SEC and FINRA Share Outstanding Issues with Crypto Custodians

The United States Securities and Exchange Commission (SEC) and the Financial Industry Regulatory Authority (FINRA) have issued a joint statement on July 8th, in which they outlined regulatory compliance issues for cryptocurrency custodians.

Both agencies believe that there are a number of questions they need to address before they can approve crypto companies’ applications to become broker-dealers.

The statement outlined important criteria for both institutions’ approach to broker-dealer regulation, investor protection including when assets are deemed as securities under the 1970 Securities Investor Protection Act (SIPA), as well as various factors related to many of these questions such as when to consider approving a broker-dealer application of crypto-related companies.

The statement reads:

“The requirements of the Customer Protection Rule have produced a nearly 50-year track record of recovery for investors when their broker-dealers have failed. […] This record of protecting customer assets held in custody by broker-dealers stands in contrast to recent reports of cybertheft, and underscores the need to ensure broker-dealers robust protection of customer assets, including [cryptocurrency] securities.”

Broker-dealers in the U.S. are registered and regulated to buy and sell securities for themselves or their clients. And some firms use digital assets such as securities, thus allowing them to cater to institutional investors that cannot hold or directly buy assets.

“Put simply, the Customer Protection Rule requires broker-dealers to safeguard customer assets and to keep customer assets separate from the firm’s assets, thus increasing the likelihood that customers’ securities and cash can be returned to them in the event of the broker-dealer’s failure,” notes the report.

Apparently, the agencies claim that a crypto custody service may not be able to sufficiently prove that it actually controls the assets it supposedly holds. For instance, although a broker can verify that it has private keys to a crypto wallet, the challenge is to prove that no other individuals or institutions hold a copy of the private key, which could allow them to transfer digital asset security without obtaining permission from the broker-dealer.

In addition to that, if the transaction is made successfully, the custodian has no power to reverse it. This is applicable to all transactions a custodian wants to cancel or reverse.

Apart from custodial services, the regulators have suggested in the statement that they consider over-the-counter (OTC) trading, where brokers do not have custody of the digital asset securities, as lower-risk. This would mean such OTC trading would not require high levels of scrutiny. The report further tackles issues such as non-custodial service registration, bookkeeping policies, and liquidation following SIPA’s protocol.

Meanwhile, the SEC requested feedback back in March on how it might regulate crypto settlements. The agency showed further interest in the role of custodians in non-delivery versus payment trading as well as what safeguards are currently in place.