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US SEC and FINRA Issued Latest Custody Guidance on Digital Assets Securities

The United States Securities and Exchange Commission (SEC) and the Financial Industry Regulatory Authority (FINRA) issued a statement addressing regulatory issues regarding the custody of digital asset securities on 8 July.

The recent statement highlighted that any entity involved in the transactions with digital asset securities must register with the SEC as a broker-dealer, and broker-dealers are required to “safeguard customer assets and to keep customer assets separate from the firm’s assets” under the Customer Protection Rule.

It was noted that some broker-dealers engage in digital asset securities without custody functions. Such noncustodial activities do not raise the same level of concern as long as the activities are compliant with relevant securities laws, SRO rules, and other legal and regulatory requirements. An example of a non-custodial activity is a digital wallet, where an issuer settles the transaction between the buyer and the issuer. The broker-dealer only instructs the customer to pay the issuer directly and issuers to issue digital asset security to the customer directly.

The SEC recognized the custody of digital asset is exposed to fraud, theft, and the possibility of losing private keys. The regulators urged broker-dealer to comply with Rule 15c3-3, hold in possession, or control digital asset securities. Besides, regulators also raised concerns that the other party could have a copy of the private key and transfer the digital asset security without the consent of the broker-dealer. As a result, the broker-dealer might not be able to reverse or cancel mistaken or unauthorized transactions despite the private key is held by the custodian.

Grayscale Investment Company Receives FINRA Approval to Trade Bitcoin Cash and Litecoin Publicly

The Financial Industry Regulatory Authority (FINRA) in the US has approved shares of Grayscale’s Litecoin Trust and Bitcoin Cash Trust for public trading.

New York-based Grayscale institutional investment cryptocurrency company will now make Litecoin and Bitcoin Cash available for public trading through shares of the company’s cryptocurrency trusts. This marks the first publicly-quoted securities in the United States, deriving value from Litecoin (LTC) and Bitcoin Cash (BCH).

Now BCH and LTC Trading on OTC markets

Both Trusts would be available on OTC markets under “LTCN” for Litecoin and “BCHG” for Bitcoin Cash. Buying these shares would enable people to invest in cryptocurrency without having to hold the underlying asset.

According to Grayscale, this strategy avoids the challenges of safekeeping, storing, and buying digital Litecoin or Bitcoin Cash directly.

Public trading for the two crypto assets remains subject to full compatibility with the Depository Trust Company (DTC), the world’s largest securities depository. Grayscale stated that: “There will be no trading volume in the shares’ public quotations until the respective shares are DTC eligible, which BCHG and LTCN are expected to receive soon.”

As of June 30, 2020, Grayscale has reported it has 509,400 shares of the Litecoin Trust, with each share worth 0.09433120 (4.11) Litecoin, totaling $2 million assets and 2,725,300 shares in its Bitcoin Cash Trust, with each share worth 0.00943312 ($2.16) Bitcoin Cash, totaling $5.8 million assets under management.

As of now, Litecoin and Bitcoin Cash are trading at $43.42 and $228.86, with both up 2% and 1.2%, respectively. Current CoinMarketCap figures show that Bitcoin Cash is rated as the fifth-largest cryptocurrency, while Litecoin is the ninth.

Institutional Interest in Crypto Investments Skyrockets

Grayscale investments company has been at the forefront of providing a means of investing in cryptocurrency without having to actually hold the digital assets. This service has gained lots of popularity among traditional investors who want to bypass volatility in the crypto space.

Grayscale has been providing several cryptocurrency products for OTC trading, and the latest being shares of the company’s Litecoin and Bitcoin Cash Trusts for trading on OTC markets.

In the recent past, the company obtained approval to offer shares for Bitcoin (BTC), Ethereum Classic (ETC), and Ethereum (ETH). Zcash (ZEC), Stellar Lumens (XLM), Horizen (ZEN), and XLM are also offered for trading via a trust at the company.

Litecoin and Bitcoin Cash are the company’s sixth and fifth publicly-quoted cryptocurrency products.

Prometheum's License Approval: Republican Lawmakers Challenge SEC and FINRA Decisions

A digital asset company called Prometheum Ember Capital LLC has recently gained attention for being named the first Special Purpose Broker-Dealer (SPBD) for digital assets. Republican members of the House Financial Services Committee have expressed reservations about this decision, leading them to ask the Securities and Exchange Commission (SEC) and the Financial Industry Regulatory Authority (FINRA) for explanation.

