In November 2022, FINRA published a podcast that discussed available guidance concerning several paths through which broker-dealers can be approved by FINRA for digital asset securities activity: 1) as a placement agent in private placement digital asset securities offerings, 2) as an ATS facilitating secondary transaction of digital asset securities, and 3) as a special purpose broker-dealer (SPBD) with custody of digital asset securities.

1) Placement agent in private placement digital asset securities offerings

Overview

The broker-dealer sends the trade-matching details (e.g., identity of the parties, price, and quantity) to the buyer and issuer of a digital asset security—like a traditional private placement—and the issuer settles the transaction bilaterally between the buyer and issuer, away from the broker-dealer. In this case, the broker-dealer instructs the customer to pay the issuer directly and instructs the issuer to issue the digital asset security to the customer directly (e.g., the customer’s “digital wallet”).

Everything happens away from the broker-dealer so it does not custody the digital asset. The broker-dealer does not handle, control, or receive customer funds or securities. Issuers and investors directly transact with each other through an escrow account established by issuer.

Key Considerations in a Placement Agent Application

1. Demonstrate an understanding of the risks of the digital asset security.
2. Communicate how the risks will be disclosed and how the offering documents will be reviewed.
3. Evidence an understanding of the obligations under FINRA’s advertising rules (including if first-year firm conditions apply).
4. Detail the role and function of the broker-dealer with specificity.
5. Be able to show that that there are procedures that are specific to digital asset securities and the distributed ledger.

2) ATS facilitating secondary transaction of digital asset securities (two types)

ATS #1: Bilateral settlement without ATS involvement

Overview

The 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).

• Step 1 - the buyer and seller send their respective orders to the ATS;
• Step 2 - the ATS matches the orders;
• Step 3 - the ATS notifies the buyer and seller of the matched trade; and
• Step 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.

ATS #2: Custodians carry out conditional instructions using information from ATS

Overview

In this case, there is a higher degree of control exercised by the broker-dealer operator because it tells the buyer’s custodian where to send the funds and the seller’s custodian where to deliver the securities. 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) but it notifies the custodians for the buyer and seller, and the buyer and seller, of the match.

• Step 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;
  • Step 2 - the ATS matches the orders; and
  • Step 3 - the ATS notifies the buyer and seller and their respective custodians of the matched trade and the custodians carry out the conditional instructions.

Key Considerations in ATS Applications

1. Explain in detail how the transaction flows and business model involving digital asset securities and the ATS comply with either the three-step or the four-step process.
2. Ensure other documents are consistent with that process, such as:
   1. User disclosure
   1. Draft Form ATS
   1. Contracts
   1. Custodian disclosure
   1. Disclosures with other third-parties

3) Special Purpose Broker-Dealer (SPBD) with Custody of Digital Asset Securities

Overview

The business activities of a special purpose broker-dealer are limited to digital assets that are also securities (this can include operation of an ATS that trades only in digital assets securities or otherwise engages in other business involving digital assets securities). It cannot engage in business activities involving non-security digital assets or securities that are not digital assets (e.g., traditional securities).

Key Considerations in SPBD Applications

1. Demonstrate an understanding how the business model is impacted by the nine conditions detailed in the SEC Statement (dated April 27, 2021).
2. Explain how each of the nine conditions are met.
3. Make it clear where staff can find information responsive to each of the nine conditions.

Lastly, the FINRA podcast also identified several common issues with membership applications involving digital asset securities.

• Show that the applicant is capable of complying with FINRA rules and the U.S. federal securities laws and regulations.
• Missing details. For example:
  • What is the business plan?
  • What is the relationship between different parts of the broker-dealer’s business?
  • How does the transaction flow and business model involving digital asset securities fit with the available guidance?
  • How will the broker-dealer ensure that it functions in a way comporting with the applicable guidance?
  • How do the transaction flows address compliance and legal requirements?
  • Is there documentation to support that each step in the transaction flow meets those requirements?
• Being inconsistent in describing the proposed business activities involving digital assets, cryptocurrencies, distributed ledger or related products.

CRC has extensive experience with helping firms successfully navigate the New Member and Continuing Member Application process with FINRA. We are specifically familiar with the fintech space and offer clients the ability to quickly scale and support their application with experienced C-Suite level personnel. Contact us today to discuss how we can provide right-sized support as you consider forming a broker-dealer.

For more information, please contact:

Mitch Avnet

p. (646) 346-2468  

mavnet@compliance-risk.com

David Amster

p. (917) 568-6470

damster@compliance-risk.com

The post <strong>Considerations for FINRA Membership involving Digital Asset Securities</strong> appeared first on Compliance Risk Concepts.

March 2022

Overview & Summary

President Biden signed an executive order on Wednesday, March 9 that will direct the federal government to produce a plan to regulate cryptocurrencies. This Executive Order will outline the first approach to addressing the risks and potential benefits of digital assets and their underlying technology. The order lays out a national policy for digital assets across six key priorities: consumer and investor protection; financial stability; illicit finance; U.S. leadership in the global financial system and economic competitiveness; financial inclusion; and responsible innovation.

Notably, the order directs the Federal Reserve to research and potentially develop its own digital dollar, which would be similar to cryptocurrencies. The order also directs the Treasury Department to develop guidelines for Americans trading and using cryptocurrency to facilitate the mitigation and reduction of fraud or market volatility. The Treasury will conduct further research on the potential role of digital assets and blockchain in future payment systems. In addition, other agencies will examine cryptocurrency's role as a speculative asset and its role in illicit finance.

The current administration has been under pressure to play more of a coordinating role in Washington’s approach regarding this asset class, as industry executives continue to lament what they believe is a lack of clarity on rules; this executive order takes a step in that direction.

