The crypto regulatory landscape has been evolving at a solid pace these past couple of years as countries worldwide take steps to establish guidelines, offer clarity, and protect customers.
In this regard, about four years ago, the US Securities and Exchange Commission (SEC) introduced a new class for those who deal with the custody of crypto asset securities. Today, we’ll take a deep dive into this and just how it is shaping up.
Breaking Down the SPBD Regime: What It Means for Broker-Dealers
In Dec. 2020, the US SEC introduced “special purpose broker-dealers” (SPBD), which is a registered broker-dealer that can custody and transact in digital asset securities.
Under the SPBD regime, the securities agency grants the SPBD license to allow broker-dealers to custody and handle digital asset securities in compliance with federal securities laws.
According to the SEC, a Financial Industry Regulatory Authority (FINRA)-approved SPBD can transact in and custody digital asset securities, unlike other broker-dealers and alternative trading systems (ATS), which can only transact in crypto securities after receiving FINRA approval but cannot custody them.
However, an entity registering as an SPBD is subject to a number of stringent compliance requirements, especially around investor protections, disclosures, and operational oversight. These conditions include:
SPBDs can not deal with traditional securities except for hedging and net capital purposes. The regime also limits SPBD’s business activities by only allowing them to conduct business involving digital assets that are securities.
These broker-dealers also need to have access to crypto securities that they wish to hold as well as the ability to transfer them using the associated distributed ledger technology (DLT). If the entity is aware of any material operational or security problems with the associated network, then it must not maintain custody of that crypto security. The SPBD further needs to provide written disclosures to its customers, including any material risks with the asset.
The SPBD registered firm has to enter into a written agreement with each customer and set forth the terms and conditions for transacting in crypto asset securities.
Furthermore, the firm needs to establish, maintain, and enforce policies and procedures to determine whether a crypto asset is a security.
In addition to analyzing whether the crypto securities it trades were issued in compliance with securities laws and regulations, the firm must have written supervisory procedures to assess the associated network and characteristics of the crypto securities before undertaking custody. These assessments, conducted at regular intervals, should be used to confirm that there are no operational problems or weaknesses in the distributed ledger technology.
Moreover, procedures need to be followed to discover and tackle threats with the associated DLT and networks. An SPBD is also required to notify its customers that crypto securities may not be “securities” to get SIPA protection, which shields customers from lost securities in case the broker-dealer goes bankrupt.
These policies must be consistent with the best practices of the industry, and the firm must demonstrate that it has exclusive control over the securities it holds in custody. The entity must comply with court-ordered seizures and protect against the loss of the private keys associated with such crypto asset securities.
SPBD Licensing: A Complex and Stringent Process
The SEC’s statement on the “Custody of Digital Asset Securities by Special Purpose Broker-Dealers” suggests three brokerage models with respect to digital asset securities, with the broker-dealer custodial (SPBD) model being one.
As per the SEC’s statement, the agency will not commence an enforcement action for a period of five years against an SPBD as long as it establishes, maintains, and enforces written policies and procedures to determine if a crypto asset is a security and sold in accordance with an effective registration statement or an exemption from it.
The second is a non-custodial model where a broker-dealer who does not have custody of crypto securities may facilitate digital asset securities’ trading as an ATS. However, the ATS cannot be involved in clearing and settling such trades. These entities are not subject to the SPBD requirements.
Next is the bank custodial model, where national banks may have custody of crypto, including securities. Here, a broker-dealer is allowed to rely on a bank as a control location for its customers’ securities and does not need to seek the permission of the Commission. Since the broker-dealer is relying on a bank for the custody of its customers’ digital asset securities, it doesn’t need to be an SPBD.
SEC’s statement is rather limiting, though, and lacks explanations for its restrictions. Also, as we noted above, an SPBD applicant is required to meet rigorous standards set by the SEC as well as FINRA. These regulatory standards further include measures related to custody, anti-money laundering (AML), and cybersecurity.
Some of the conditions that SPBDs must fulfill have made this new class an unattractive option for broker-dealers.
Many broker-dealers view SPBD as overly restrictive due to the fact that SPBDs cannot engage in traditional (non-crypto) securities on a non-custodial basis.
