FINRA warns its crypto custody list is mandatory

As federal watchdogs continue hunting down errant crypto exchanges, they're separately reminding firms that they need to be forthcoming about their dealings with digital assets.

With roughly $1.42 trillion now invested in cryptocurrencies globally, according to the trading information site CoinMarketCap, the digital assets market can no doubt prove tempting to advisors and wealth managers anxious not to miss out on the next big thing. But before U.S. broker-dealers go dipping their toes into one of the most volatile and scandal-ridden corners of the financial markets, they need to let regulators know what they're up to.

That's the thrust of a Crypto Assets key topics page published this week by the Financial Industry Regulatory Authority, broker-dealers' self-regulator. Among other things, the site calls attention to the ways firms can notify officials of plans to deal in assets like bitcoin.

A FINRA spokesperson confirmed earlier this week that 26 companies have so far obtained approval for everything from becoming a special purpose broker-dealer allowed to custody clients' crypto holdings to being able to run an alternative trading system for digital assets. FINRA said it also tallied up hundreds of member firms that have established relationships with third-parties in order to give clients a means of trading in crypto assets. And it has identified roughly 1,200 people in the industry who deal with crypto in so-called outside business activities or private securities transactions such as operating funds that invest in digital assets or even engaging in crypto "mining."

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One of FINRA's main goals for its Crypto Assets page is to remind firms of their obligation to notify regulators of any intention to enter into the digital asset business. Companies that are considering dealing with crypto assets in some form must obtain FINRA's approval of those plans by filling what's known as a continuing membership application.

First in line
So far, only one company has gotten permission from FINRA to hold digital assets in custody, which usually entails various safeguards meant to protect them against fraud and default. Prometheum Ember Capital, a subsidiary of the New York-based crypto company Prometheum Inc, won FINRA's approval on May 17 to become the first federally registered special purpose broker-dealer for digital assets.

Aaron Kaplan, the founder and CEO of Prometheum, said in an interview that his goal is to have his firm's custodian services and a separate alternative trading system for digital assets up and running early next year. He said the start of those operations will mark a major step toward bringing the crypto industry in line with longstanding U.S. securities law and norms.

Kaplan said many banks and other large financial institutions have been wary of dealing in digital assets in part because of regulatory uncertainty.

"But now with places like Prometheum ATS and Prometheum Capital, which are licensed under the securities laws, when a major institution wants to integrate with us, we speak the same compliance language," Kaplan said. "We speak securities compliance. They speak securities compliance."

Kaplan said he thinks most digital assets can fit comfortably into current U.S. financial laws. He said basic principles such as the need to disclose ownership in traded companies, provide for orderly markets and segregate customer assets apply just as well to cryptocurrencies as to standard securities.

"There's really no need to recreate the wheel here," Kaplan said. "These have been established, they've been tried and tested, they have allowed the American capital markets to flourish."

State of regulation
Securities and Exchange Commission Chairman Gary Gensler has made no secret of his opinion that too few digital asset companies have taken what he deems the necessary step of having their products registered with his agency. Gensler has often stated publicly that he believes most cryptocurrencies and similar assets — with the possible exception of bitcoin — are securities falling under essentially the same laws as stocks and bonds.

Speaking in June at the 2023 Global Exchange and Fintech Conference in New York, Gensler said neither Congress nor the SEC needs to take further regulatory action to let crypto firms know they have an obligation to get registered. Firms that fail to take that necessary step, he said, could very well find themselves faced with federal lawsuits.

The SEC has stepped up its efforts to crackdown on crypto firms in recent months. In June, the federal regulator accused the crypto firm Coinbase of running an unregistered securities exchange, brokerage and clearing agency. The SEC leveled the same charges in November against Kraken, another firm operating a crypto trading system.

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Kaplan said he and his partners have always believed that federal securities laws offered the best framework for regulating the crypto industry. He said that after the SEC announced the creation of a special purpose broker-dealer license in December 2020, Prometheum quickly began taking the steps needed to get one.

"Initially, a lot of people said it was impossible," Kaplan said. "I don't understand where that mentality comes from. But, essentially, we've put our heads down and focused on trying to achieve the license. And now that we set the precedent, I think a lot of other people understand that there's a paradigm shift."

