Statement from SEC and FINRA codifies questions for broker-dealer custody



  • The SEC and FINRA released a joint statement elaborating on questions of custody and broker-dealer compliance
  • Much of the concern focuses on how to ensure securities can’t go missing due to fraudulent activity or technical mishaps
  • The main scrutiny is placed on broker-dealer custody

There’s a backlog of crypto firms looking to snag a license to operate broker dealer licenses, but regulators are unlikely to give the green light until the space cleans up.

A statement issued jointly by the Securities Exchange Commission (SEC) and Financial Industry Regulatory Authority (FINRA) codified some of the concerns the agencies have about crypto firms operating as broker dealers, but industry experts who spoke to The Block say the industry will have to figure out how to solve to address those issues, such as accounting for and guarding against the loss or hacking of digital securities.

The joint statement comes at a time when crypto companies are looking to increase their legitimacy with a brokerage license. The Wall Street Journal reported between 35 and 40 companies with hands in digital assets have applied with U.S. securities overseers to become brokerages, but still, none have gained approval.

Part of that backlog may be connected the security concerns the agency has. Under the Securities Investor Protection Act (SIPA), securities can be insured up to $500,000 in the case that a broker-dealer is missing assets, but this does not cover other types of assets. To make matters more complicated, there is some disparity between what the SEC and SIPA deem as a security, meaning crypto securities may not be protected.

“In the case of a digital asset security that does not meet the definition of “security” under SIPA, and in the event of the failure of a carrying broker-dealer, SIPA protection likely would not apply and holders of those digital asset securities would have only unsecured general creditor claims against the broker-dealer’s estate,” reads the statement.

The agencies note that blockchain technology makes compliance difficult because of the pivotal role played by private keys and the lack of recourse if a transaction is botched, since often private keys are not significant enough evidence of ownership. Specifically, the agencies said applying current rules to the crypto space creates “novel and complex regulatory and compliance questions and challenges,” reaffirming multiple times that they are engaged in conversations with industry participants to discuss possible solutions.

On the road to approval

Jeff Bandman, CEO of BlockAgent, a transfer agent, said the statement suggests broker-dealer ATSes still face a long road to approval by the SEC. To help things along, the SEC is grappling with fundamental issues on how to protect customers and prove assets actually exist. The loss of a private key could be detrimental for crypto, as opposed to traditional assets which have multiple failsafes to show existence and ownership.

“If digital assets come under the SEC regime, they don’t want it to be in a way where they can just go disappear,” he said.

These questions are paramount for those looking to get into the space as well. Phil Liu, Chief Legal Officer and co-founder at Arca, pointed out that traditional financial institutions looking to custody aren’t looking to get into a business where assets can go missing due to a hack or technical problem, and are uninsured to boot.

“Everybody in traditional finance accepts that you can make a bad investment and your investment loses value,” he said. “What they can’t accept is that even one dollar goes missing because of fraud or gross negligence because someone screwed up on technical matters.”

But Liu said the statement is still encouraging, since word from the SEC and FINRA means these questions are continuously circling from crypto players as well as institutions like pension plans and mutual funds, indicating a growing interest in the space.

As Liu put it, the SEC and FINRA aren’t in the solutions business, they’re in the problem identification business. Without a technical solution to recover an incorrectly or fraudulently transferred token, compliant broker-dealer custody remains challenging. As the statement reiterated, it’s one the agencies look forward to discussing with the industry until a suitable solution is found.

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