Providing additional clarity on the role of an alternative trading system (ATS) in the settlement of digital asset security trades, the staff of the SEC’s Division of Trading and Markets issued a no-action letter to FINRA on September 25, 2020. In brief, the SEC staff endorsed a three-step settlement process for digital asset securities held in a third-party’s custody if certain customer-protection conditions are met.
As we previously reported, in July 2019 the staffs of the SEC and FINRA issued a joint statement on registered broker-dealers operating ATSs that trade digital assets. The 2019 joint statement described several non-custodial activities involving digital assets that, in effect, involves 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.
Several broker-dealers seeking to operate ATSs that trades digital asset securities have observed that this non-custodial four-step process may increase operational and settlement risk. They instead proposed a 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 SEC staff approved the three-step process and advised FINRA it would not recommend enforcement action under the SEC’s Rule 15c3-3, the customer protection rule, so long as a broker-dealer operating an ATS in this fashion complies with the following four additional conditions:
(1) The broker-dealer operator must maintain a minimum of $250,000 in net capital;
(2) The agreements between the broker-dealer operator and its customers must clearly state that the broker-dealer operator does not guarantee or otherwise have responsibility for settling the trades;
(3) The broker-dealer operator must have established and maintain 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
(4) The transactions in digital asset securities must otherwise comply with the federal securities laws.
The no-action letter notes that it solely addresses an ATS trading digital asset securities and does not otherwise address broker-dealer custody or control of digital asset securities. Custody of digital assets remains elusive for registered broker-dealers, but recent interpretive guidance for national banks and federal savings associations maintaining custody of digital assets may provide a circuitous path forward.