Industry pushback
Prometheum's willingness to go along with the SEC on regulation hasn't necessarily gone down well in other corners of the industry. In July, Blockchain Association, an crypto advocacy and lobbying group, sent a letter to the SEC's office of inspector general asking for an investigation into whether Gensler had reached a "sweetheart deal" to grant Prometheum its special purpose broker-dealer license in return for supporting his regulatory agenda.

"While Congress is taking steps to provide guidance and answers to the American digital assets industry, Chair Gensler's SEC continues to stand in the way by spreading a false narrative that the laws are already clear," Kristin Smith, Blockchain Association CEO, said in a statement.

Kaplan said he has little doubt that federal regulation is the way forward for the digital asset industry. He pointed to an SEC proposal in February that would make firms that deal in cryptocurrencies subject to the same custody requirements as traders in traditional stocks and bonds.

Besides Prometheum, the only firm to provide custody for crypto assets at the national level is Anchorage Digital Bank, which falls under banking regulations rather than the SEC and works primarily with other financial institutions. Large brokerage firms that allow clients to trade in crypto and other assets mostly now meet their custody obligations at the state level.

Fidelity Investments — which began letting all of its customers invest in bitcoin and ethereum in March — custodies digital assets in New York at what's known as a state-chartered trust. Fidelity started the trust, officially called Fidelity Digital Asset Services, in 2018 just as it was looking to enter the crypto business.

In a letter sent to the SEC in response to its newly proposed custody rules for digital assets, Jonathan Chiel, the general counsel for Fidelity Management & Research Company, argued the state-level system has served the industry and investors well. Criticizing various aspects of the SEC's custody proposal, Chiel argued that state-licensed custodians should be allowed to continue operating even should the federal rule for safeguarding digital assets be adopted.

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"The SEC should acknowledge the critical role that state-chartered trust companies fill in protecting client interests and ensuring that investment advisers and their clients continue to have access to the sophisticated custody services they provide," Chiel wrote.

Regulatory clarity
Of course, for most businesses that want to comply with the law, it makes little difference if it's being enforced at the state or federal level. They simply want to know how to avoid trouble.

Ron Geffner, a former SEC enforcement lawyer whose practice now involves providing advice to companies on digital assets, said he thinks governmental officials have done a reasonably good job letting firms know what they can and can't do.

"I think there's enough clarity to move forward to reduce your risk depending on your value system, or if you even want to stay in compliance," said Geffner, a partner at New York-based Sadis & Goldberg. "The government also wants to see what efforts you can engage in to comply with the law. So even if you have done it a little bit wrong, if you made the effort to do it right, that goes a long way as well."

But some think more regulatory clarity is needed. Cass Sanford, the deputy general counsel of OTC Markets — which provides a trading system for stocks not listed on traditional exchanges — said many institutions will continue to steer away from digital assets that have not been officially registered with the SEC or some other federal agency.

She said OTC Markets has not yet begun handling cryptocurrency transactions despite winning FINRA's approval in May to operate an alternative trading system for digital assets. So far, Sanford said, the only digital-related securities OTC Markets has facilitated trading in have been products like the Grayscale Bitcoin Trust, which tracks the market for bitcoin without actually consisting of cryptocurrency.

Sanford said no overhaul of U.S. securities laws is needed to accommodate the crypto industry.

"I think there needs to be some movement, just to clarify obligations," she said. "And whether that comes from the [SEC], or out of Congress. I'm not sure. But I think that there are some differences between digital assets and traditional securities that require some clarity."

New uses
Kaplan said he foresees a day when companies like his are used to custody digital assets going beyond the sorts of cryptocurrencies that are now most commonly traded. Blockchains could eventually be used to complete transactions in traditional securities like stocks and bonds.

One huge advantage to the technology, he said, is its ability to settle trades with almost no lag time. That will come in handy as firms come under greater pressure by the SEC to speed up the completion of investor transactions. A rule adopted in February, for instance, gives broker-dealers one day to complete a securities trade, down from the previous requirement of two days.

"This is just clearly a trend where we're essentially going to instantaneous settlement," Kaplan said. "And I think one of the best means of achieving instantaneous settlement, possibly the only one that I think that really makes sense, is by having assets exist on the blockchain. It's just a question of when, not if, in my mind."