The House Financial Services Committee, spearheaded by Chair Patrick McHenry and supported by 22 other members, dispatched letters to both FINRA and the SEC on August 9, 2023. These letters question the “timing and circumstances” of Prometheum’s approval, especially given the concurrent legislative discussions on digital asset market regulations.

In response to the concerns raised, Prometheum emphasized their technology’s alignment with federal securities laws. They highlighted their commitment to crafting a market infrastructure for digital asset securities that adheres to these regulations.

Founded in 2017, Prometheum had remained relatively under the radar in the crypto domain until its co-founder and co-CEO, Aaron Kaplan, testified before the House committee in June. The firm’s SPBD license, granted in May, has since raised eyebrows regarding its products, services, and the approval process.

A significant point of contention raised by the committee revolves around Prometheum’s previous association with Shanghai Wanxiang Blockchain Inc., a Chinese entity. Although their collaborative effort to develop blockchain trading software was eventually terminated, lingering concerns persist due to Wanxiang’s affiliations with the Chinese Communist Party (CCP).

Noteworthy figures in the crypto industry, including Coinbase CEO Brian Armstrong, have expressed their apprehensions regarding Prometheum’s connections and the approval process. Armstrong underscored the paramount importance of equal treatment under the law, while BitBoy Crypto alluded to potential undisclosed collaborations between the crypto startup and the SEC.

In a bid for transparency, the House committee members have urged both the SEC and FINRA to furnish documents and communication records related to Prometheum’s SPBD license by August 22, 2023. It’s also pertinent to mention that the SEC had previously concluded its investigation into Prometheum’s ties with Wanxiang and its affiliates, with the Committee on Foreign Investment in the United States (CFIUS) refraining from initiating a formal probe into these associations, stating “Simple. Gary came up with the idea and then stamped it.”

The endorsement of Prometheum as an SPBD has ignited discussions on the regulatory framework of digital assets in the U.S. As lawmakers strive for clarity on the approval mechanism, the crypto community remains vigilant, emphasizing the imperative of transparency and equitable treatment.

SEC's Chair Gary Gensler Issues Statement on Amendments to Broker-Dealer Registration Rule

The U.S. Securities and Exchange Commission (SEC) oversees the registration of broker-dealers, individuals or firms engaged in buying and selling securities. This registration ensures adherence to federal securities laws and SEC rules, safeguarding market integrity and investor confidence.

Chair Gary Gensler recently provided clarity on the amendments to Rule 15b9-1, a specific regulation concerning the registration requirements for broker-dealers with national securities associations like the Financial Industry Regulatory Authority (FINRA). Established in the 1960s and last significantly updated in 1976, the rule is being amended to better reflect the current landscape of the capital markets.

Rule 15b9-1 was crafted to allow a subset of exchange floor members to bypass membership with the National Association of Securities Dealers (NASD), the predecessor to FINRA. This exemption was tailored for broker-dealers primarily registered with a single exchange, conducting floor business, and meeting other specific criteria.

However, the dynamics of the market have undergone significant changes since then. With the rise of high-frequency trading and the proliferation of cross-exchange or off-exchange activities by many broker-dealers, there’s been a noticeable shift. Some broker-dealers still operate under an exemption from national securities association registration that predates even the advent of mobile phones. This has resulted in a regulatory void, with several firms that have monthly trading volumes in the ballpark of hundreds of billions of dollars escaping the purview of national securities association oversight.

The newly introduced amendments aim to redefine and restrict the conditions under which broker-dealers can sidestep registration with a national securities association. This move is anticipated to bolster consistent and rigorous oversight, especially in the realms of cross-market and off-exchange activities. Mandatory membership in national securities associations for a significant number of these previously exempt firms is expected to amplify transparency and oversight, particularly in the Treasury markets.

Such measures are projected to be advantageous for investors, promoting markets that are fair, orderly, and efficient.

FINRA's 2024 Oversight Report Emphasizes Crypto Asset Compliance

The Financial Industry Regulatory Authority (FINRA), a key self-regulatory organization in the United States, recently published its 2024 Annual Regulatory Oversight Report. This report is of particular interest due to its inclusion of a dedicated section on crypto assets for the first time, reflecting the growing significance of cryptocurrencies in the financial landscape. This section is aimed at guiding member firms engaged in or planning to engage in crypto-related activities to adhere to compliance standards and SEC regulations.

