By Rob Daly

Digital Custody Becomes Even More Complicated

Crypto exchanges that plan to attain the status of alternative trading systems via becoming, partnering with, or purchasing broker-dealers could have to forgo their digital custody business due to the Securities Investor Protection Act.

Securities Investor Protection Corp.’s definition of what it considers a security is much narrower than how the Securities Act of 1933 and the Securities Exchange Act of 1934 define securities, noted Elizabeth Blaird, deputy director, Division of Trading and Markets at the Securities and Exchange Commission, during a panel discussion during the SEC Fintech Forum.

“For example, if a broker-dealer were to custody bitcoin or ethereum, which is not something we look favorably on, there would be no protection for the investor if indeed the broker-dealer were to go under or if there was some theft or hacking,” she said.

Under its rules, SiPC does not consider digital currency as cash, nor does it cover securities that are not registered with the SEC.

“There are not a lot of digital securities registered with the SEC,” said Baird. “There are Airfox and Paragon as well as others that are talking about registering.”

The SiPC would not cover the loss of digital securities via a dissolutionment or theft that had received exemptions from SEC registration, she added.

However, it might be time to re-think the definition of custody with the continued rise of digital assets, suggested fellow panelist David Forman, chief legal officer at Fidelity Brokerage Services.

Custody has gone beyond holding physical assets like a stock certificate, cash, or coins, he added. “The focus, going forward, should be less about what the asset itself is and more about protecting the bit of information with which you have been trusted.”

Custodians could define their obligations and entitlement regarding digital assets via contracts and protect the assets through the use of multiple-signature wallets.

When using multi-signature wallets, a transaction would require the use of multiple private keys to enable transactions. In a scenario where there are three private keys, at least two would be needed to buy or sell a digital asset.

“No one key has effective control,” said C. “Take that multi-sig wallet, which could have any number of signatures. You could have as many keys as you like and distribute them however you like.”

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