Back in July 2019, the joint staffs of the Division of Trading and Markets of the U.S. Securities and Exchange Commission and the Office of General Counsel of FINRA issued a statement discussing various aspects of broker dealers broker-dealer custody of digital asset securities. The focus of the statement was on the ability of a broker-dealer to comply with aspects of the Customer Protection Rule and established laws and practices regarding the loss or theft of a security, that may not be available or effective in the case of certain digital assets.

In particular, the Joint Staff Statement discussed paragraph (b) of Rule 15c3-3, under which the broker-dealer must obtain and maintain physical possession or control of all fully paid or excess margin securities carried by a broker-dealer for the account of customers, as well as the potential difficulties in complying with this provision due to the nature of digital asset securities.

What became clear at that time was that a single, public Layer One chain token in and of itself would be insufficient for use as a security for all market participants.

As a related matter, the Staffs have received inquiries from broker-dealers, including ATSs, wishing to utilize an issuer or transfer agent as a proposed “control location” for purposes of the possession or control requirements under the Customer Protection Rule.  As described to the Staffs, this would involve uncertificated securities where the issuer or a transfer agent maintains a traditional single master security holder list, but also publishes as a courtesy the ownership record using distributed ledger technology.  While the issuer or transfer agent may publish the distributed ledger, in these examples, the broker-dealers have asserted that the distributed ledger is not the authoritative record of share ownership.  To the extent a broker-dealer contemplates an arrangement of this type, the Division will consider whether the issuer or the transfer agent can be considered a satisfactory control location pursuant to an application under paragraph (c)(7) of Rule 15c3-3.

The Joint Staff Statement described several non-custodial activities involving digital asset securities, including where an ATS matches the orders of buyers and sellers of digital asset securities and the trades are either settled directly between the buyer and seller, or the buyer and seller give instructions to their respective custodians to settle the transactions.

In either case, a broker-dealer operator does not guarantee or otherwise have responsibility for settling the trades and does not at any time exercise any level of control over the digital asset securities being sold or the cash being used to make the purchase (e.g., the ATS does not place a temporary hold on the seller’s wallet or on the buyer’s cash to ensure the transaction is completed). In effect, this non-custodial ATS model involved a four-step process:

  1. the buyer and seller send their respective orders to the ATS;
  2. the ATS matches the orders;
  3. the ATS notifies the buyer and seller of the matched trade; and
  4. the buyer and seller settle the transaction bilaterally, either directly with each other or by instructing their respective custodians to settle the transaction on their behalf. 

September 2020 No Action Letter

In September of 2020, SEC issued a no action letter requested by FINRA to clarify further the issues pertaining to broker-dealers and ATSs that wish to facilitate trading and settlement of digital asset securities tokens.

Following the issuance of the Joint Staff Statement, several broker-dealers sought to operate an ATS that trades digital asset securities have asserted that the four-step process described above increases operational and settlement risks. 

These broker-dealers proposed the following process (the “Three-Step Process”):

  1. the buyer and seller send their respective orders to the ATS, notify their respective custodians of their respective orders submitted to the ATS, and instruct their respective custodians to settle transactions in accordance with the terms of their orders when the ATS notifies the custodians of a match on the ATS;
  2. the ATS matches the orders; and 
  3. the ATS notifies the buyer and seller and their respective custodians of the matched trade and the custodians carry out the conditional instructions. 

The custodians would then settle the trade on behalf of the buyer and seller based on the instructions received in Step 1. 

As with the four-step process, the broker-dealer operator does not guarantee or otherwise have responsibility for settling the trades and does not at any time exercise any level of control over the digital asset securities being sold or the cash being used to make the purchase (e.g., the ATS does not place a temporary hold on the seller’s wallet or on the buyer’s cash to ensure the transaction is completed) other than by notifying the custodians for the buyer and seller, and the buyer and seller, of the match. 

Broker-dealers seeking to operate an ATS asserted that the primary benefit of the three-step settlement process is that it would reduce operational and settlement risk. 

SEC No Action

The SEC agreed and issued a no action letter for the Three Step Process. However, they clarified that the position solely addressed ATS trading of digital asset securities under the circumstances set forth in the letter and did not otherwise address broker-dealer custody or control of digital asset securities under Rule 15c3-3.

This leaves open the functional issue of custody and control, and the involvement of a transfer agent or even using the issuer as a control location.

XDEX and the Three Step Process

10XTS believes that based upon the current position of the SEC, XDEX is the only market infrastructure solution in existence that satisfies the data and communications requirements between all market participants for the custody, trading, settlement, and transfer of tokenized digital asset securities.

By maintaining a book entry form of data at the transfer agent level, XDEX becomes a side chain oracle solution embedded within the courtesy copy of a Layer One token that messages the XDEX source of truth to ensure compliance and accuracy of any Layer One token courtesy copy.

With API integration and messaging connectivity, an ATS may effectively match orders while sending notifications to the respective custodians and transfer agent. Following the completion of the custodial function, the transfer agent receives notification of a successful transaction from the custodians and records the final book entry of the token.

In effect, this makes the Layer One token a synthetic derivative form of the uncertificated book entry share, while still providing the interchange as if it were a form of digital certificated instrument.

Certainly it could be argued that the Layer One token is the actual exchangeable form of value stored in an electronic record format. Particularly with regard to the current evolution of UCC Section 12 recommendations under contemplation by the Uniform Law Commission to “perfect by control of an electronic record” for collateralization of lending against a digital asset. This is still an area of regulatory clarity that must be further defined. 

We believe that XDEX provides a compliant market infrastructure framework today, while also enabling a future-proofed assurance that as the various laws evolve, XDEX will continue to meet the requirements and needs.

Contact us to discuss how we can help you enter the world of tokenized securities and market infrastructure!

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.