Our Take

The cryptocurrency market is now worth more than $3 trillion. Surveys suggest that around 16 percent of adult Americans – approximately 40 million people – have invested in, traded, or used cryptocurrencies.

Whether you are an adviser looking to expand your investment strategy to include digital assets, or you are looking to participate in ICOs or build out a platform for trading cryptocurrency as a broker-dealer, it is wise to consider partnering with an established compliance team who can help you navigate this imminent regulation and provide assistance from initial registration to regulatory examination.

CRC recommends that firms prepare to ensure that appropriate controls and procedures are developed to allow sufficient oversight into this area.

As with any compliance initiative or change to regulation, CRC recommends that all personnel are well trained, and that such training is both highly specific to firm policies and procedures and appropriately documented.

Opportunities for CRC to Assist Your Firm

• CRC is available for outsourced support with respect to cryptocurrency.
• CRC can proactively conduct a review of your existing compliance program to identify opportunities to potentially implement enhancements in preparation for regulatory examinations.
• CRC is available to assist with examination responses.
• CRC can prepare written electronic communications and record retention policies and procedures designed to comply with relevant industry rules, regulations, and laws.
• CRC offers best practices guidance to firms that seek to improve current protocols or to further strengthen existing program compliance.

Please contact Mitch Avnet for more information.

Mitch Avnet at mavnet@compliance-risk.com  or (646) 346.2468

The post News Update: Biden Takes Step to Regulate Cryptocurrencies appeared first on Compliance Risk Concepts.

The Securities and Exchange Commission announced on July 26^th that 21 investment advisers and 6 broker-dealers have agreed to settle charges that they failed to timely file and deliver their client or customer relationship summaries to their retail investors. In the release the SEC’s Director of Enforcement, Gurbir Grewal, notes:

“Today’s cases reinforce the importance of meeting those obligations and providing retail investors with information that is intended to help them understand their relationships with their securities industry professionals.”

The penalties ranged from $10,000 to $97,523. 

The Cost of Non-Compliance

Appropriate implementation, maintenance, and distribution of a two-page document could have saved these firms the hassle and embarrassment of fines and reputational damage. At CRC, we firmly believe that the best compliance program is a proactive one; the fines above demonstrate that regulators agree. 

Our Take

Regulators have continued to display heightened focus on transparent communication and disclosure when interacting with retail investors. Recent examinations of both SEC-registered investment advisers and broker-dealers have shown a sharp emphasis on Regulation Best Interest (Reg BI) related policies and procedures, particularly regarding the content and distribution (and subsequent evidence of delivery) of Form CRS. As such, firms should ensure that the Form CRS includes all mandated language and meets formatting requirements as specified by Reg BI. A firm’s compliance policies and procedures should also accurately reflect the processes implicated by Reg BI, including the delivery of Form CRS; firms should consider testing such procedures to ensure efficacy. If you have concerns regarding your firm’s Reg BI policies and procedures, please contact your Compliance Professional at CRC, or contact CRC using the method’s listed below so that we can connect you with a member of our team. 

For more information:

 Mitch Avnet at mavnet@compliance-risk.com  or (646) 346.2468 

Kate Gibbs at kgibbs@compliance-risk.com or (781) 742.4688 

The post News Update: SEC Fines 27 Firms for Form CRS Failures appeared first on Compliance Risk Concepts.

Background & Summary

On July 8, 2019, the US Securities and Exchange Commission (SEC) issued a joint statement in conjunction with FINRA’s general counsel addressing various elements of digital currency amid request for clarity on whether broker-dealers can hold digital assets under federal securities laws. The regulator reiterated its growing concerns relative to investor protection and clarified the fact that entities seeking to participate in digital currency markets must comply with relevant securities laws. The release placed specific emphasis on compliance with the customer protection rule. While recounting the success and importance of the customer protection rule, the SEC added, "[t]his record of protecting customer assets held in custody by broker-dealers stands in contrast to recent reports of cyber theft, and underscores the need to ensure broker-dealers robust protection of customer assets, including digital asset securities."

With respect to custody and digital securities, the SEC’s statement would seem to indicate that the regulator seeks to regulate such assets as uncertificated securities (i.e. ownership is confirmed via electronic certificate rather than a physical one). As such, broker-dealers would likely need to establish custody through the use of an SEC registered transfer agent, who would also maintain applicable records relating to security ownership. The statement also seems to allude to the fact that custodying digital assets through the use of digital wallets and maintaining private keys that would be controlled by the broker dealer are unlikely to be looked upon favorably, or ultimately approved by regulators. While the tone of the statement seems to be geared towards preparing digital securities for more mainstream access (i.e., gearing it towards retail investors), the bottom line for regulators, as evidenced by this release, is customer protection. As the industry navigates the nuances of digital securities markets, it should do so through the lens of protecting against fraud, theft, or misappropriation of client funds and/or information. 

Our Take

As always, it is our position at CRC that cooperation with regulators is key for the successful operation of financial services organizations. Regulators have continued to display heightened focus on the protection of retail and senior investors. As such, digital currency in particular is a developing area where cooperative, responsible players will hold the ace. Prompt, efficient, and honest communication and responses will satisfy regulators and clients alike, while also and bringing a sense of legitimacy and scrupulousness to digital currency operations. If you would like to speak with one of our Compliance Specialists about custody implications or have any other questions regarding digital currency, please do not hesitate to contact us. 

Contact Mitch Avnet at mavnet@compliance-risk.com or (646)346-2468 for more information. 

The post News Update: SEC Issues Statement Regarding Digital Assets appeared first on Compliance Risk Concepts.