SEC Issues No-Action Letter on Digital Settlement Process

In a move to reduce operational risks for brokers, the U.S. Securities and Exchange Commission (SEC) took a prominent step towards simplifying the settlement of digital asset securities. Previously, it was a four-step process, but it has now been compressed into three. A no-action letter was issued by the SEC on 25th September in which the regulator said that it no broker-dealer would be penalized for operating an alternative trading system (ATS) for trading digital asset securities, as long as they are ready to adhere to the new guidelines. The regulator said that a number of ATS wish to follow a streamlined model in situations where there is no custody problem in regard to the assets being traded.

A four-step process is followed by most ATS; first, orders are sent to the ATS by the buyer and seller, secondly, the orders are matched by the ATS, thirdly the buyer and seller are notified by the ATS about the matched trade and the transaction is bilaterally settled in the last step, either via their custodians or through each other. However, more clarity was demanded by the Financial Industry Regulatory Authority (FINRA) in the event that physical custody of the asset wasn’t taken by the broker-dealer.

In the opinion of some broker-dealers, this four-step process left them exposed to a lot of risk. The ATSs asked that they be permitted to streamline this process. As per the no-action letter, the steps that will be involved include:

First step: Orders will be sent to the ATS by the buyer and sellers and they will also notify their respective custodians about the submitted orders. They will also instruct their respective custodians to that when the ATS notifies them of a match on the ATS, they should settle the transactions according to the terms of the order.

Second Step: The orders are matched by the ATS.

Third Step: The buyers and sellers, along with their respective custodians, are notified of the matched trade and the conditional transactions are carried out by the custodians.

Under the Customer Protection Rule of the SEC, broker-dealers will have to obtain and then keep physical possession of all the excess margin or fully-paid securities for their customers. This rule is designed to protect customers from delays or losses in accessing their security in the event the ATS fails. However, this can become difficult when you are dealing with digital assets. According to the SEC, the broker-dealers choosing the streamlined model wouldn’t face any enforcement action related to the Customer Protection Rule.

It was noted by the letter that broker-dealers who are thinking about implementing this process are concerned about their custodial role because they operate with a minimum capital of $250,000. Plus, they clearly inform their customers that the broker-dealer cannot take responsibility of guarantee settling trades. Nonetheless, the SEC clarified that the no-action letter just addresses the digital asset securities under the circumstances mentioned in the letter and doesn’t focus on broker-dealer custody or the control of the digital assets in question.