Alert November 21, 2022

FINRA Sheds Light on Path to Digital Asset Security Broker Registration

Interest in engaging in a crypto business seems to be at an all-time high, including doing so in or through regulated and compliant businesses in traditional financial services firms. Brokers-dealers sit atop that list. The path to registration for digital or crypto asset securities brokers can be long and arduous. Just one example — FINRA views digital asset securities business lines as material and, for existing members, requiring approval under FINRA Rule 1017 as a “material change in business operations.” To provide a modicum of clarity, a recent FINRA podcast outlined the FINRA Membership Application Program’s (MAP) approach to seeking approval for a material business expansion in this area.

FINRA noted that there are approximately two dozen firms with an approved digital asset business line and another two dozen firms with pending applications (evenly split between new and continuing member applications). FINRA has approved applications for activity in two types of non-custodial activity: (1) serving as a placement agent for digital asset securities, and (2) operating an ATS that facilitates secondary transactions of digital asset securities. These ATSs must operate pursuant to what have come to be known as the “three-step” and “four-step” models outlined in an SEC No Action letter and an SEC/FINRA joint statement (each discussed below). FINRA also discussed the “special purpose broker-dealer guidance,” though it notes that no firms have been approved for this type of activity yet.

Placement Agents

In 2019, the SEC and FINRA issued a joint statement on custody of digital assets and the importance of the customer protection rule in this context. The joint statement, among other things, describes a private placement business model for digital assets (which is inherently non-custodial) in which the broker-dealer sends trade matching details to the issuer and investor, and the issuer and investor transact directly with each other or through the use of an escrow account established by the issuer. In this model, the activity of the broker-dealer is very limited, and importantly the transaction occurs entirely away from the broker-dealer. Broker-dealers using this model also need to have a comprehensive understanding and disclosure of the particular risks involved. In addition, firms need to describe how they will review offering materials, have an awareness of their responsibilities under the advertising rules, and have detailed procedures outlining their supervision of all of these elements.

ATSs

2020 SEC No Action Letter outlined two potential models for ATSs that facilitate secondary transactions in digital asset securities. In both models, the “broker-dealer operator [must] not guarantee or otherwise have responsibility for settling the trades and [must] 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 . . . other than by notifying the custodians for the buyer and seller, and the buyer and seller, of the match.” A broker-dealer seeking to operate an ATS pursuant to this no action relief can operate pursuant to either the “four-step” or “three-step” model.

Under the four-step model:

  1. Buyer and seller send their respective orders to the ATS
  2. The ATS matches the orders 
  3. The ATS notifies buyer and seller of the matched trade
  4. 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

Under the three-step model:

  1. Buyer and seller send their respective orders to the ATS, notify their respective custodians of the same, 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 
  2. The ATS matches the orders
  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 three-step model has slightly more involvement by the broker-dealer, in that it influences the disposition of customer funds and securities by providing settlement instructions to the buyer’s custodian. As a result, broker-dealers operating ATSs pursuant to the three-step model need to meet heightened requirements compared to the four-steppers:

  • The broker-dealer must maintain at least $250,000 in net capital
  • The agreements between the broker-dealer and its customers must clearly state that the broker-dealer does not guarantee or otherwise have responsibility for settling the trades 
  • The broker-dealer must 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 of the digital asset security on or through the ATS are made pursuant to an effective registration statement or an available exemption from registration
  • The transactions in digital asset securities must otherwise comply with federal securities laws

Special Purpose Broker

A 2020 SEC statement and request for comment outlined this third business model for digital asset securities brokers. A “special purpose broker” provides custody of funds and digital assets that are securities. The broker’s business must pertain solely to digital asset securities, i.e., neither traditional securities nor non-security digital assets can be in scope. The business model can include operating an ATS, provided that the ATS trades only in digital assets securities or otherwise engages in other business that involves only digital assets securities.

A special purpose broker must comply with nine specific requirements, including:

  1. It must have access to the digital asset securities and the capability to transfer them on the underlying distributed ledger 
  2. It must have reasonably designed policies and procedures designed to (i) analyze whether an asset is a security; (ii) assess the underlying distributed ledger technology and associated network prior to undertaking to maintain custody of the digital asset; (iii) demonstrate how the broker-dealer has exclusive control over the digital asset securities and guard against theft, consistent with industry best practices; and (iv) address how the broker-dealer will respond to specific events that could affect custody, including without limitation, blockchain malfunctions, air drops, hard forks, and 51% attacks 
  3. It must make certain required disclosure related to custody and risks and enter into a written agreement with each customer setting for the terms and conditions with respect to receiving, purchasing, holding, safekeeping, selling, transferring, exchanging, custodying, liquidating, and otherwise transacting in digital asset securities

Given the breadth and depth of these requirements, it is not surprising that FINRA has not yet approved any firms to operate a special purpose digital asset broker. On the other hand, the heightened operational limitations create a high barrier to entry, and only permitting business in digital asset securities narrows the scope of permissible activity, likely limiting the number of firms who would seek this custody permission.

A Path Forward

Few firms have made it through FINRA’s proverbial pearly gates to achieve digital asset security broker status. Those who have occupy space in somewhat of a grey zone, including given the lack of clarity surrounding whether various digital assets are securities or non-securities assets.  To say the SEC has not been helpful in this regard is a massive understatement.

On the bright side though, FINRA’s MAP group is beginning to focus more deliberately on applications for digital asset security business lines. New or existing brokers seeking FINRA’s approval should ensure they have a comprehensive application clearly describing how every aspect of the business complies with applicable guidance. The SEC’s frequent refrain is “come in and register,” and at least for certain types of business lines, that is slowly becoming more feasible.