SEC Requests Comment on Broker-Dealer Custody of "Digital Asset Securities"

Steven Lofchie Commentary by Steven Lofchie

The SEC requested comment on allowing limited purpose broker-dealers to custody "digital asset securities," consistent with SEA Rule 15c3-3 ("Customer protection-reserves and custody of securities"), provided that they do not custody any other assets.

In its statement and request, the SEC said that it would not recommend enforcement action against a broker-dealer on the basis of the broker-dealer deeming itself to "have obtained and maintained physical possession or control of customer fully paid and excess margin digital asset securities" if, among other things, the broker-dealer:

  • restricts its business to digital asset securities;

  • creates and maintains policies and procedures that are reasonably designed to mitigate risks associated with digital asset securities; and

  • provides certain disclosures to customers in relation to the risks associated with engaging in transactions that involve digital asset securities.

Comments regarding the custody of digital asset securities by broker-dealers must be submitted within 60 days of the request's publication in the Federal Register.

Commentary

The SEC has been struggling for a number of years with the question of how to allow broker-dealers to custody digital securities where the procedures for holding these assets may be less assured than of holding ordinary securities. From a policy perspective, this is a more difficult issue for the SEC than it might be for the banking regulators. In the event of a broker-dealer's insolvency (for example, in a case where the digital assets were stolen), all of the firm's customers share losses pro rata. Thus, customers who custody only ordinary securities with the broker-dealer would be injured pro rata through the disappearance of the digital assets with the customers who owned the assets.

By limiting the broker-dealer to the holding of digital assets, the SEC is effectively limiting the custody risk to that group of customers who have agreed to assume the risk. (Presumably, all customers would qualify for SIPC reimbursements in the event of a broker-dealer insolvency, to the extent that the relevant instruments qualified.) One notable restriction in the SEC's request for comment is that the broker-dealer could hold only "digital asset securities" - presumably, it could not hold digital currencies. 

The request for comment contains a fairly detailed list of compliance procedures that would be expected of a digital asset broker-dealer. Firms considering establishing such a broker-dealer should consider whether the procedures are reasonable.

It is worth noting that the SEC previously used a similar process to educate itself as to a new development in the financial markets. Some time ago, the SEC provided for the operation of "over-the-counter derivatives dealers" so that the SEC could gain experience with the use of models to calculate financial risk and net capital requirements. When the SEC gained some confidence in the use of models, it somewhat expanded their permissible uses.

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