New SEC/FINRA Staff Statement On Digital Securities Favors Wyoming
As Originally Published on forbes.com
The State of Wyoming just got a big boost from the Securities and Exchange Commission (SEC) and the Financial Industry Regulatory Authority (FINRA). Their recent joint staff statement on broker-dealer custody of digital securities provides support for Wyoming’s regulatory approach to the custody of digital assets.*
Earlier this year, Wyoming enacted SF 125 which sets forth a regulatory framework for digital assets, and HB 74, which authorizes a new type of financial institution, the special purpose depository institution (SPDI) (collectively the “Acts”). Taken together, the Acts enable a new type of financial institution that allows approved Wyoming corporations to engage in banking business related to digital assets, including custodial services.
The SEC/FINRA staff statement focuses primarily on custodial requirements in Rule 15c3-3 under the Securities Exchange Act of 1934, commonly referred to as the Customer Protection Rule. The Rule applies to entities that buy, sell, or are otherwise involved in transactions in all securities, including digital securities, for customers or their own accounts. The purpose of the Rule is to protect customers’ securities held by broker dealers in the event that the broker dealer fails. The Rule requires broker-dealers to safeguard customer securities and to separate customer assets from the firm’s accounts, among other requirements.
Under the Rule, broker-dealers are required to maintain physical possession or control over customers’ fully paid and excess margin securities, or maintain them free of liens at a good control location. Generally, the good control location requirement allows broker-dealers to use third-party custodians, such as the Depository Trust Company and transfer agents, to custody customer securities.
Footnote 13 of the SEC/FINRA staff statement explains that a good control location is based, in part, on the entity’s ability to maintain exclusive control over customer securities, and that a bank constitutes a good control location. Significantly, the Rule provides a safe harbor for a bank to meet the good control location requirement. The definition of “bank” differs widely across different laws, but here the SEC/FINRA staff use the definition in Section 3(a)(6) of the Securities Exchange Act of 1934, which includes state-chartered banks but, notably, excludes trust companies. It further explains that to meet the good control location requirement, a bank is required to acknowledge that customer securities are not subject to any kind of security interest or claim, and that the securities are under its “exclusive control.” And that’s the nub of Wyoming’s criteria for a Wyoming SPDI to provide custodial services for digital assets under the Acts. 
Of course, with a Wyoming state-chartered bank serving as a good control location for a broker-dealer, the SPDI could perform custodial services in all 50 states (with few exceptions). It would not need to seek approval on a state-by-state basis (nor be regulated under 50 different sets of regulations). Surely, this would lead to all sorts of efficiencies, not to mention the saving of time, money and effort for all involved, and ensuring consistency in the delivery of custodial services across the country.
Under SF 125, banks providing custodial services are required to maintain exclusive control over customers’ digital asset securities and have no claim or any property rights in such assets. Digital assets under the bank’s control do not become a depository liability or an asset of the bank. Rather, they are the subject of a bailment under various conditions designed to protect the consumer, similar to that which exists when you drop off your dry cleaning or leave your car with valet parking.
Additionally, customers elect whether their digital assets are to be held in fungible or non-fungible form and, in either case, the custodian is required to segregate the customer’s assets from the bank’s accounts. Alternatively, customers may choose to have the bank hold the digital assets indirectly in the bank’s omnibus account. In stark contrast to traditional securities markets, when customers elect this option, the Wyoming law requires customers to acknowledge a clear disclosure that they have relinquished ownership of their securities and have instead entered into a relationship where the customer only has a claim to a particular asset, not unlike a securities entitlement or creditor/debtor relationship. Under this option, the bank may undertake transactions with the digital assets pursuant to instructions given by the customer in order to provide consumers with an opportunity for a return on their assets. Also, under this option, the bank enters into an agreement with the counterparty to a transaction which includes a time for return of the asset. Importantly, the bank is not liable for any loss suffered with respect to a transaction under this provision, except for liability consistent with serving as fiduciary/custodian.
The SEC/FINRA staff statement, including its explanatory footnote 13, comes at a good time. Interest in digital securities continues to grow. And it would appear that the ultimate potential for digital securities is limitless. But institutional investors are not likely to actively invest in digital securities (and spur growth in the nascent asset class) until the regulatory framework is fully formed, including the ability for financial institutions to provide custodial services for digital securities that are in compliance with the Customer Protection Rule. The SEC/FINRA staff statement suggests that Wyoming’s innovative legislation not only provides a compliant solution, but also is solidly on the right track. It would have been even more helpful if the staff statement were official guidance from the SEC and FINRA. No doubt that will come too. For the time being, this is a great first step.
*Footnote 2 clarifies that the SEC/FINRA joint staff statement is not a “rule, regulation, guidance or statement of the [SEC] or FINRA, and the Commission and FINRA’s Board have neither approved nor disapproved its content.”
**Caitlin Long from the Wyoming Blockchain Task Force ably highlightsthis footnote and its implications in this tweet thread.
***Another footnote of particular interest is number 15 which identifies (without addressing) the related question of whether a blockchain or a distributed ledger that maintains a single master security holder list establishes control of uncertificated securities by the issuer or transfer agent. It leaves that question for another day. And, therefore, so must we.
