SEC's New Guidance Focuses on Rule 15c3-3(b)(1)

Understanding the U.S. SEC's New Guidance on Crypto Asset Securities

The U.S. Securities and Exchange Commission (SEC) has recently issued a statement outlining specific circumstances under which broker-dealers can consider physical possession of customer crypto asset securities as a valid means of identification. This guidance aims to provide clarity on how broker-dealers can comply with custody obligations for crypto asset securities under existing federal rules.

Key Details of the Statement

The statement is part of an effort to provide clarity on the application of federal securities laws to crypto asset securities. According to the U.S. SEC, the guidance focuses on paragraph (b)(1) of Rule 15c3-3 under the Securities Exchange Act of 1934. This rule allows and regulates broker-dealers to promptly obtain and maintain physical possession or control of all fully paid and excess margin securities carried for customer accounts.

Crypto asset securities are defined as tokenized representations of equity or debt securities recorded on distributed ledger technology. The new guidance applies to any broker-dealer handling crypto assets for customers, including firms engaged in both traditional securities operations and digital asset activities.

Focus on Physical Possession

The U.S. SEC Division of Trading and Markets emphasized that its views are confined to physical possession and do not extend to the control aspect, except for broker-dealer financial responsibility rules and additional federal securities law requirements. The staff noted that the statement carries no legal enforcement, does not modify applicable laws, and imposes no new or further obligations.

Hester M. Peirce, a U.S. SEC Commissioner, praised the clarity of the statement and called for prompt recommendations on potential amendments to Rule 15c3-3. She highlighted the importance of private key protection that aligns with industry best practices.

Five Conditions for Compliance

The SEC crypto task force staff outlined five circumstances in which they would not recommend enforcement action against a broker-dealer for taking physical possession of customer crypto asset securities:

1. Immediate Access and Technical Ability: The broker-dealer must have immediate access to the asset and the technical ability to transfer it across the blockchain.
2. Written Policies and Procedures: The broker-dealer must establish, maintain, and enforce reasonable, written policies and procedures for thorough assessments of the blockchain and its associated networks. These evaluations must be conducted before initiating custody and at reasonable subsequent intervals.
3. Evaluation Factors: Key evaluation factors include performance reliability, transaction speed and throughput, scalability for increased activity, resilience in times of failure, and security features. Consensus mechanisms, complexity for maintenance, extensibility for new features, visibility through public code, and documentation are also essential.
4. Governance Processes: Governance processes such as protocol upgrades, changes, airdrops, and token exchanges must be reviewed to detect weaknesses that may impair possession.
5. Material Security Vulnerabilities: The broker-dealer must not be aware of material security vulnerabilities, operational deficiencies, and other potential risks directly tied to custody of assets on the specific blockchain.

Safeguarding Private Keys and Disruptions

The third circumstance prevents claiming possession if the broker-dealer is aware of material security vulnerabilities, operational deficiencies, and other potential risks directly tied to custody of assets on the specific blockchain, independent of market or reputational concerns.

The fourth circumstance requires the broker-dealer to have robust policies, procedures, and controls that are consistent with industry best practices in safeguarding private keys against theft.

Lastly, the fifth circumstance requires a pre-planned policy and procedures that address potential disruptions. These procedures are in response to events such as blockchain malfunctions or failures. Additionally, the pre-planned arrangements should include mechanisms to comply with court orders to seize, freeze, burn tokens, or blockchain transfers.

If you're reading this, you’re already ahead. Stay there with our newsletter.