SEC relief streamlines noncustodial settlement of digital asset trades, but broker-dealer custody is still off-limits.
On September 25, 2020, the US Securities and Exchange Commission (SEC) issued a no-action letter (the Letter) granting more leeway to registered alternative trading systems (ATSs) that settle trades involving digital asset securities. The no-action relief is intended to reduce operational and settlement risks that ATSs face as they seek ways to provide noncustodial digital asset services, including settlement of trades involving virtual currencies, coins, and tokens.
Context: 2019 Joint Statement
On July 8, 2019, the SEC and FINRA issued a joint staff statement (the Joint Statement) maintaining that given certain regulatory concerns — particularly those pursuant to the custodial requirements under Rule 15c3-3 of the Securities Exchange Act of 1934 (Customer Protection Rule) — broker-dealers were not yet permitted to custody digital assets. (See Can Broker-Dealers HODL? SEC and FINRA Say Keep It Noncustodial for Now.) However, the Joint Statement specified a few instances in which broker-dealers that seek to engage in noncustodial brokerage activities with digital assets should be permitted to do so. One potential permissible noncustodial model presented by the Joint Statement involved an ATS that simply matched buyers and sellers and allowed the buyers and sellers to independently settle the resulting digital asset transactions either directly between themselves or by instructing their respective custodians to settle the transactions. Under this model, according to the Joint Statement, the 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.” The Customer Protection Rule would therefore not be a roadblock to such secondary market transactions.
From Four Steps to Three
In the wake of the Joint Statement, ATS models that settled trades of digital asset securities by following a four-step process wherein buyers and sellers had to take action both before the match (by sending their order to the ATS) and after the match (by instructing their custodians to settle) in order to effect the trade. The four-step process was as follows:
- The buyer and seller send their orders to the ATS.
- The ATS matches the orders.
- The ATS notifies the buyer and seller about the matched trade.
- The buyer and seller settle the transaction bilaterally (either with each other or through their custodians).
The Letter allows ATSs to simplify this process for subscribers by allowing them to, simultaneously with sending their order to the ATS, send a conditional instruction to their respective custodian to settle the transaction if a match is made. Accordingly, Step 4 is eliminated as follows:
- 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.
- The ATS matches the orders.
- The ATS notifies the buyer and seller and their respective custodians about the matched trade, and the custodians carry out the conditional settlement instructions.
While this approach is not materially different from a regulatory perspective, it is a welcome practical clarification for digital asset ATSs. Requiring buyers and sellers to send a separate instruction to their custodians after the match was cumbersome for ATS subscribers and, as the Letter points out, increased operational and settlement risks.
The Fine Print
The SEC states in the Letter that it will not pursue enforcement against an ATS using the three-step process to settle trades in digital asset securities, so long as the following conditions are met:
- The broker-dealer operator maintains a minimum of US$250,000 in net capital.
- The agreements between the broker-dealer operator and its customers clearly state that the broker-dealer operator does not guarantee or otherwise have responsibility for settling the trades.
- The broker-dealer operator has established and maintains 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 otherwise comply with the federal securities laws.
More Action by No-Action
The Letter continues a string of no-action relief and guidance on digital asset securities that the SEC has released over the past few years. While the Letter is a welcome sign that the agency is willing to engage with companies making good-faith efforts to bring innovative blockchain-based products and services to the marketplace, many questions remain unresolved. Until a robust and comprehensive framework for digital asset securities is brought forth, market participants and regulators will continue to advance one narrowly tailored no-action letter at a time.