A step forward for the secondary trading of digital assets

A new no-action letter from the U.S. Securities and Exchange Commission (SEC) is widely expected to make life easier for parties trying to buy or sell digital asset securities on the secondary markets.

The letter came about because two partners at Davis Polk, acting on behalf of several of their clients who had expressed frustration at the existing trading structure, put together a proposal for a better structure, and pitched it to the SEC staff. Those partners are Annette Nazareth and Zachary Zweihorn. Nazareth is a former SEC commissioner, and Zweihorn recently moderated the ABA’s Blockchain and Digital Currency National (Virtual) Institute this year.

The SEC staff decided to issue this relief not in the form of a response to any Davis Polk clients, but more broadly as an industry-wide no-action letter addressed to FINRA. A no-action letter is not a rule, but informs the recipient, in this case in essence the industry, that it will not be the target of an enforcement action if it follows the course of conduct detailed therein.

Cutting four steps down to three

Under existing regulations, transactions in digital assets on alternative trading systems have been cleared and settled in a cumbersome four step process. First, the buyer and seller send their respective orders to the alternative trading system (ATS). Second, the ATS matches the orders. Third, the ATS notifies the buyers and sellers of the match. Fourth, and finally, the buyer and seller settle their transaction bilaterally, generally by instructing their respective custodians to do so on their behalf.

This has been thought necessary because the SEC has made it very clear that the ATS’ themselves cannot be involved in the clearance or settlement processes. The no-action letter does not change that SEC stance.

But what the no-action letter does is authorize a streamlined three-step process. First, the buyer and seller are now, as they send their respective orders to the ATS, at the same time to notify their respective custodians of those orders, and to instruct the custodians to settle transactions in accord with those submissions if the ATS notifies the custodians of a match on the ATS. Second, the ATS matches the orders. Third and finally, the ATS notifies buyer and seller and their respective custodians of the matched trade so the custodians can clear and settle as conditionally instructed.

In the words of James Dowd, founder of North Capital Private Securities, which operates the PPEX ATS for secondary trading of digital assets, the change to the three-step process “does have the potential to save a lot of the time and to save a lot of the risks in the settlement process.” It is not ideal, because the wall between broker-dealers and custodians still imposes inefficiency, but it is in Dowd’s view “better than nothing.”

Conditions on the streamlining

The no-action letter imposes some conditions on those who would avail themselves of the three-step process. The broker-dealer must maintain a minimum of $250,000 in net capital;  the agreements between this broker-dealer and its customers must clearly state that the former does not guarantee or otherwise have responsibility for settling the trades; the broker-dealer must have established and maintain reasonably designed procedures to assess whether a digital asset security was offered and sold initially pursuant to an effective registration statement or an available exemption from registration, and whether any secondary transactions of the digital asset security on or through the ATS are made pursuant to an effective registration statement or an available exemption from registration; and, finally, the transactions in digital asset securities must otherwise comply with the federal securities laws.

The timing of this no-action letter is intriguing: the SEC issued it on September 25, only four days after a letter from the chief counsel of the Office of the Comptroller of the Currency confirmed that national banks may hold crypto assets for their customers.

Together, these two actions may, in the words of a Davis Polk client memo, “allow legal, regulated, and fully functional trading platforms for digital asset securities to finally come to market.” It is a landmark in the regularization of asset classes until recently understood as a sort of ‘Wild West’ of finance.

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