Even in the crypto realm, SPBDs are only allowed to deal with, transact in, and maintain custody of crypto asset securities. This puts the largest trillion-dollar market cap cryptocurrency, Bitcoin, out of the equation. Not to mention, the digital asset framework in the US is still undefined, and its classification as securities is complex. As a result, many digital assets operate in regulatory gray zones, adding further complications.
Moreover, SPBDs cannot deal with crypto that isn’t registered or exempt from registration under federal securities laws.
These restrictions prevent SPBDs from transacting in or custodying a good chunk of cryptocurrencies, making only a few crypto securities available for them. Such cryptocurrencies are typically thinly traded as well.
The Limited Players in the SPBD Space
An extremely limited number of companies have successfully secured the SPBD license, which didn’t come until last year.
More than two years after the introduction of SPBD, the SEC approved the Prometheum Ember Capital LLC to operate as an SPBD and as the first entity to custody crypto securities.
Founded in 2017 by a group of Wall Street attorneys, Prometheum Inc. operates through its two subsidiaries — Prometheum ATS (trading) and Prometheum Capital LLC. (settlement, clearing, and custody).
In Sept. 2024, the registered broker-dealer announced the launch of its digital asset securities custody platform. This will allow traditional financial institutions to custody their crypto securities via Prometheum Capital, which is a FINRA member firm.
As an SEC-registered SPBD, Prometheum Capital is a ‘qualified custodian’ and is tailored to meet the regulatory compliance guidelines implemented at the federal level.
“Prometheum believes that investors and product issuers need a partner operating under the full rigor of federal securities laws.”
– Aaron Kaplan, co-CEO and co-founder of Prometheum
The SPBD currently supports Ethereum (ETH), Arbitrum (ARB), Optimism (OP), Uniswap (UNI), and The Graph (GRT) with future plans to onboard traditional securities covering equities, options, mutual funds, ETFs, money market funds, debt, and other investment contract products issued and transferred on a blockchain.
Recently, yet another name was added to the very short list of SPBDs as tZero Group Inc., as it obtained an SPBD license in the US after three and a half years of efforts.
“This is a unique opportunity for us to develop the infrastructure to support regulated digital assets in the United States.”
– tZero’s chief legal officer, Alan Konevsky, in an interview
Being the second-ever company to get this license, tZero can now custody crypto securities. The firm is required to treat any tokens that it custody as securities no matter how they’re identified by their issuers.
“It’s fine to say that a number of these assets should be treated as securities.”
– Konevsky told Blockworks
tZero will be supporting custody of crypto security in pursuant to the guidance from the FINRA and the SEC. This means, tZeo will cover assets that were not initially issued as registered securities but are deemed as such by the SEC now.
However, regulators need to create a “pathway” for how these assets can be traded legally by a broker-dealer, and this guidance, according to Konevsky, hasn’t been offered for the tokens that Prometheum supports. He said:
“We would welcome guidance and clarity from the regulators on how we can lawfully support those types of assets, and then we’ll execute on that guidance.”
With its license, the firm aims to create a way ahead for safe, regulated digital asset securities trading in the US. tZero will launch its custody service early next year with its own stock, TZROP, as the first asset to be supported on the platform.
Controversies Surrounding SPBDs and Their Impact on Crypto
Over the past many years, Prometheum has been focused on meeting the regulatory and compliance standards promulgated by the federal securities laws, which its CEO Kaplan believes is important due to the crypto industry “still suffering from a lack of trust following the collapse of FTX.“
As an SEC-registered broker-dealer platform, Prometheum aims to address this issue and bridge the gap between traditional finance and digital assets, enabling all kinds of investors to participate. However, the company has been subject to market censure after it launched Ethereum custody services.
Such a move essentially presents a view that Ethereum is a security, which is in line with the SEC Chairman Gary Gensler but against the broad crypto market, which argues that the vast majority of crypto should not be treated as securities under the SEC. Under Gensler’s guidance, the SEC has been cracking down on the crypto sector, issuing Wells Notices against many companies, including Ethereum developer Consensys.
According to Kaplan:
“(Its Ether custody) marks the first time that…an investment contract digital asset security is being custodied and treated under the securities laws.”
Prometheum’s announcement of the Ether custody service, however, has been met with vitriol from crypto advocates as they fear the service launch would have far-reaching consequences for the sector.
The Cedar Innovation Foundation called this launch “simply the latest attempt orchestrated by the SEC to drive the crypto market out of the United States,” adding that the securities agency and Prometheum are the only ones claiming ETH as security.
