The staff (“Staff”) of the Division of Trading and Markets of the U.S. Securities and Exchange Commission (SEC) issued a no-action letter (NAL) at the request of the Financial Industry Regulatory Authority (FINRA) on September 25, 2020, which built upon a joint statement (“Joint Statement”) issued by the staffs of the SEC and FINRA in 2019 (please see our prior client update for additional discussion of this 2019 guidance). As part of its guidance, the Joint Statement provided an example of a noncustodial business model for broker-dealers that involved the operation of an alternative trading system (ATS). Upon a request by FINRA on behalf of its broker-dealer members, the NAL provides modified relief for ATSs that meet certain conditions, enabling them to settle digital asset security trades under a slightly modified structure designed to reduce operational and settlement risks.
2019 Joint Statement
The Joint Statement articulated primary regulatory concerns regarding broker-dealers’ ability to comply with financial responsibility rules in the context of digital asset securities. Of chief concern was the Customer Protection Rule (i.e., Rule 15c3-3 under the Securities Exchange Act of 1934), which governs custody. The noncustodial business model for a broker-dealer settling digital asset security trades in its operation of an ATS involved a four-step process:
Step 1 – the buyer and seller send their respective orders to the ATS;
Step 2 – the ATS matches the orders;
Step 3 – the ATS notifies the buyer and seller of the matched trade; and
Step 4 – the 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.
2020 No-Action Letter
Since the issuance of the Joint Statement in 2019, broker-dealers operating ATSs have expressed concern that the four-step process increased operational and settlement risks. To reduce these risks, the Staff approved a modified three-step process:
Step 1 – 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;
Step 2 – the ATS matches the orders; and
Step 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 custodians would then settle the trade on behalf of the buyer and seller based on the instructions received in Step 1. To utilize this modified three-step process, the broker-dealer operator must comply with four conditions:
- The broker-dealer operator maintains a minimum of $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; and
- The transactions in digital asset securities otherwise comply with the federal securities laws.
The NAL does not expand the context of the Joint Statement’s prior guidance but rather provides a modified process that enables broker-dealer operators of ATSs to reduce their settlement and operational risks. The NAL does not address broker-dealer custody or control of digital asset securities under Rule 15c3-3. In addition, through its third condition, the NAL reiterates that the onus is on the broker-dealer operator to have sufficient procedures and controls to assess compliance with the federal security laws for digital asset securities traded on the ATS. The modified three-step process seeks to increase the amount of information shared by the respective parties at the beginning of the trade cycle to simplify the end of the settlement process.