On July 8, 2019, the U.S. Securities and Exchange Commission (SEC) and the Financial Industry Regulatory Authority (FINRA) put out a joint statement discussing broker-dealer custody of digital asset securities.
These organizations aspire to address compliance issues faced by companies wishing to transact in “digital asset securities” (any kind of asset that is issued and transferred on a distributed ledger or blockchain and meets the definition of a security under federal security laws — also known as “security tokens”). One SEC law in particular, the Customer Protection Rule, poses a unique challenge for broker-dealers (BDs) trying to interact with security tokens because it requires strict standards for the custody of customer assets.
The Customer Protection Rule
This rule was adopted in 1972 for the purpose of safeguarding securities held by a BD, in order to prevent investor loss in the event of the BD’s failure. It also enhances the ability for the SEC to monitor against unsound business practices. To comply, the BD must keep the customer’s assets separate from the firm’s assets so that it’s easy to return them in the event of a problem with the BD.
According to CipherTrace, approximately $1.7 billion worth of bitcoin and other digital assets were stolen in 2018. Approximately $950 million of this was from hacks of bitcoin trading platforms. According to the SEC, the Customer Protection Rule has been a large factor in the much stronger 50-year track record for customers getting their assets back when a BD fails.
The SEC and FINRA have received several new membership applications from existing BDs looking to expand into the security token space with a business model that involves holding custody over customers’ assets. At this time, the SEC and