Since 2016, a number of companies and individuals have sought to raise capital for business enterprises by conducting Initial Coin Offerings ("ICOs"). Many of these ICOs were unregistered securities offerings, effected in violation of the federal securities laws.1 Many were also frauds and caused significant losses to investors.2 Not withstanding these incidents, it is clear that the blockchain technology that enables ICOs may be an effective way to issue and trade securities.
However, before securities intermediaries, such as broker-dealers, investment advisers and investment funds, conduct business in a blockchain environment, it will be necessary to determine whether and how they can maintain custody of such digital assets on behalf of their clients and customers.3 This article outlines some of the basic concepts of custody that have historically applied to firms that hold securities on behalf of customers and clients. It then describes how blockchain technology users currently maintain custody of other types of virtual assets. Finally, it describes the challenges that securities intermediaries would face in meeting federal custody requirements with respect to securities issued and traded in open blockchain networks. It suggests that the securities industry should prioritize the development of closed blockchain networks before seeking to use open networks as a means to secure and safeguard securities for customers and clients.
I. CUSTODY REQUIREMENTS UNDER FEDERAL SECURITIES LAWS.
Multiple provisions of federal law require intermediaries in the securities markets to maintain custody of securities that they hold on behalf of their customers and clients. For example, broker-dealers are required to comply with SEC Rule 15c3-3 (the "Customer Protection Rule"), which requires a broker-dealer to "obtain and . . . maintain the physical possession or control of' its customers' fully-paid securities and excess margin securities.4 The physical possession standard may be satisfied by holding certificated securities on the broker-dealer's premises in a vault. But since most securities are uncertificated, maintaining "control" is a more common practice. A broker-dealer maintains control over securities when they are held at specified entities, known as "control locations," including registered clearing agencies, custodian banks, foreign institutions as approved by the SEC, and any other location that the SEC has approved.5
Under the Investment Company Act of 1940 ("ICA") and its implementing regulations, SECregistered investment funds must maintain their securities investments in the custody of certain designated entities, such as banks, members of securities exchanges, or SEC-registered clearing agencies.6 A registered fund generally may not maintain custody of securities itself except by depositing them "in the safekeeping of, or in a vault or other depository maintained by, a bank or other company whose functions and physical facilities are supervised by Federal or State authority."7
SEC-registered Investment Advisers ("RIAs") must also ensure that their clients' investments are held in a safe and secure manner. Under SEC Rule 206(4)-2, an RIA is deemed to have custody of client securities if it holds or has any authority to obtain possession of them, including by acting in any capacity that gives legal ownership or access to client securities.8 In such a case, the RIA must maintain the securities with a "qualified custodian," such as a broker-dealer or bank.9
II. THE FUNCTIONS OF SECURITIES CUSTODIANS.
The purposes of the federal custody requirements, and the services that custodians provide, can best be understood by recalling the time when securities were represented by physical certificates. Once upon a time, a person could buy a share or bond issued by a company and receive a handsomely printed certificate on heavy bond paper as evidence of ownership. The owner could take the certificate home if they wished.
On the other hand, if an investor held the certificate at home, it could be lost, stolen or destroyed in a fire. In addition, it required the investor to journey into town whenever they wanted to sell a share or collect a dividend or interest payment. Therefore, banks and broker-dealers offered to hold their customers' securities in custody, usually in a vault on the premises. The practice is still used today (such as when a smaller company issues shares and an owner deposits them for safekeeping) and is similar to the practice of holding other important documents such as deeds, or passports or valuable items, in a safe deposit box.
Certain banks and trust companies concentrated on this type of service. These firms, especially those in the financial markets of New York City, came to hold large numbers of certificates issued by many companies. For this type of custodian, transferring a share or bond could be effected by moving a certificate from one customer's deposit box to another's, and moving an amount of cash the other way. Over time, the transfer came to be effected by simply making an entry on the custodian's books and records.
