On July 8 this year, the SEC and FINRA issued a joint statement on the regulatory issues facing digital asset custody and transactions. Issued from the SEC’s Division of Trading and Markets and FINRA’s office of general counsel, the statement brings good news for the digital asset business and foreshadows the decisions we can expect in other common-law jurisdictions, particularly Hong Kong.
One of the first things that stands out on reading the statement is the careful use of the term ‘digital asset securities.’ This isn’t totally new ground for the SEC, which has issued guidance in the past on which digital assets are to be considered securities, but here they’re making a point of establishing separate types of digital assets.
‘The term “digital asset” refers to an asset that is issued and transferred using distributed ledger or blockchain technology, including, but not limited to, so-called “virtual currencies,” “coins,” and “tokens,” the statement explains. ‘A digital asset may or may not meet the definition of a “security” under the federal securities laws. For the purposes of this statement, a digital asset that is a security is referred to as a “digital asset security.”’
This shows that the SEC has been watching carefully and has developed a really sophisticated understanding of the digital asset industry. Under the guidelines laid out in this statement, we can see three types of digital asset emerging: currencies and stablecoins, securities, and utility tokens. While there’s no sign that the SEC is coming after all digital assets as securities — quite the opposite, in fact; see Are Bitcoin and Ether considered securities? — it’s clear that there will soon be a very little regulatory grey area for utility tokens, many of which will be classed as securities.
The announcement acknowledges that the Customer Protection Rule applies to digital asset securities, which is something that Legacy and other voices in the industry have been advocating forwell over a year. We’ve argued that separation of powers, as in the traditional financial world, is required to safeguard investors in the digital asset space. While this has seemed a little too abstract for many in the industry, it’s obvious that the SEC has been thinking along similar lines.
One crucial issue raised in the announcement is that of private key possession. Just because entity A can prove they have the private key to digital asset account X, does not mean they can prove no-one else has it. If a broker-dealer sets up a wallet, there’s no way they can prove that they have not passed the private key to that wallet to some third party.
This is absolutely central to understanding how the SEC will approach the subject, and underlines the extent to which digital assets are reliant on the same structures of trust and probity that underpin the traditional financial industry.
At first glance, this is a checks-and-controls issue, mostly procedural, and not very exciting, though without it, the space cannot progress. But custodians must be able to show and prove the entire lifecycle of key generation and storage if they are to meet these requirements. There’s no way they can do that with the current toolkit, so this procedural issue requires a twofold solution: the right structures, and the right technology to facilitate them. Legacy has entered into a partnership with Ledger for just this reason.
Even while the new statement provides a lot of answers, it leaves plenty of questions. It touches on accounting, but offers nothing definitive beyond a restatement of the problem. Broker-dealers will have to comply with relevant accounting requirements, but how this is to actually be achieved is unclear. It’s not yet practicable to use blockchain’s inherent auditing functionality because the tools to do so across chains and to the required standards don’t currently exist, and intricacies in the functionality of different chains makes a chain-agnostic accountancy layer difficult to create and deploy. Therefore, notwithstanding the existence of detailed on-chain data that would be useful for accounting, the most practical short-term solution is to use traditional accounting techniques, which is in fact largely what industry participants are doing, including Legacy.
This announcement clearly has broker-dealers as its major target audience, and it recasts the debate over regulation of digital assets custody and trading, pointing the way forward for the USA and other jurisdictions. We can expect to see similar announcements coming out of Hong Kong soon. We’re gratified to find that it validates our own beliefs about the direction that legislation is likely to take, and that in some cases — our partnership with Ledger and use of their enterprise Vault tool, for instance — we have been able to get our clients ahead of the curve. More regulation of this space is coming — and that’s a good thing for everybody.