On July 8, 2019, the Securities and Exchange Commission ("SEC") and the Financial Industry Regulatory Authority ("FINRA") issued their much-anticipated guidance on how broker-dealers could operate using blockchain technology under current custody regulations and requirements. The guidance also ameliorated the regulatory concerns over using blockchain in securities trading. Based on the guidelines provided in the July 8, 2019 “Joint Staff Statement on Broker-Dealer Custody of Digital Asset Securities” (the “Joint Statement”), FINRA promoted the following four-step process for meeting the Joint Statement requirements:
- A buyer and seller send their respective orders to an alternative trading system (“ATS”)
- The ATS matches their orders
- The ATS notifies the buyer and seller of the matched trade
- 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
In response, understandable concern arose regarding whether the four-step process would create “increased operational and settlement risks,” particularly in the areas of secondary trading of digital asset securities and trading of digital asset securities on an ATS.1
To address this issue, the SEC’s Division of Trading and Markets issued a no-action letter to FINRA on September 25, 2020.
The no-action letter confirmed that the SEC staff would not recommend an enforcement action against broker-dealers trading digital asset securities that followed the three-step process noted below:
- A buyer and seller send their respective orders to an ATS, notify their respective custodians of their respective orders submitted to the ATS, and instruct their respective 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
- The ATS notifies the buyer and seller and their respective custodians of the matched trade and the custodians carry out the conditional instructions
The three-step process provides a more effective avenue for broker-dealers to operate a trading platform for digital asset securities. The no-action letter also noted the following requirements:
- The broker-dealer will maintain a minimum of $250,000 in net capital
- The agreements between the broker-dealer and its customers clearly state that the broker-dealer does not guarantee or otherwise have responsibility for settling the trades
- The broker-dealer will establish and maintain reasonably designed procedures to assess:
- whether a digital asset security was offered and sold initially pursuant to an effective registration statement or an available exemption from registration
- whether any secondary transactions of the digital asset security conducted on or through the ATS were made pursuant to an effective registration statement or an available exemption from registration
- The transactions in digital asset securities otherwise comply with federal securities laws
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1 For purposes of this alert, the term “digital asset security” refers to an asset that is issued and/or transferred using distributed ledger or blockchain technology and is deemed to be a “security” under federal and state legislation.