How to Protect Innovation and Consumers in Digital Asset Securities

Part of ensuring that the digital asset space grows in a way that both fosters innovation and takes seriously consumer protection is having the right regulatory framework in place. Toward the end of supporting both innovation and consumer protections, the SEC published a request for comment regarding the custody of digital asset securities by broker-dealers, and the custody of digital asset securities more generally. Anchorage Digital provided in-depth comment on a number of pertinent issues in this letter, the main points which are summarized below.

Perhaps the most important context for secure custody of digital asset securities is, as the SEC rightly points out, the fact that “the technical requirements for transacting and custodying digital asset securities are different from those involving traditional securities.” From this fact follows a number of best practices — elements we believe to be essential for operating a digital asset securities market in the best interest of consumer protection. For would-be broker-dealers and other providers of custody services, these include:

Proof of Existence and Exclusive Control

Securities Exchange Act of 1934 §15c3–3(d) (“the Customer Protection Rule”) requires broker dealers and other custody providers “to maintain physical possession of or control over customers’ fully paid and excess margin securities.” While the mechanism in digital assets differs from that used in traditional securities, we believe that proof of exclusive control and proof of existence are the ideal proxies for “physical possession” of digital assets. At the expiration of the safe harbor period the SEC has set, we believe digital asset custody providers should be held to this requirement.

We put forth the best way to achieve these two goals is through the use of hardware security modules — which are easily auditable, and can act as the sole point of origin and storage for private key materials in a way that traditional cold storage does not.

Technical Analysis

Each and every digital asset and underlying protocol requires a certain level of expertise to handle, custody, and service adequately. This means that the complexity of servicing digital assets scales with the number and type of assets supported. We firmly believe that broker-dealers or any other custody providers must be able to proactively monitor the blockchains for any asset they wish to support, both initially and at regular intervals. This is essential to 1) identify and report code defects or other vulnerabilities, 2) establish whether or not an asset and its underlying blockchain were developed in accordance with secure software development practices, and 3) to establish an overall assessment of an asset and its underlying blockchain’s unique features and capabilities.

Blockchain governance analysis

Given the fact that no two blockchains are alike, and that the mechanisms by which governance is implemented varies from chain to chain, it is imperative for broker-dealers and other providers of custody services to assess these models on a per asset basis. For the purposes of simplification, we see blockchain as falling into three main categories: Permissioned networks (“closed” blockchains where a core group forms consensus essentially with themselves), unpermissioned networks (“open” networks where groups of individuals may concentrate influence over the network), and token-based networks (networks reliant on smart contracts). Each of these categories requires its own set of risk assessments that we believe, to provide custody services, broker-dealers and other custody providers should be able to adequately perform.

Other considerations‍

Beyond technical capabilities and analyses, broker-dealers and custody providers in the digital asset space, including digital asset securities, must be able to comply with existing BSA/AML regulations, conduct sanctions screenings, monitor for market manipulation on a given network or exchange with a given asset to ensure market integrity, and ensure network compliance with all applicable, laws, regulations, and regulatory guidance. What’s more, in the best interest of consumer protection, broker-dealers and other custody providers should provide a series of written disclosures relating to the risks associated with participating in digital asset securities, and with using technology reliant on private keys more generally.Finally, we would like to applaud the Commission for making the space for innovation in digital asset securities while keeping consumer protections front of mind. We believe that it is right in its initiative to allow a limited number of special purpose broker-dealers to show proof of concept, and to ensure the right controls and regulations are in place as the space continues to grow. We are of the belief that drastic misalignment between regulators and industry can stifle innovation, and, given the Commission’s present approach, we are optimistic about the future of the space.If you’d like to read the letter in full, you can find it here.