Background
Since 2017, SEC guidance and enforcement actions have made clear that many, but not all, digital assets are “securities” under both the U.S. Securities Act of 1933 (Securities Act) and the Exchange Act.4 As such, the growth of private offerings in digital asset securities in 2018 and 2019 created the need for broker-dealers to support the primary offering and secondary trading of digital asset securities, including operating alternative trading systems to support the developing market. Given the influx of broker-dealer applications received by FINRA and the SEC (either to register as broker-dealers and/or to commence operations as an ATS) for trading activities involving digital asset securities, the Joint Statement was released to offer guidance under the Customer Protection Rule with respect to potential broker-dealer business models involving digital asset securities. In particular, the Joint Statement stated that a broker-dealer could operate an ATS that matches buyers and sellers of digital asset securities where the trade executed on the ATS is settled directly between buyer and seller or through a third-party custodian. In either case, the securities and funds relating to a “matched” transaction effected by the ATS do not pass through the broker-dealer, and the broker-dealer would generally not be subject to the possession/control or reserve requirements of the Customer Protection Rule.5
The SEC No-Action Relief
As described in the Letter, the Joint Statement described an ATS model that involves the following “four-step process”:
- Step 1 - the buyer and seller send their respective orders to the ATS.
- Step 2 - the ATS matches the orders.
- Step 3 - the ATS notifies the buyer and seller of the matched trade.
- Step 4 - 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.
A number of broker-dealers who each sought to operate an ATS to trade digital asset securities have asserted that the four-step process unnecessarily increases operational and settlement risks, presumably, because the buyer and seller do not notify or instruct their respective custodians to transfer ownership of the digital asset securities until after the ATS has matched the trade, and thus after the buyer and seller having entered into a binding contract. As such, conducting the notification/instruction after the matching could increase the risk that a custodian will refuse to recognize a transfer and, thus, could increase the risk of a “failed” settlement.
Alternatively, a “three-step process” was suggested that relies on a buyer and seller providing notification/instruction to their respective custodians to settle a trade to be executed on the ATS, but now before the trade is matched on the ATS and a binding contact is established:
- Step 1 - the buyer and seller send their respective orders to the 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.
- Step 2 - the ATS matches the orders.
- Step 3 - the ATS notifies the buyer and seller and their respective custodians of the matched trade, and the custodians carry out the conditional instructions.
The custodians would then settle the trade on behalf of the buyer and seller based on the instructions received in Step 1.
As with the four-step process (and as described in the Joint Statement), the broker-dealer/ATS would not guarantee or otherwise have responsibility for settling the trades and would not, at any time, exercise any level of control over the digital asset securities being sold or the cash being used to make the purchase (for example, the ATS does not place a temporary hold on the seller’s wallet or on the buyer’s cash to ensure that the transaction is completed); the broker-dealer only notifies the buyer and seller, and their respective custodians, of the match.
The Staff granted the no-action relief for a broker-dealer/ATS to rely on the three-step process with respect to trades involving digital asset securities, provided that the broker-dealer/ATS must also satisfy the following conditions: (i) maintain a minimum of $250,000 in net capital in accordance with SEC Rule 15c3-1,6 (ii) clearly state in its agreements with customers that it does not guarantee or otherwise have responsibility for settling the trades, (iii) 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, and whether any secondary transactions on or through the ATS are made pursuant to an effective registration statement or an available exemption from registration, and (iv) the transactions in digital asset securities must otherwise comply with the federal securities laws.
The Letter, however, expressly does not “otherwise address broker-dealer custody or control of digital asset securities under Rule 15c3-3,” such as the ability of a broker-dealer to “possess” digital asset securities or rely on a “good control location” for digital asset securities thereunder. Thus, the Letter does not address the ability of a broker-dealer to directly possess digital asset securities or custody digital securities for customers or other broker-dealers at a national bank or federal savings association or at any other location, and, at this time, the SEC has not provided guidance on the ability of a broker-dealer to provide for such possession or custody.
