The U.S. SEC, with guidance from FINRA, has offered an update on the current situation of custodial solutions with broker-dealers in an official release. The update offers clarity on how custodial and non-custodial solutions are going to be treated and the various benefits and drawbacks that apply to each of these, July 8, 2019.
Current Scenario for Custodial Solutions
In their findings, the SEC has revealed that in their detailed interaction with market participants and industry beneficiaries that most custodial solutions in the U.S. do not comply with the Customer Protection Rule.
Entities that seek to do business in digital assets and offer any degree of custodial service must comply with the SEC’s guidelines for custodial broker-dealers as well as the Customer Protection Rule. In most cases, companies that are required to register will need to comply with the rules of a self-regulation organization (SRO); this SRO is usually FINRA.
The purpose of the rule is to protect the interests of the customers by first and foremost, separate custody of assets of clients and the broker themselves.
From their interactions and study on the topic, the SEC has concluded that most custodial services are incapable of doing so. Moreover, from an ownership perspective, access to private keys is merely one step and not nearly enough to prove possession of said assets.
Private keys can be copied by other parties, giving them access to the funds. Simply put, showing regulators their ability to keep private keys solely with them is going to be a necessity – despite the difficulty of doing so – from now onward.
An important update is that broker-dealers offering custody but not abiding by these rules will not be offered the $500,000 protection given to brokers under the Securities Investor Protection Act, 1970.
Verdict for Non-Custodial Solutions
Decentralized exchanges (DEX) have a lot less regulatory scrutiny to deal with. Non-custodial solutions are not required to comply with the Customer Protection Rule as they have no possession of client funds.
Entities like Coinbase and Bitstamp that hold client funds in custody will hence be required to abide by these rules, whether it is already being done is unknown but Coinbase is well regarded as having best in class compliance processes.
If the rules become increasingly difficult to comply with, the U.S. may lead the charge in moving from centralized exchanges to their decentralized counterparts despite certain DEX’s barring US customers. DEX’s have long been touted as the future of crypto trading but have struggled to pick up any traction.