian could comply with the SEC’s Customer Protection Rule. Put simply, the Customer Protection Rule requires broker-dealers to safeguard customer assets by keeping customer assets separate from the firm’s assets. This results in an increased likelihood that customers’ securities and cash can be returned to them in the event of the broker-dealer’s failure.

The Issue of Exclusive Control

One key issue around custody comes from the fact that while broker-dealers can easily verify that cryptocurrencies in any given wallet belong to them, it is harder to prove that the broker-dealer has exclusive control and no other parties have access to the holdings. The broker-dealer’s maintenance of the private key is not sufficient in evidencing that no other parties have access to the private key and could transfer the digital assets without prior consent from the broker-dealer. The SEC has been trying to determine how digital asset securities fit within existing federal law, which often requires a custodian to take physical possession of a security.

“A digital asset … is controlled by whoever possesses the private key, and it’s hard to prove a negative,” explained Valerie Szczepanik, SEC’s senior advisor for digital assets during a panel at the D.C Blockchain Summit in March. She further said that these firms “need to show that they have possession and control and that could be hard to demonstrate with a digital asset.” These remarks along with the recent SEC statement are in agreement that holding securities in a wallet controlled by the broker-dealer through private keys face a more difficult path to approval.

The Future of Custody for Cryptocurrency

Digital asset securities continue to raise complex regulatory and compliance questions and challenges. The SEC and FINRA are still working to articulate their main concerns regarding regulatory compliance by broker-dealers wishing to maintain custody of cryptocurrency. The organizations encourage innovation regarding these topics and remain open to ongoing discussions with investors and market participants as the digital asset space continues to develop and evolve.

Click here to read the Joint Staff Statement on Broker-Dealer Custody of Digital Asset Securities in its entirety.

Browse our previous blog posts on these topics: Digital Assets and Custody.

 

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