The digital securities market is a fast-growing sector within the financial services industry, providing investors with unique opportunities and challenges. The FINRA SEC No-Action Letter, issued on September 25, 2020, has played a pivotal role in shaping the regulatory landscape for digital asset trading in secondary markets, ensuring the soundness of investor’s assets while adhering to regulatory requirements. 

The FINRA SEC No-Action Letter and the Three-Step Process

The No-Action Letter provided a groundbreaking regulatory framework that allowed broker-dealers to operate alternative trading systems (ATS) without facing enforcement action from the SEC for not meeting the custody requirements under Rule 15c3-3. This framework is crucial because it fosters the growth of digital asset trading while ensuring investor protection and regulatory compliance.

The three-step process outlined in the No-Action Letter includes the following steps:

  1. The buyer and seller of the digital asset security send their respective orders to the ATS.
  2. The ATS matches the orders, and the buyer and seller agree on the transaction terms.
  3. The buyer and seller coordinate with their respective custodians to facilitate the settlement of the transaction.

This process is significant because it establishes a clear and efficient mechanism for trading digital securities while adhering to the regulatory requirements under Rule 15c3-3.

The Importance of Qualified Custodians and the Role of Wyoming SPDIs

One of the key aspects of investor protection is the requirement to use a qualified custodian for holding digital securities, rather than relying on self-custody. Qualified custodians ensure the asset’s safety, accessibility, and compliance with regulatory requirements.

A Wyoming SPDI is a prime example of a qualified custodian that offers numerous benefits to investors, including:

  1. Enhanced Security: Wyoming SPDIs provide a higher level of security for digital assets compared to self-custody, where investors may lose their private keys, resulting in an inability to access their security in their wallet.
  2. Regulatory Compliance: As regulated financial institutions, Wyoming SPDIs adhere to strict regulatory requirements, ensuring compliance with applicable laws and regulations.
    No Lending Risk: As non-lending banks, Wyoming SPDIs do not expose customer assets to lending risks, further safeguarding investor assets.
  3. By using a fully remoted for benefit of custody account with a qualified custodian like a Wyoming SPDI, investors can ensure that their assets are secured, unencumbered, and compliant with regulatory requirements.

The Drawbacks of Self-Custody

While self-custody might seem like a more direct approach to managing digital assets, it exposes investors to several risks:

  1. Loss of Private Keys: If an investor loses their private keys in a self-custody setup, they can no longer access their assets, leading to a permanent loss of their investment.
  2. Vulnerability to Hacks and Cyber Attacks: Self-custody solutions can be more susceptible to hacks and cyber attacks, putting investor assets at risk.
  3. Limited Legal Recourse: In cases of theft or loss of assets under self-custody, investors may have limited legal recourse to recover their lost assets.
  4. Lack of Regulatory Compliance: Self-custody solutions may not always comply with regulatory requirements, putting investors at risk of violating applicable laws and regulations. For example, Form 4 reporting of change of beneficial ownership of an insider.

Conclusion

The FINRA SEC No-Action Letter and its outlined three-step process have been instrumental in developing a regulatory framework for digital securities trading that prioritizes investor protection and soundness of assets. By requiring the use of qualified custodians like Wyoming SPDIs, the risks associated with self-custody are mitigated, ensuring that investors’ assets remain secure, unencumbered, and compliant with regulatory requirements while trading in secondary markets. 

Contrary to the claims that the regulations are unclear with respect to digital assets and securities, the No-Action Letter paved the way for the growth of the digital asset market, fostering innovation while maintaining the necessary safeguards for investor protection. Folks just need to read it for what it is, and then follow the rules.

Michael Hiles is founder & CEO of 10XTS. He regularly writes and speaks about digital transformation, information governance, risk and compliance, government systems, blockchain, and regulatory policy. His D&D character alignment is chaotic good and he keeps a pretty lit collection of Spotify playlists.