On November 1st, FINRA released a podcast Membership Application Program: Reviewing and Approving Digital Asset Firms. This podcast provides background information on the application process for broker-dealers requesting approval for certain digital asset activities through FINRA’s MAP department for new member applications and changes to membership. Approximately two dozen firms have been approved by FINRA to provide services and securities backed by digital assets, and more firms are requesting the same. Mr. Armando Valdes, an application manager with FINRA’s Membership Application Program (MAP), and David Aman, a senior advisor with the Office of Financial and Operational Risk Policy within the Chief Legal Office were the guests on the show.
Below is a summary of some challenges and best practices for Firm’s looking to enter the space.
Current Digital Asset Related Business Lines
FINRA guests noted that “For every prospective or existing member that is looking to engage in the digital asset, they will have a touchpoint with the Membership Application Program (“MAP”).” Members that have been approved to engage in digital asset securities consist of non or limited custodial business models. A non-custodial model is where a broker-dealer is acting as a placement agent in a private placement digital asset securities offering. The second is operating an alternative trading system or ATS, which facilitates the secondary transaction of digital asset securities in alignment with either the four-step process also outlined in the 2019 SEC and FINRA Joint Statement, known as the non-custodial model, or the three-step process outlined in the SEC’s September 2020 No-Action Letter, known as the limited custodial model. Finally, there is an additional category related to the custody of digital asset securities by a special purpose broker-dealer or SPBD. This category is limited to only those Firms with a single business model involving digital assets that are also securities and as of the date of the podcast, no member firm has been approved for the special purpose category.
Common Challenges
The major challenge theme noted by the FINRA guests was the lack of detail and consistency. Specifically, they noted that many new member applications stemmed from teams coming from technology backgrounds with little knowledge of legal and compliance considerations that FINRA requires Firm’s to provide. Firms need to show through their application that they are following U.S. federal securities laws and regulations and FINRA rules. These considerations should be fleshed out in a detailed description of the business. Another key issue is that this is a new area, so many legal firms and consultants don’t have experience and known templates to use to support applicants in building a clear and consistent plan.
Private Placement Firms
For private placement firms, FINRA guests saw challenges with Firm’s understanding and identifying areas of risk related to digital assets, or the blockchain. Disclosure of risks, communications with the public, supervisory oversight and solid procedures were also key considerations. Firm’s also needed to provide detailed information on the flow of activity and the broker-dealer having no involvement in the custody of the asset.
ATS (Alternative Trading Systems)
For Firms such as an ATS who provide either the 3 step or the 4 step non-custodial models, FINRA noted the importance of getting clarity about the operation of the ATS, transaction flows, and business models (using the 3-step process or the 4-step process) is key. For example, the 3-step process from the SEC No Action letter provides a number of conditions including a 250k minimum net capital.
Special Purpose Broker-Dealer
Although no member has been approved for this activity, the FINRA guests provided similar guidance on what they expect applicants to provide as best practice. This includes understanding the business model and how the applicant meets the nine conditions laid out by the SEC.
Broker-Dealers and Non-Broker Dealer Affiliate Crypto Arrangements
FINRA guests noted that some Firms choose to have an arrangement where their customers use an outside company to invest in cryptocurrencies or non-securities digital assets. Sometimes the customers will originally be customers of the cryptocurrency firm who want a model to allow them to also invest in securities. In these arrangements, FINRA is looking for clear disclosure that the products are not those of or the responsibility of the broker-dealer, not protected by SIPC, and not regulated by Securities and Exchange Commission (“SEC”) or the Financial Industry Regulatory Authority (“FINRA”).
If you decide to start a broker-dealer or have interest in adding digital assets to your Firm’s business line, understanding the key requirements of the Securities and Exchange Commission (“SEC”), Financial Industry Regulatory Authority (“FINRA”) and other regulatory bodies are vital. Unless you have expertise and experience with the application and registration process, you should consider professional support. With decades of experience, our team can provide specialized support to start your own broker-dealer or support your Firm in updating its membership agreement. Contact us today.