Crypto Asset Developments

FINRA’s Membership Application Program (MAP) aligns with the SEC’s guidelines, focusing on evaluating member firms’ business plans in the realm of crypto asset securities. This includes assessing financial responsibility and adherence to customer protection rules. The report provides guidance for firms contemplating engaging in crypto asset-related activities, highlighting the importance of due diligence and compliance with applicable regulations.

Advertised Volume and Cybersecurity

The report touches on topics such as inflated trade volumes and unreasonable supervision. It also emphasizes the increasing variety, frequency, and sophistication of cybersecurity incidents. Firms are guided on identifying, preventing, and mitigating such incidents.

Anti-Money Laundering and Fraud

Member firms are required to develop and implement written Anti-Money Laundering (AML) programs. The report outlines the necessary steps to ensure compliance with these programs, along with the need for robust fraud and sanctions screening processes.

Retail Communications and Compliance

Retail communications involving crypto assets are noted for having a significantly higher non-compliance rate compared to other products. The report suggests that firms establish written policies, procedures, and controls related to crypto asset activities conducted by the firm and its associated persons.

Potential Implications of Pending Supreme Court Decision

The report mentions a pending Supreme Court decision that could impact regulatory practices involving in-house judges, which could have implications for FINRA’s regulatory mechanisms.

Implications for the Industry

The inclusion of a crypto assets section in FINRA’s annual report is a testament to the organization’s responsiveness to the dynamic nature of financial markets. By setting compliance standards and providing detailed guidance, FINRA is equipping its members to navigate the complex and rapidly evolving crypto sector. This proactive approach is crucial for maintaining market integrity and protecting investor interests in the face of new financial technologies and trends.

FINRA Identifies Widespread Violations in Crypto Communications

The Financial Industry Regulatory Authority (FINRA) has identified a staggering rate of potential regulatory violations. In a targeted exam initiated in November 2022, FINRA reviewed over 500 retail communications related to crypto assets from member firms. The findings, disclosed in January 2024, reveal that approximately 70% of these communications potentially violated FINRA’s Rule 2210, which governs communications with the public.

Rule 2210 is a cornerstone regulation that ensures fairness and balance in broker-dealer communications. It prohibits false, exaggerated, promissory, unwarranted, or misleading claims, and demands that any communication provide a sound basis for evaluating the facts regarding any product or service discussed. The rule is critical in maintaining market integrity and protecting investors from misleading information.

The violations identified by FINRA primarily involve misleading statements and comparisons about crypto assets. These include false implications that crypto assets function like cash or equivalent instruments, unclear and misleading explanations of crypto assets’ operations, and comparisons of crypto assets with other assets, like stocks or cash, without a sound basis. Notably, some communications falsely suggested that crypto assets were protected by federal securities laws or FINRA rules, or misleadingly stated the extent to which certain crypto assets are protected by the Securities Investor Protection Corporation (SIPC).

This review is part of FINRA’s ongoing efforts to regulate the burgeoning crypto market. It comes in the wake of increased interest in crypto assets and the potential harm caused by problematic communications in this rapidly evolving market. The findings underscore the need for member firms to rigorously adhere to regulatory standards, especially in a market as volatile and complex as cryptocurrencies.

FINRA’s report is more than a mere compilation of compliance issues; it serves as a vital tool for member firms to refine their communication strategies. The high rate of non-compliance in crypto communications highlights the need for heightened vigilance and adherence to regulatory standards. As the crypto industry continues to evolve, FINRA’s oversight and subsequent regulatory actions will play a crucial role in shaping the landscape of cryptocurrency and its integration into the broader financial system.

FINRA’s findings are a stark reminder of the growing pains of the crypto industry and the importance of rigorous oversight. The organization’s role may be further influenced by an upcoming Supreme Court decision regarding the SEC’s use of in-house judges, which could have repercussions for FINRA’s own practices. This decision follows a 2023 ruling by the Court of Appeals for the District of Columbia Circuit against FINRA’s use of these judges.

In summary, the report from FINRA serves as a critical reminder of the challenges facing the crypto industry and the importance of maintaining high standards of regulatory compliance. As the crypto market continues to grow and attract investor interest, the role of regulatory bodies like FINRA in ensuring market integrity and investor protection becomes increasingly vital.