On July 8, the Securities and Exchange Commission (SEC) issued a statement regarding the complexity around digital assets and the broker-dealer relationship.  The SEC did not put forth new rules or guidelines. Rather, they articulated some of the issues under consideration from a policy perspective and how digital assets may or may not fit within this framework. 

The goal of Consumer Protection Rules is as follows:

“[T]o safeguard customer securities and funds held by a broker-dealer, to prevent investor loss or harm in the event of a broker-dealer’s failure, and to enhance the Commission’s ability to monitor and prevent unsound business practices. “

Digital securities have introduced new technologies and platforms that have opened the door to new business models that make traditional broker-dealer rules difficult to enforce. The core issue the SEC is wrestling with comes down to the matter of custody. With cryptocurrency, the traditional notion of custody applies with some large caveats. In some cases, there is no broker-dealer at all as the transaction is entirely peer-to-peer.  

Traditionally, when a broker-dealer has access to customer funds, they must carry insurance in the event of a loss of funds through theft, fraud or malfeasance. They must also maintain detailed records of customer accounts and transactions. As the SEC notes, broker-dealer’s financial records must also be independently auditable by third parties. But as we will see, even though transactions are recorded on the blockchain, it can be insufficient in determining who actually moved the funds.  

In terms of digital assets, custody is a question of who has access to the private keys. Private keys are required to claim or spend assets. Thus, the popular phrase “not your keys; not your bitcoin”. Only someone with access to private keys can claim or spend funds. While this makes cryptocurrency generally more secure, from the view of a regulator charged with consumer protection, there is no way of determining whether a transaction was fraudulent per se. If a transaction is signed with the necessary keys, it is final. There is no way to invalidate the transaction.  

Additionally, a broker-dealer cannot guarantee they are the only ones with access to the private key. Even though a broker-dealer in a cryptocurrency exchange may have a customer’s private key, that customer may also hold it. The customer’s spouse may also have access to the key, their brother or sister, and so forth. The private key could be compromised and someone could use it to steal a person’s funds. This transaction will show up on the blockchain like any other. However, there is really no way to verify – at least not without sophisticated analytics and even then it isn’t guaranteed – who actually executed the movement of funds.  

This makes insuring customer funds problematic as a broker-dealer may have no way of definitely determining whether the transaction was indeed executed by their client.  

The challenge before the SEC is trying to regulate something that is analogous to a standard bearer instrument but is wholly digital. Existing regulatory frameworks assume broker-dealers maintain full records and have near total visibility into their client’s assets. However, like standard bearer instruments, cryptocurrencies often do not provide nor do they require the trusted third-party to acquire or exchange.  

As the SEC considers how regulations need to evolve for broker-dealers and digital assets, the agency needs to understand not just how cryptocurrencies work, but also why people invest in crypto. What attracts investors to crypto assets is in part, the fact that they do not need to trust a broker-dealer. We believe this is an important factor that any governing body needs to keep in the forefront of their deliberations. 

Contact us @Suredbits

Contact Dan @GoDanSmith

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