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The Application of Broker-Dealer and Exchange Regulations to Secondary Markets – Thought Leaders

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The Application of Broker-Dealer and Exchange Regulations to Secondary Markets Trading of Digital Assets.

The U.S. Securities and Exchange Commission’s (“SEC” or “Commission”) recent enforcement actions involving AirFox, Paragon, Crypto Asset Management, TokenLot, and EtherDelta’s founder illustrate that market participants must still adhere to well-established and well-functioning federal securities law framework when dealing with technological innovations, regardless of whether the securities are issued in certificated form or using new technologies, such as blockchain.

Broadly speaking, the issues raised in these actions fall into three categories: (1) initial offers and sales of digital asset securities (including those issued in initial coin offerings (“ICOs”)); (2) investment vehicles investing in digital asset securities and those who advise others about investing in these securities; and (3) secondary market trading of digital asset securities. [mfn] See Statement on Digital Asset Securities Issuance and Trading by the SEC’s Division of Corporation Finance, Division of Investment Management, and Division of Trading and Markets (Nov. 16, 2018). https://www.sec.gov/news/public-statement/digital-asset-securites-issuuance-and-trading[/mfn]  This article discusses some of the nuances of trading of digital asset securities in the secondary market.

As the Commission’ statement made clear “[a]ny entity that provides a marketplace for bringing together buyers and sellers of securities, regardless of the applied technology, must determine whether its activities meet the definition of an exchange under the federal securities laws. Exchange Act Rule 3b-16 provides a functional test to assess whether an entity meets the definition of an exchange under Section 3(a)(1) of the Exchange Act. An entity that meets the definition of an exchange must register with the Commission as a national securities exchange or be exempt from registration, such as by operating as an alternative trading system (“ATS”) in compliance with Regulation ATS.” [mfn] Id.[/mfn]

In determining whether an individual, entity or platform is acting as a broker-dealer or an exchange, the SEC will conduct its analysis based upon 1) the totality of the activities conducted by the participant as well as 2) the functional reality of what those activities achieve.  If an entity provides a marketplace for bringing together buyers and sellers of digital asset securities, the SEC may find that such an entity is operating as an exchange. If an entity or a person is effecting transactions in digital assets or buying and selling digital assets for its own account, the SEC may find that such an entity or individual is acting as a broker or dealer in securities. [mfn] See Scheibe, Taub, Selinger, Steele and Woodward, SEC DIVISIONS ISSUE DIGITAL ASSET SECURITIES STATEMENT November 28, 2018 https://www.mwe.com/insights/sec-divisions-issue-digital-asset-securities-statement/ [/mfn] Any such broker-dealer must register with the SEC, as well as become a member of a self-regulatory organization, such as FINRA.  Registration as a broker or dealer also results in adherence to a far-reaching compliance and investor protection regime.

Some of the most basic requirements that can pose roadblocks or speedbumps for the development of secondary market trading of digital assets include:

  • Books and Records: Registered broker-dealers must make and maintain current books and records. Rules 17a-3 and 17a-4 under the Exchange Act and FINRA Rule 4511, for example, require that broker-dealers preserve certain records for specified periods of time and use certain technology such as write once read many (WORM) format. How can a digital-asset ATS be sure that the use of Digital Ledger Technology for recording and maintaining such information is in compliance with the SEC and FINRA’s requirements? The short answer should be that the blockchain is immutable and thus satisfies this requirement but some regulatory assurances on this would be helpful.

 

  • Customer Protection: Under SEC Rule 15c3-3, a broker-dealer must maintain the physical possession or control of all fully paid securities and excess margin securities carried by the broker-dealer for the account of its customers. It is currently unclear whether the requirements of Rule 15c3-3 are met where transactions in digital securities are recorded on a database that is maintained over a public or private network. Does a Broker-dealer have the ability to demonstrate receipt, delivery and custody of securities and other assets of their customer’s accounts where such records are held on chain? For example, is it required that ICO tokens, securities or other assets be held in a customer’s account (wallet) or does the ATS sponsor need to provide for the custody of these securities and assets with a third-party qualified custodian?

 

  • Examinations: Broker-dealers and regulators are still figuring out these new technologies and how existing regulations apply to them. FINRA’s current examination module for an ATS may very well be ill suited to a digital asset ATS.  FINRA in Notice 18-20 (July 6, 2018) made clear that is seeking additional information from broker-dealers and “to encourage each firm to promptly notify FINRA if it, or its associated persons or affiliates, currently engages, or intends to engage, in any activities related to digital assets”.

 

  • Net Capital Rules: The Commission’s net capital rules will arguably have the most severe impact on the development of secondary trading markets in digital assets. The SEC has previously stated that Exchange Act Rule 15c3-1 “requires broker-dealers to maintain a minimum level of net capital (consisting of highly liquid assets) at all times.” [mfn] See SEC Securities Exchange Act Release No. 70073 (July 30, 2013) (Order Approving File No. S7-23-11).[/mfn] FINRA Rule 4100 Series (Financial Condition) expands the various requirements for broker-dealers to ensure compliance with the SEC’s net capital rules.  Given that digital assets coming off the Reg D imposed restriction period are unlikely to meet the requirements for highly liquid assets, these net capital requirements may pose the biggest hurdle in allowing for deep and liquid markets to come into being in the near term. In order to allow this nascent digital asset securities market to grow and bring liquidity to shareholders, the Commission and FINRA may wish to allow for a pilot program to facilitate the development and oversight of this market.

 

In conclusion, the promise of DLT and the application of Exchange Act Rules still have some ways to go before digital assets can be traded freely and transparently on exchanges and ATS’. That being said, it’s not too early for market participants in this space and regulators to come together to address a roadmap for the near future in the U.S. A discussion of some of these topics at the upcoming SEC Forum [mfn]SEC Staff to Hold Fintech Forum to Discuss Distributed Ledger Technology and Digital Assets, SEC Press Release 2019-35 (March 15, 2019)[/mfn] is essential for furthering this dialogue and unlocking the promise of liquidity that digital asset issuers aspire to.

Considered to be a blockchain regulation visionary, Gautam S. Gujral is the Co-Founder and General Counsel at Vertalo SEZC.

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