Last year, the non-profit Blockchain Association wrote a letter to the SEC Inspector requesting an investigation into how Prometheum received a “first-of-its-kind license” to operate as an SPBD. The Association believes the SEC may have forced FINRA to award Prometheum the license and that Gensler’s may be using the firm and the SPBD licensure process to spread “the false narrative that the law is already clear with regard to digital asset securities.”
The Association claims Prometheum may have gotten this “sweetheart” deal from the SEC in exchange for supporting the agency’s crypto policies, given that the company has no working product and has listed no assets.
Earlier this year, numerous members of the House Committees on Agriculture and Financial Services also wrote a letter to Gensler, pointing out how both the CFTC and SEC have acknowledged ETH as a digital commodity. Gensler’s reluctance to clarify ETH treatment, as per the members, “only exacerbates the confusion and uncertainty regarding ETH’s classification.“
The lawmakers further argued that it is “unacceptable” to allow one market participant to dictate the future of digital asset regulation.
Before Prometheum’s Ether Custody launch, the company got under the limelight when Kaplan testified before Congress that the SEC had clearly laid out a path to compliance for firms. The crypto industry questioned Prometheum’s intentions and just how the little-known firm became a poster boy for SEC compliance without offering any products or services.
The company remains unfazed by the backlash and, in late May 2024, soft-launched its controversial Ether custody, which, according to Kaplan, “eliminates a lot of the arguments that things can’t be done under existing laws.”
Prometheum is targeting banks, hedge funds, registered investment advisers, and asset management firms for its services, which will later be expanded to retail clients.
“Our primary focus is securities on the blockchain, and investment contracts are just a small fraction of that,” said Kaplan in an interview, as he shared the company’s plan to jump on the tokenization trend.
SPBDs Adding to the Regulatory Debate Over Digital Assets
SEC’s approach to crypto has been regulated by enforcement, which intensified after the collapse of the regulated crypto exchange FTX in late 2022. As we noted, under Gensler’s leadership, the SEC has been cracking down on crypto and hinting at treating ETH as a security.
Despite Ether’s existence for nearly a decade, regulatory bodies still can’t agree on a single classification for Ethereum. While initially, it was seen as security during the ICO sale due to centralized control, over time, it was deemed decentralized enough not to be labeled as such.
The CFTC already classified ETH as a commodity. In March this year, CFTC Chair Rostin Behnam appeared at the Congressional testimony and repeated the agency’s stance that Ether is a commodity. He further stated that if the SEC takes any action to validate the ETH’s custody as a security, then “it will then put our registrants, our exchanges who list [ETH] as a futures contract sort of in non-compliance of SEC rules as opposed to CFTC rules.”
Back in 2018, the former Director of Corporate Finance at SEC William Hinman also stated that the Ethereum network had sufficiently decentralized to the point where its token, ETH, could no longer be considered a security and regulating it otherwise adds “little value” for investors or regulators. A year after that, former SEC chair Jay Clayton also said that he didn’t consider Ether security.
But then the Merge happened, following which Gensler said that cryptos with a proven history of staking might be eligible for securities because “the investing public is anticipating profits based on the efforts of others.”
In Dec. 2022, Gensler also stated that there is no need for tailored crypto rules, in complete opposition to the broad crypto market’s call for bespoke regulations due to crypto’s decentralized nature.
“The rules are there. The law firms know how to advise their clients to comply.”
– Gensler
In an interesting turn of events, now, the SEC itself is regretting “any confusion it may have invited” by falsely stating that tokens themselves are securities.
The SEC has clearly failed to provide any clear guidance, which has led to dissonance over which crypto assets fall under securities laws. This confusion is further exacerbated when companies like Prometheum label such assets as securities, completely disregarding broader consensus. Not to mention, calling ETH and similar token securities can potentially stifle innovation.
Conclusion
Overall, the introduction of Special Purpose Broker-Dealers (SPBDs) by the SEC has been a significant step in regulating digital asset securities. However, the SPBD regime’s stringent requirements and restrictive nature reflect its limiting adoption. Meanwhile, with the likes of Prometheum and tZero entering the space, the debate surrounding SPBDs has only intensified.
As the regulatory landscape continues to evolve, clearer guidance from authorities are crucial to resolve these ongoing tensions and foster a more robust, transparent, and thriving digital asset ecosystem in the US and worldwide.