The Custody challenges of digital asset securities

According to the U.S. SEC market participants wishing to custody digital asset securities may find it challenging to comply with the broker-dealer financial responsibility rules without putting in place significant technological enhancements and solutions unique to digital asset securities. 

A broker-dealer seeking to custody digital asset securities must comply with the Customer Protection Rule. If the broker-dealer fails, customer securities and cash should be readily available to be returned to customers.

There are many significant differences in the mechanics and risks associated with custodying traditional securities and digital asset securities. For instance, the manner in which digital asset securities are issued, held, and transferred may create greater risk that a broker-dealer maintaining custody of them could be victimized by fraud or theft, could lose a “private key” necessary to transfer a client’s digital asset securities, or could transfer a client’s digital asset securities to an unknown or unintended address without meaningful recourse to invalidate fraudulent transactions, recover or replace lost property, or correct errors. Consequently, a broker-dealer must consider how it can, in conformance with the law, hold in possession or control digital asset securities.

If, for example, the broker-dealer holds a private key, it may be able to transfer such securities reflected on the blockchain or distributed ledger. However, the fact that a broker-dealer (or its third party custodian) maintains the private key may not be sufficient evidence by itself that the broker-dealer has exclusive control of the digital asset security (e.g., it may not be able to demonstrate that no other party has a copy of the private key and could transfer the digital asset security without the broker-dealer’s consent). The above mentioned risks could cause securities customers to suffer losses, with corresponding liabilities for the broker-dealer, imperiling the firm, its customers, and other creditors.

It should be noted that the broker-dealer’s difficulties in evidencing the existence of these digital asset securities may in turn create challenges for the broker-dealer’s independent auditor seeking to obtain sufficient appropriate audit evidence.

The Crypto asset market (digital asset) or the law may need to continue devolving and/or amending in order to achieve an understanding.

 

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