Implications for the Industry
The Letter comes shortly after the U.S. Office of the Comptroller of the Currency (OCC) issued an interpretative letter (OCC Letter) confirming the authority of national banks and federal savings associations to provide custody services for digital assets, including digital asset securities, on behalf of their customers.7 Taken together, the Letter and OCC Letter help clarify a path toward establishing a secondary market for digital asset securities while complying with the federal securities laws because buyers and sellers of digital asset securities could more easily access an ATS to effect trades, thereby potentially increasing liquidity for those securities and having access to the custodial services of a national bank or federal savings association for these purposes. The Letter is notable in that it confirms and elaborates on the ATS model noted in the Joint Statement while also providing for additional flexibility on how a broker-dealer may structure a noncustodial ATS for trading digital asset securities.8
2 Division of Trading and Markets, U.S. Securities and Exchange Commission Office of General Counsel, Financial Industry Regulatory Authority, Joint Staff Statement on Broker-Dealer Custody of Digital Asset Securities, July 8, 2019. See also our Sidley Update.
3 As noted in the Letter, an ATS is a trading system that is operated by a registered broker-dealer and that meets the definition of an “exchange” under federal securities laws, but is not required to register as a national securities exchange if it is in compliance with Regulation ATS (17 CFR §§ 242.300 – 242.304) under the Exchange Act.
4 Most recently, the Staff noted that whether a digital asset is a security is “inherently a facts and circumstances determination” but that it believes a digital asset may be structured and sold “in such a way that it does not constitute a security and implicate the registration, reporting, and other requirements of the federal securities laws.” SEC Strategic Hub for Innovation and Financial Technology (FinHub) Staff, SEC FinHub Staff Statement on OCC Interpretation (Sept. 21, 2020). Digital asset securities deemed to be “securities” under the Securities Act and the Exchange Act by reason of constituting “investment contracts” would not appear to be “securities” under Section 78lll(14) of the Securities Investor Protection Act of 1970 if the security is privately placed and not the subject of a registration statement under the Securities Act.
5 SEC Rule 15c3-33(b) requires that broker-dealers promptly obtain and thereafter maintain possession or control of all fully paid or excess margin securities carried by the broker-dealer for the account of customers and imposes potential reserve requirements on broker-dealers who may use or rehypothecate customers’ margin securities. See also our Sidley Update on recent SEC and FINRA interpretations relating to compliance with the Customer Protection Rule with respect to certain broker-dealers that do not carry customer accounts.
6 7 C.F.R. § 240.15c3-1. Pursuant to SEC Rule 15c3-1(a)(2)(i), a broker-dealer/ATS is required to maintain minimum net capital of $250,000 if such broker-dealer/ATS carries customer or other broker-dealer accounts and receives or holds funds or securities for those persons. Under the three-step process, the broker-dealer/ATS notifies the buyer and seller, and their respective custodians, after a transaction is matched on the ATS and a binding contract is established — in contrast to the buyer and seller providing such notification/instruction to their respective custodians in the four-step process. As a result, the SEC may have been concerned that the broker-dealer/ATS might be deemed for these purposes to have “received” securities prior to settlement of the transaction and, thus, wanted such a broker-dealer to be subject to a minimum net capital requirement of $250,000. If a broker-dealer/ATS that seeks to rely on the Letter is subject to a minimum net capital requirement of less than $250,000 as memorialized in the broker-dealer’s FINRA membership agreement (for example, a $5,000 minimum requirement under SEC Rule 15c3-1(a)(2)(vi)), the broker-dealer may need to, first, seek approval from FINRA via a “continuing membership application” under FINRA Rule 1017(a)(5) and (b) for a “material change in business operations” before moving to the three-step process under the Letter. In this regard, pursuant to FINRA Rule 1011(l)(3), a “material change in business operations” means “adding business activities that require a higher minimum net capital under SEA Rule 15c3-1.” FINRA might view the change to the three-step process from the four-step process as “adding” a new business activity.
7 OCC Interpretative Letter No. 1170 (July 22, 2020). See also our Sidley Update.
8 The Joint Statement “is not a rule, regulation, guidance, or statement” of the SEC or FINRA and “does not alter or amend applicable law and has no legal force or effect.” Similarly, the Letter is based strictly on the facts and circumstances described therein, “does not purport to express any legal conclusions on the questions presented,” and is subject to modification or revocation by the Staff at any time.
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