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Custody Guidance Leaves Crypto Market Wanting
Traders Magazine Online News, July 23, 2019
The Securities and Exchange Commission and the Financial Industry Regulatory Authority have left broker-dealers and the operators of digital asset trading platforms treading water with the joint guidance regarding the custody of digital assets the regulators released earlier this week.
“What the guidance really says is that if brokerage firms want to intermediate transactions in digital securities that do not involve custody, that is a workable approach from a regulatory perspective,” Matthew Comstock, a shareholder at the law firm of Murphy & McGonigle, told Markets Media.
Compliance with Rule 15c3-3 of the Securities Act of 1934, better known as the Customer Protection Rule, remains the sticking point with the regulators.
“I think many broker-dealers when they decided a year or two ago that they would get permission from the regulators to custody and trade digital securities that they would be able to hold those digital securities for their customers in wallets,” said Comstock. “They would have private keys and make sure they were using things like cold wallets, and things of that nature to protect the assets. To date, the SEC staff and the FINRA staff have not gotten comfortable that that would be a viable approach. This joint statement does not change that.”
The regulators noted in the guidance their concerns regarding the risk of broker-dealers being the victims of fraud or theft as well as losing a client’s private key and lacking a claw-back mechanism if a broker-dealer transferred the digital assets to an unintended counterparty.
They cited an estimate by one blockchain forensic analysis firm that thieves stole approximately $1.7 billion worth of bitcoin and other digital assets in 2018, of which $950 million was from bitcoin-trading platforms.
On the other hand, Customer Protection Rule has helped recover investor assets in the event of a broker-dealer’s failure for approximately the past 50 years by requiring broker-dealers to safeguard client assets and keeping client and firm assets separate.
The Division of Markets and Trading and FINRA are still in discussions with industry participants regarding custody solution that the participants believe would meet the Customer Protection Rule’s possession and control standards.
“What the joint-statement makes clear is that if those [trading] platforms want to have a matching service where buyers and sellers post orders, which are then matched and executed, FINRA and the SEC do not take an issue with that,” said Comstock. “But, if the same entities are not only matching orders but carrying customer accounts and hold the securities that would trade on those ATS platforms, that is a problem.”
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