FINRA Wants to Know If Broker-Dealers Are Involved in Digital Assets

The Financial Industry Regulatory Authority (FINRA) is ‘encouraging’ broker-dealers to keep it informed about their activities involving digital assets…

The Financial Industry Regulatory Authority (FINRA) is ‘encouraging’ broker-dealers to keep it informed about their activities involving digital assets. Under Notice 20-23, FINRA is requesting that broker-dealers keep their Risk Monitoring Analyst informed if the firm, or its associated persons or affiliates, currently engages, or intends to engage, in any activities related to digital assets.

“As the area of digital assets continues to evolve and present unique regulatory challenges, FINRA believes it is important to keep the lines of communication with [dealers] open,” FINRA said in the Notice.

FINRA Oversight of Digital Assets

Although FINRA has not established specific rules governing the emerging industry, its latest Notice confirms that it plans to keep a close eye on firms’ digital asset activities, even those that may not be considered “securities.” Digital assets that fall under the definition of an “investment contract” under Section 2(a)(1) of the Securities Act of 1933 or under Section 3(a)(10) of the Securities Exchange Act of 1934 are considered  “securities” and governed by the federal securities laws and FINRA rules.

Last summer, FINRA and the SEC staff issued a Joint Statement regarding broker-dealer custody of digital assets. The Joint Statement emphasized that “digital asset securities and related innovative technologies raise novel and complex regulatory and compliance questions and challenges.” It went on to discuss several concerns that are unique to digital assets, including compliance with the custodial requirements under Rule 15c3-3 under the Exchange Act, which is known as the Customer Protection Rule.

In its Risk Monitoring and Examination Priorities Letter for 2020, FINRA identified digital assets as an examination priority, citing that they raise novel and complex regulatory issues under federal securities laws and FINRA rules. FINRA also noted that receiving an increasing number of New Member Applications (NMAs) and Continuing Member Applications (CMAs) from firms seeking to engage in business activities related to digital assets. As set forth in FINRA 2020 Priorities Letter, it may take the following factors, among others, into consideration when reviewing a firm’s digital asset activities:

• If your firm is considering engaging in digital asset activities, has it filed a CMA with FINRA?
• Does your firm provide a fair and balanced presentation in marketing materials and retail communications, including addressing risks presented by digital asset investments, and not misrepresenting the extent to which digital assets are regulated by FINRA or the federal securities laws or eligible for protections thereunder (such as Securities Investor Protection Corporation coverage)?
• Do your firm’s communications misleadingly imply that digital asset services offered through an affiliated entity are offered through and under the supervision, clearance, and custody of a registered broker-dealer?
• If your firm is engaging in digital asset transactions, what controls and procedures has it established to support facilitation of such transactions, including initial issuance or secondary market trading of digital assets?

FINRA’s Latest Digital Asset Guidance

FINRA issued its latest guidance on July 18, 2020. For purposes of the Notice, the term “digital asset” refers to cryptocurrencies and other virtual coins and tokens (including virtual coins and tokens offered in an initial coin offering (ICO) or pre-ICO), and any other asset that consists of, or is represented by, records in a blockchain or distributed ledger (including any securities, commodities, software, contracts, accounts, rights, intangible property, personal property, real estate or other assets that are “tokenized,” “virtualized” or otherwise represented by records in a blockchain or distributed ledger).  

As set forth in the Notice, the types of activities of interest to FINRA if undertaken (or planned) by a member, its associated persons or affiliates, is extensive and includes, but are not limited to:

• purchases, sales or executions of transactions in digital assets;
• purchases, sales or executions of transactions in a pooled fund investing in digital assets;
• creation of, management of, or provision of advisory services for, a pooled fund related to digital assets;
• purchases, sales or executions of transactions in derivatives (e.g., futures, options) tied to digital assets;
• participation in an initial or secondary offering of digital assets (e.g., ICO, pre-ICO);
• creation or management of a platform for the secondary trading of digital assets;
• custody or similar arrangement of digital assets;
• acceptance of cryptocurrencies (e.g., bitcoin) from customers;
• mining of cryptocurrencies;
• recommend, solicit or accept orders in cryptocurrencies and other virtual coins and tokens;
• display indications of interest or quotations in cryptocurrencies and other virtual coins and tokens;
• provide or facilitate clearance and settlement services for cryptocurrencies and other virtual coins and tokens; or
• recording cryptocurrencies and other virtual coins and tokens using distributed ledger technology or any other use of blockchain technology.

What Could be Required in the Future?

FINRA’s “request” will be effective until July 31, 2021. However, assuming the digital assets industry continues to evolve, and given the ‘warnings’ in the Notice and Joint Statement, firms should expect regulators to continue to keep a watchful eye on their involvement with this category of investment for the foreseeable future.

If you have questions, please contact us

If you have any questions or if you would like to discuss these issues further,
please contact Paul Lieberman or the Scarinci Hollenbeck attorney with whom you work, at 201-896-4100.