What does the SEC’s no-action letter regarding digital asset securities trading mean?

This letter of no objection is another attempt made by the U.S. regulatory authorities in the supervision of digital asset securities trading that deserves attention.

Written by: Zhang Gaijuan

Last Friday, the U.S. Securities and Exchange Commission (SEC) issued a no-action letter regarding the transaction processing procedures of digital asset securities trading custodian brokers. Specifically, the SEC's trading and market staff stated that brokers trading digital asset securities can implement a "three-step approach" to reduce operational and settlement risks and protect investors under certain circumstances.

Before understanding the specific matters included in the no-action letter and its meaning, let's first look at what the no-action letter issued by the SEC means and under what circumstances it will be issued?

What is a no-objection letter?

No Action Letters, also known as no-action letters. If an individual or entity is unsure whether a product, service, or behavior violates federal securities laws, they can request that the SEC staff issue a no-action letter. After analyzing the specific facts and circumstances involved and discussing the applicable laws and rules, the staff will consider whether to issue a no-action letter. If the staff agrees to the request and issues a no-action letter, it means that the SEC is recommended not to take enforcement action on the relevant behavior.

Why did the SEC issue a no-action letter regarding digital asset trading?

On September 25, the U.S. SEC’s Division of Trading and Markets issued this no-objection letter and sent a letter to Kris Dailey, Vice President of Risk Oversight and Operational Regulation at the U.S. Financial Industry Regulatory Authority (FINRA).

The key points of the no-objection letter are as follows:

If brokers operating ATSs that trade digital asset securities (hereinafter referred to as digital asset securities trading brokers) implement the " three-step approach " to reduce settlement risks and protect investors, the SEC staff will not recommend that the SEC take enforcement action in this regard. It is worth noting that this only applies to custodial broker-dealers that do not perform settlement .

Note: ATS refers to a trading system that meets the definition of "exchange" under federal securities laws.

In fact, the no-objection letter is a response to the Joint Staff Statement issued by the SEC and FINRA in July 2019 regarding the transaction processing procedures and methods of digital asset securities brokers.

In 2019, market participants questioned whether custody and trading of digital asset securities are subject to federal securities laws and the relevant rules of the U.S. Financial Industry Regulatory Authority. In response, the U.S. SEC Division of Trading and Markets and FINRA issued a Joint Staff Statement in July 2019. In the statement, the staff stated that entities (companies and individuals) seeking to participate in the digital asset securities market must comply with federal securities laws, may also need to register with the U.S. SEC, and become members of self-regulatory organizations (in most cases, FINRA). If the entity is a broker-dealer, it must also comply with the financial responsibility rules for broker-dealers, including the custody requirements set forth in the Securities Exchange Act of 1934, namely the customer protection rule. The rule requires broker-dealers to segregate customer assets from company assets to protect investors.

The staff also discussed Section 15c3-3 (b) of the Securities Exchange Act and described several non-custodial activities involving digital asset securities. At the same time, the statement finally pointed out that this is not a rule, regulation or guidance of the SEC or FINRA, but only represents the views of the staff.

The SEC stated that the transaction processing of this non-custodial ATS is divided into the following four processes:

1. Buyers and sellers send their orders to the ATS;

2. ATS matches orders;

3. The ATS notifies the buyer and seller of the completed trade;

4. Buyers and sellers settle bilaterally or by asking their respective custodians to trade bilaterally on their behalf.

Since the release of the Joint Staff Statement, several digital asset securities trading brokers have contacted SEC staff, saying that the above process increases operational and settlement risks. They hope to simplify the transaction processing process into three steps to reduce operational and settlement risks.

1. The buyer and seller send their respective orders to the ATS and submit the order information to their respective custodians . When the ATS notifies the custodian of the match, the buyer and seller instruct their respective custodians to settle the transaction according to the terms of their orders;

2. ATS matches orders;

3. ATS notifies the buyer and seller and their respective custodians of the matched transaction information, and the custodian executes the conditional instructions.

This means that in the “three-step method”, the custodian will settle on behalf of the buyer and seller based on the instructions received in step 1. However, similar to the four-step method, the broker-dealer does not guarantee, is not responsible for settling the transaction, and does not control the assets of the buyer and seller until settlement is completed.

Digital asset securities brokers seeking to implement the “three-step approach” also provided additional instructions to address concerns about asset control.

1. Broker-dealers will maintain a minimum of $250,000 in net capital ;

2. The agreement between the broker-dealer and its customers expressly states that the broker-dealer does not guarantee or is not responsible for settling transactions;

3. Broker-dealers will establish procedures to evaluate whether digital asset securities traded comply with an effective registration statement or exemption from registration;

4. Ensure that transactions in digital asset securities comply with federal securities laws.

Based on this, the SEC’s Division of Trading and Markets stated that in the above situation, if the broker-dealer of the ATS that trades digital asset securities implements the “three-step approach”, the staff will not recommend to the SEC that enforcement action be taken under Section 15(c)(3) and Rule 15(c)(3) of the Securities Exchange Act.

what does that mean?

Although this letter of no objection only applies to ATS trading digital asset securities under the circumstances specified in this letter, and does not involve the broker's custody or control of digital asset securities, and only represents the position or opinion of SEC staff on enforcement actions, and is not a legal rule , it has promoted the convenience and liquidity of digital asset securities transactions.

Drew Hinkes, an attorney at the US law firm Carlton Fields, said the letter of no objection will bring the following changes to digital asset securities trading:

• Trading digital asset securities has become easier;

• Brokers clarify the rules for handling digital asset securities transactions;

• The role of the custodian will become more important;

• Broker-dealers need to evaluate whether the digital asset securities being traded are subject to a valid registration statement or exemption from registration;

• Helps improve the liquidity of digital asset securities.

On the other hand, Brian Brooks, acting director of the U.S. Office of the Comptroller of the Currency (OCC), said the no-objection letter was dedicated to protecting investors in the emerging asset space.

It can be seen that this letter of no objection is another attempt made by the US regulatory authorities in the supervision of digital asset securities trading that deserves attention.

At present, the US SEC has not yet determined the securities attributes of digital assets. In July this year, Heath Tarbert, chairman of the US Commodity Futures Trading Commission (CFTC), said that the CFTC is waiting for the SEC to determine the securities attributes of digital assets to allow more futures trading of digital assets. He explained that "it is the sole responsibility of the SEC to determine whether digital assets are securities. From a legal perspective, digital assets belong to a particularly tricky field. To truly realize the full potential of this field, we need to cooperate internationally."

But there are increasing signs that the U.S. SEC is expected to accelerate the introduction of digital asset-related rules in the next few years. In August, the U.S. Senate Executive Conference confirmed that SEC Commissioner Hester Peirce will be re-elected for a second term, which will expire in 2025. Hester Peirce, who took office in 2018, is friendly to cryptocurrencies and blockchains and advocates the approval of Bitcoin ETFs. In February of this year, Hester Peirce formally proposed to provide a three-year grace period for cryptocurrency projects that do not violate U.S. securities laws. In early September, Hester Peirce said in an interview, "Although DeFi is still in its early stages, it has attracted the attention of the SEC because DeFi raises the issue of "changing the rules of the game." This will challenge our regulatory approach. "