Industry sources tell FinOps Report that FINRA is in discussions with the Securities and Exchange Commission’s Department of Trading and Markets about FINRA crafting a regulatory notice informing broker-dealers how to apply the SEC’s Rule 15c3-3 to digital assets. The goal of the rule, adopted in 1972 as part of the Securities Exchange Act of 1933, is to protect customer funds and securities held by broker-dealers so that they can be accessed even if the broker-dealer goes bankrupt. Broker-dealers must segregate their customers’ cash and securities from their own and not use them for their own trading and operational activities.
The SEC would not comment on any input to FINRA’s potential new guidance and FINRA would not acknowledge its talks with the SEC which were briefly mentioned at a recent national conference on the securities industry co-hosted by the trade group Securities Industry and Financial Markets Association in New York. Instead FINRA referred FinOps Report to a notice it issued in July 2018 which called on broker-dealers to inform FINRA if they are taking part in any business related to digital assets. “In addition, until July 31, 2019, FINRA encourages each firm to keep its Regulatory Coordinator abreast of changes in the event the firm, or its associated persons or affiliates, determines to engage in activities relating to digital assets not previously disclosed,” says the notice. The laundry list of activities include transactions in or advice relating to digital assets, transactions in derivatives, such as futures and options and structured products linked to digital asset offerings and custody.
FINRA’s guidance is likely to be of greatest help to existing broker-dealers who wish to add digital assets to the list of products they trade and safekeep for clients. Newcomers to the market for “qualified custodians” which might consider the brokerage designation as a selling point for wining business from registered investment advisers seeking some regulatory clarification over the safekeeping of digital assets to promote themselves to institutional investors.
Broker-dealers are one of five categories of firms registered investment advisers must pick as their “qualified custodians'” to safekeep customer assets; the others are banks, trust companies, futures commission merchants and foreign financial firms. For now, the SEC has no intention of amending its custody rule for RIAs to apply to digital assets, say industry sources. However, many RIAs are still selecting qualified custodians to safekeep digital assets to avoid any potential SEC criticism and attract institutional investors who have been hesitant to enter the digital asset market because of conflicting legal interpretations over who can safekeep digital assets and operational requirements.
The SEC has not defined cryptocurrencies, such as Bitcoin, as assets prompting some fund managers to argue that the custody rule for RIAs doesn’t apply. FINRA’s possible guidance on applying the customer protection rule to cryptoassets suggests that it and the SEC will avoid directly addressing the issue of whether or which cryptoassets are actually securities.
Legal designation is only one of a number of criteria RIAs will use in their decision-making process for qualified custodians; the others are likely the types of digital assets covered and the level of asset safety and accessibility. All of the providers of digital asset custody cite the superiority of their “cold wallets” and multiple signatories to safekeep and access digital assets.
Understanding the distinctions among rivals can a mindboggling challenge and with escalating competition comes heated rhetoric. In her emailed response to questions from FinOps Report, Shahla Ali, chief compliance office and chief legal officer at Palo-Alto headquartered BitGo calls its BitGo Trust Company the only independent regulated qualified custodian with a purpose-built service for digital asset custody. Therefore, she suggests only BitGo Trust can ensure it follows strict policies, procedures and disclosures only guaranteed by qualified custodians.
Broker-dealers and exchanges serving as qualified custodians suffer from a conflict of interest, security and regulatory risk. Or so Ali claims. “Allowing a broker-dealer, which is in effect incentivized to control liquidity and bid/asks poses the potential for self-dealing, principal trading and possible market manipulation,” says Ali whose firm has won approval as a trust company from the South Dakota Division of Banking.
BitGo’s entrance into the digital asset custody space for registered investment advisors follows a failed attempt at a merger with the Murray, Kentucky-based Kingdom Trust which is also registered as a trust company in South Dakota. Cryptocurrency exchanges Gemini and itBit are providing custody services as trust companies approved by the New York Department of Financial Services, which legal experts insist has more rigorous oversight standards than its South Dakota peer. Therefore, any qualified custodians falling under New York’s guidelines will have a competitive edge over others which meet South Dakota’s. Given that none of the firms meeting the SEC’s classifications of qualified custodians are willing to dislose the number of registered investment advisors as customers or the value of their digital assets under custody, it is unclear whether the clients agree with the legal pundits.
In a statement to FinOps Report, Chad Cascarilla, chief executive officer of itBit, was quick to dispute BitGo’s stance, also citing itBit’s dual role as benefit. “We are a trust and can only act as a fiduciary and agent,” he says. “We are never a principal and never trade against our customers. Offering our customers the ability to trade with each other in a way in which we never trade against our customers is a product and feature which our customers appreciate. At the same time, as a qualified custodian, our customers know that their assets are safe with us.”
Secaucus, New Jersey-based Digital Asset Custody Company, which in July told FinOps Report that it had applied to FINRA and the SEC to become a registered broker-dealer, doesn’t appear to offer trade execution services cited by BitGo’s Ali as hampering fiduciary obligations. DACC, whose website touts its platform as “purpose-built” for digital asset custody would not respond to questions from FinOps Report about either BitGo’s comments or DACC’s regulatory status. “DACC and our counsel at Lowenstein Sandler have had helpful discussions with both FINRA and the SEC over the past several months,” says David Brosgol, general counsel and chief compliance officer for DACC in a statement to FinOps Report. “Our understanding is that regulators are rightly focused on investor protection and we support such efforts.”
Financial services powerhouse Fidelity has just announced that it will launched a new cryptocurrency trading and custody solution but further details on its regulatory classification or operational strategy for avoiding conflicts of interest could not be determined at press-time. CoinBase, the US’ largest cryptocurrency exchange, wouldn’t directly comment on BitGo’s stance. Instead a spokesman for the firm emailed FinOps Report a new press release citing Coinbase’s approval from the New York Department of Financial Services as a trust company. He wouldn’t respond to FinOps Report’s question as to why CoinBase would want or need such approval after announcing it had teamed up with Electronic Transaction Clearing, an SEC-registered broker-dealer and FINRA member, to offer pure custody services. ETC also would not comment on CoinBase’s new legal standing.
So far, most fund managers investing in digital assets have managed to sidestep the SEC’s custody rule and serve as their own custodians because they fall under the US$150 million threshold for assets under management to require registration. However, cryptofund managers and others who wish expand their books of business by nabbing institutional business might discover not have much choice, but to sift through the all marketing noise to pick one of the current accredited qualified custodians.
The decision of which qualified custodian to select will only get harder as the list of candidates could grow with the entrance of traditional providers such as Citi, Northern Trust, and State Street into the foray. Whether FINRA’s potential guidance to broker-dealers will have any impact on who wins the greatest share of the institutional custody market for digital assets remains to be seen.