The term “digital asset” refers to an asset that is issued and/or transferred using distributed ledger or blockchain technology. A digital asset may or may not meet the definition of a security under the federal securities laws. A digital asset that is a security is referred to as a “digital asset security.”

SIFMA believes it is important that the definition of a digital asset security not be overly broad, as there are various types of securities and ways of digitally representing and transferring such securities that would be miscategorized as digital assets were the definition of a digital asset security not well crafted.

Q:  What are digital asset securities?

A:  The term “digital asset” refers to an asset that is issued and/or transferred using distributed ledger or blockchain technology. A digital asset may or may not meet the definition of a security under the federal securities laws. A digital asset that is a security is referred to as a “digital asset security.”

SIFMA believes it is important that the definition of a digital asset security not be overly broad, as there are various types of securities and ways of digitally representing and transferring such securities that would be miscategorized as digital assets were the definition of a digital asset security not well crafted.

Security tokens are one type of digital asset. In November 2020 SIFMA published a whitepaper to outline a foundational understanding of how distributed ledger technology (DLT) and digital assets such as security tokens interplay with the current securities market. It also describes the key operational challenges faced by U.S. broker-dealers hoping to adopt this technology and recommends where regulatory clarity would be helpful in addressing these challenges.

Q:  How are digital asset securities regulated?

A:  Digital asset securities are regulated by the Securities and Exchange Commission (SEC).

SIFMA understands the need for the SEC to distinguish between digital asset securities and digital assets that are not securities, as not all digital assets are securities. However, any future rulemaking should not be framed in such a way that restricts a broker-dealer’s ability to conduct business by virtue of the technology it wishes to implement.

Rather, the SEC should take a principles-based approach to regulating activities related to digital asset securities in order to allow a broker-dealer the flexibility to develop best practices and comply with its existing regulatory obligations, rather than focusing on the underlying technology (i.e., distributed ledger technology), as it and other regulators have done in the past.

Any future rulemaking by the SEC should not be based on a general distinction between digital asset securities and “traditional” securities, but rather should be technology neutral, should be principle-based, and should allow firms the ability to evaluate what digital securities they will support, taking into consideration the relevant operational risks and regulatory requirements related to the technology underlying the digital asset security and unique configuration and facts related to a particular digital asset security.

Q:  How could blockchain technology transform the securities industry?

The United States has the deepest and most liquid capital markets in the world, facilitating growth and innovation across all industry sectors. And throughout the years, the U.S. capital markets have continued to innovate as technology has allowed for rapid and significant advances. Over the last few years, distributed ledger technology (DLT) has rapidly gained interest in the securities industry.

The U.S. securities industry is exploring the potential benefits of using DLT, including and not limited to using the technology to create efficiencies and issuance; leverage the blockchain to create efficiencies in clearing and settlements; the possibility of creating efficiencies; creating efficiencies in automating regulatory compliance, which is an important point; also to integrate programmability into an asset via smart contract; leverage data immutability; and improve trade efficiencies.

Q:  Why is it important to develop a framework to meet possessions and control requirements for digital asset securities?

A:  Custody refers to a broker-dealer holding securities on behalf of a client. The creation of various controls will help broker-dealers mitigate potential risks involved with the custody of digital asset securities.

It is important to establish, maintain, and enforce reasonably designed written policies, procedures, and controls for safekeeping and demonstrating that they have exclusive possession or control over digital asset securities.  These should be consistent with industry best practices to protect against the theft, loss, and unauthorized and accidental use of the private keys necessary to access and transfer the digital asst securities the broker-dealer holds in custody.

The SEC has provided a starting point for broker-dealers to consider requirements needed to mitigate the risks associated with digital asset securities that other regulations do not expressly proscribe, and SIFMA appreciates this step forward. We also support the adoption of minimum practices or principles that every broker-dealer involved with digital asset securities should meet.

Q: Are all digital assets the same? Or are there some key differences in how they operate and their levels of risk?

A:  All digital assets are not the same.

There are various types of securities and ways of digitally representing and transferring such securities, each with different characteristics and risk profiles.  For instance, a bearer security in a public network may have significant differences that inform the associated operational and regulatory risks when compared to a non-bearer security in a permissioned network. There may also be significant differences even within these broad categories depending on how a particular digital asset or network is configured.

Q:  What are special purpose broker-dealers, and are they necessary to handle digital asset security business?

A:  Special purpose broker-dealers would limit their business exclusively to holding digital asset securities on behalf of clients in order to isolate risk. SIFMA does not believe SPBDs are necessary to the digital asset security business, as traditional broker-dealers can develop appropriate operational procedures to establish that digital asset securities are sufficiently within their control and do not pose extraordinary risks. Moreover, by and large, the risks for digital asset securities are the same as the risks of traditional securities, such as loss of value through market risk.

Both traditional securities and digital asset securities will be in place for the foreseeable future. Attempting to isolate risk via the establishment of an SPBD may not support the long-term objectives of building the industry capability and insights required to manage a mainstream offering that includes both methods of recording securities – it merely continues the bifurcation seen in the marketplace today between regulated broker-dealers and digital asset service providers.

Q: How could the special purpose broker dealer requirement hinder the development of markets for these securities?

A:  As explained above, SIFMA believes that traditional broker-dealers can provide adequate protections for digital asset securities, making a special purpose broker-dealer unnecessary. The establishment of an SPBD goes further than the existing bifurcation, and would result in a trifurcated market between digital and traditional securities (and further, non-security digital assets). This trifurcation creates obstacles for broker-dealers and customers alike.

The creation of SPBDs would also increase costs, be unable to leverage the benefits of established controls and risk management protocols already in place, tested, and relied on at existing broker-dealers, disadvantage investors by requiring them to open multiple accounts with multiple broker-dealers depending on the assets they own, concentrate risk in a narrow category of securities, and pose clearance and settlement challenges.

Q:  What investor protections are in place (or should be) for digital asset securities?

A:  As products regulated by the SEC, digital asset securities are highly regulated and subject to existing investor protection rules.

It is important to distinguish between factors that may contribute to the risk of loss or theft of digital asset security, and factors that may contribute to the operational performance of a particular digital asset network, and potentially the value of a particular digital asset. For instance, certain factors, such as performance/transaction speed, scalability, resilience, complexity, and visibility, are related to the operational performance of a digital asset network. While these factors may impact the value of a digital asset security, they may not impact the risk of loss or theft of private keys.  Material facts about a digital asset security would need to be disclosed by the issuer and broker-dealer – but this relates to the value of a digital asset security, and not the risk that the possession or control of private keys would be lost by a broker-dealer.

Even digital asset securities that rely on public blockchains may be configured in such a manner to enhance investor protections. For example, digital assets securities may be issued on “sidechains” that contain minimal information on the public blockchain, and reference external data in a centralized database.

Q: What are some of the key other regulatory issues that need to be resolved to support the further development of digital asset security markets?

A:  As a security is created, subsequently traded, and then transferred, there are various reporting and reconciliations that are required at each level of intermediation.  However, one area where further clarity is needed is with respect to the application of books, recordkeeping and reporting obligations of digital asset securities.  Regulatory guidance is needed on whether DLT can act as the official books and records for market participants.  Similar guidance is needed for the registration requirements for digital asset securities.

Charles DeSimone is Vice President, Technology and Operations, SIFMA

Related Resources

• White Paper

  Digital Security Tokens

• The SIFMA Podcast

  Using Security Tokens to Facilitate Capital Formation