Prior to 1973, these types of depository, custodial, payment and settlement services were handled by many different financial firms that had to physically transfer large amounts of cash and securities around town in armored cars. These arrangements were not suited to modern, high-volume financial markets. Therefore, for the most actively traded instruments, financial markets evolved the institution of the central repository. The Depository Trust Company ("DTC") is an example. DTC holds book-entry securities and physical securities certificates in its vaults on behalf of financial institutions who, in turn, are acting on behalf of their customers.
As a result of the invention of the central repository, a custodial institution no longer holds physical securities on its premises (except, as we have noted, in the case of certain smaller companies). Rather, a custodian maintains book-entry, electronic records that (a) interface with the central repository and (b) internally reflect the identity and amounts of the securities that a customer owns. In addition, custodians continue to provide numerous other services that are associated with this core function. These include settlement of trades, collection and payment of dividends and interest, valuation of securities positions, generation of statements, handling corporate actions such as stock splits or proxy voting, and more.10
Due to their important role in the securities markets, custodians are highly regulated entities. As banks and securities broker-dealers, they are subject to regulations that require, inter alia, segregation of customer assets, compliance with capital standards, background checks for personnel, and regular and special examinations by regulators. Oversight of custodians promotes customer protection, and by extension, confidence in the securities markets and the formation of capital.
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Footnotes
1. See e.g., SEC Rel. No. 81207, Report of Investigation Pursuant to Section 21(a) of the Securities Exchange Act of 1934: The DAO (July 25, 2017).
2. In a review of 1,450 ICOs, the Wall Street found "rampant plagiarism, identity theft and promises of improbable returns." Hundreds of Bitcoin Wannabes Show Hallmarks of Fraud; Wall Street Journal (May 17, 2018).
3. Of course, custody is but one of numerous matters that a securities firm would have to address before venturing into the world of block- chain securities. A broad survey of such matters can be found in the Report on Distributed Ledger Technology: Implications of Blockchain for the Securities Industry issued by the Financial Industry Regulatory Authority ("FINRA") in March, 2017.
4. 17 CFR § 240.15c3-3(b). "Fully paid" securities are those that the customer has paid for in full. 17 CFR § 240.15c3-3(a)(3). "Excess margin securities" are securities that are carried as margin collateral to the extent they exceed 140% of the amount of the debit balances in a customer's account. 17 CFR § 240.15c3-3(a)(5).
5. 17 CFR§ 240.15c3-3(c); see e.g., Letter from M. Macchiaroli, Associate Director, SEC Division of Trading and Markets to Peter Morgan III, Senior Vice President and General Counsel, Charles Schwab and Co., Inc. (Feb. 3, 2012) (granting no-action relief based on use of National Securities Clearing Corporation's Alternative Investment Products Service to establish satisfactory control locations under the Customer Protection Rule for uncertificated securities).
6. 15 U.S.C.A. § 80a-17(f); 17 CFR § 270.17f-1 through 17 CFR § 270.17f-7. The ICA's custody requirement applies to a registered investment fund's securities and "similar investments." Thus, its standards would also apply to a mutual fund's digital assets that are not securities, such as Bitcoin. See SEC Staff Letter to the Investment Company Institute and Securities Industry and Financial Markets Association: Engaging on Fund Innovation and Cryptocurrency-Related Holdings (Jan. 18, 2018) (describing custody requirements for the "holdings" of a registered investment fund), available at https://www.sec.gov/divisions/investment/noaction/2018/cryptocurrency-011818.htm.
7. 17 CFR § 270.17f-2(b).
8. 17 CFR § 275.206(4)-2.
9. 17 CFR § 275.206(4)-2(d)(6).
10 The Clearing House, The Custody Services of Banks (Jul. 2016) (available at https://www.theclearinghouse.org/-/media/tch/documents/research/articles/2016/07/20160728_tch_white_paper_the_custody_services_of_banks.pdf).
Originally published by FinTech Law Report, Thomson Reuters.
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