The staff of Division of Trading and Markets of the Securities and Exchange Commission (“SEC”), in its letter dated September 25, 2020 (“No-Action Letter”) issued to the Financial Industry Regulatory Authority (“FINRA”), addressed and approved a 3 (three) step process for broker-dealers operating non-custodial alternative trading systems (ATS) model for digital assets securities.
The No-Action Letter defines an ATS as a trading system that meets the definition of an ‘exchange’ however is not required to register under the Exchange Act if it complies with certain exemption conditions. An entity which complies with the Regulation ATS must register as a broker-dealer with the SEC.
Earlier on July 8, 2019, a Joint Staff Statement on Broker-Dealer Custody of Digital Asset Securities (“Joint Staff Statement”) was issued by SEC and FINRA wherein among other things, views were expressed on compliance with Rule 15c3-3 of the Securities Exchange Act of 1934 (“Exchange Act”). Rule 15c3-3 requires the broker-dealers to maintain the fully paid and excess margin securities in physical possession at a good control location and free of lien.
As per the description of the ATS model in the Joint Staff Statement, the settlement of non-custodial activities involved the following 4 (four) step process:
Step 1- orders are places on the ATS by the buyers and sellers;
Step 2- ATS matches the order;
Step 3- buyers and sellers are notified by the ATS in case of a match; and
Step 4- the buyers and sellers either unilaterally settle the transaction or instruct their custodians to settle the transaction on their behalf.
However, under the aforesaid 4 (four) step process, for the purpose of the Customer Protection Rules and the Exchange Act, the broker-dealer did not exercise any possession or control over the digital assets securities. The broker and dealer did not have any responsibility of settling the trades since they could not place a hold on the digital securities being sold or the cash being used to buy the digital securities.
The buyers and the sellers, in the above stated process, do not inform the custodian to settle the trade until after the ATS has matched the order, i.e. after having entered into a binding contract. Therefore, it may lead to a failed settlement if for any reason, the custodian refuses to recognise the transfer. This in turn increased the operational and settlement risk.
Therefore, the following 3 (three) step process was suggested and approved:
Step 1- buyers and sellers place their orders on the ATS and notify their custodians of the order and instruct the custodians to settle the transaction in accordance with the terms of the order when the ATS notifies of the match;
Step 2- ATS matches the order;
Step 3- ATS notifies the buyer and sellers and their custodians of the match and custodians carry out their conditional instructions.
The SEC has stated that it shall not recommend an enforcement action under Rule 15c3-3 if the broker dealer, while following the 3 (three) step process above, complies with the following conditions:
(i) The broker dealer maintains a minimum net capital of $ 2,50,000;
(ii) The agreement between the broker dealer and the customer clearly state that the broker dealer does not guarantee or have the responsibility of settling the trade;
(iii) The broker dealer shall have a reasonably designed procedure established to assess whether the digital asset securities were initially sold pursuant to an effective registration or under an available exemption from registration and whether the secondary digital asset securities transaction through ATS is pursuant to an effective registration statement or under an exemption from the registration requirement.
(iv) Digital assets securities transactions comply with the federal securities transactions.
The No Action Letter provides guidance on the secondary market for the digital assets securities. However, it shall be noted that the No Action Letter does not address the custody and control of digital asset securities under Rule 15c3-3. Interestingly, the SEC recently allowed the national banks and the federal savings associations to provide custodial services for cryptocurrencies.
As the Joint Staff Statement recognised, the non-custodial services for digital assets securities do not raise the same level of concerns as long as the SRO rules and other rules and regulations are complied with.
The article is authored by Samaksh Khanna, Co-Founder and Shivani Agarwal, Founder, BlockSuits.
Comments