No United States of Digital Assets
It is at this point a bit difficult to speak with complete authority about digital assets. This is because there remains a large degree of uncertainty regarding adequate custody of the asset class. The uncertainties include which digital assets may be deemed to be regulated products, whether or not custody rules will be imposed upon investment advisors, and certain institutional investors in the context of digital assets. How these considerations ultimately conclude is dependent upon the answers to two fundamental questions:
- What is the economic and legal substance of the digital asset?
- How do you own or control it? Or is it even possible to own or control it?
The US Securities and Exchange Commission (SEC), and other regulators, are still in the process of understanding the nature of digital assets and their appropriate characterization under applicable prevailing securities laws. The SEC is actively grappling with these questions and is inviting input from the industry to better understand the digital marketplace.
What is a digital asset?
The SEC defines the term “digital asset” as “an asset that is issued and transferred using distributed ledger or blockchain technology, including, but not limited to, so-called ‘virtual currencies,’ ‘coins,’ and ‘tokens.’” In some cases, a digital asset is considered an “investment contract” and subject to federal securities laws.
A digital asset becomes an “investment contract” when the arrangement that it represents:
- Is an investment of money or other value
- Is in a common enterprise
- Has a reasonable expectation of profits
- Is derived from the efforts of others
On April 3, the SEC published a comprehensive statement of the policy of characterizing digital assets as investment contracts.
This means, the SEC is most likely to apply existing law and regulation, rather than a new body of law, to govern digital assets. Effectively, the SEC has taken the position that if it walks like a duck and quacks like a duck, it’s a duck — even if it’s a digital duck.
In applying the “quacks like a duck” approach, the SEC have found:
- A “digital assets supermarket” that processed initial coin offerings, provided a secondary market, took value or volume-based compensation, and bought as principal for resale was engaged in brokerage is subject to registration as a broker dealer.
- BitCoins and other cryptocurrencies are not merely a medium of exchange but are an investment contract because of its exposure to secondary market price variation.
- Initial coin offerings (ICOs) that have the economic substance of investment contracts will be subject to the normal rules for registration and exemption from registration of securities offerings.
- Registered investment advisors (RIAs) are subject to the same duties regarding investment in digital assets as they are with respect to any other investment asset. This means that an RIA will be responsible for “portfolio management of digital assets, trading, safety of client funds and assets, pricing of client portfolios, compliance, and internal controls.”
Thus far, the SEC has focused on the economic and commercial substance of the asset and has been agnostic as to form and administration of the asset. That’s because they do not want to dictate technological specifications or limit the development and implementation of new technologies to digital assets. The bad news about this approach is that while the economic substance of an arrangement (rather than the details of its form and administration) will determine whether a digital asset is a regulated security, the practical and legal form and digital administration of the asset will largely determine the practicalities and legalities of custody of these assets. The SEC, and other regulators, has not yet explicitly addresses rules to govern the intermediation of digital assets. There is also neither commercial law nor judicial precedent that shed any light on intermediation of these assets.
Custody of Digital Assets
Traditional notions of custody can be applied to physical certificates, entries that are maintained on the books of the issuer or their transfer agent, entitlements through intermediaries, like brokers and custodians, or central securities depositories or other types of securities exchanges. As indicated by questions the SEC outlined in a March letter about the custodial practices of digital assets, the subject of custody of digital assets presents several challenges at this time given:
- The developing nature of digital assets.
- The absence of an “issuer” in the traditional sense.
- The difficulty in determining applicable law under traditional approaches that rely on the place where the property or the financial intermediary is located.
- The substantive and technical structure of the asset as the structure relates to control or ownership.
- The difficulty of characterizing a digital asset within the framework of traditional custody concepts such as nominal ownership, bailment and control.
- The substantive nature of and the obligations contained in any contract attached to the digital asset.
- The inclusion of digital assets custody in external audit examination.
While rights to non-digital assets are generally established by possession of a certificate or credit to an entitlement account at an issuer registrar, transfer agent, intermediary, or an exchange or depository, the establishment of rights in a digital asset is achieved by cryptographic means. The SEC describes this situation as follows:
Advancements in blockchain and distributed ledger technology have introduced innovative methods for facilitating electronic trading in digital asset securities. Platforms colloquially referred to as “decentralized” trading platforms, for example, combine traditional technology (such as web-based systems that accept and display orders and servers that store orders) with new technology (such as smart contracts run on a blockchain that contain coded protocols to execute the terms of the contract). These technologies provide the means for investors and market participants to find counterparties, discover prices, and trade a variety of digital asset securities.
In any case, the intervention of an intermediary/custodian will likely involve:
- Control of the applicable cryptographic codes in a lock box arrangement.
- Receipt and transmission of instructions which will have to be formatted and encoded in variable formats for input into the relevant blockchain.
- The development of some kind of “two-key” system to afford control without more onerous involvement in the digital asset.
Administration of digital assets
The administration of digital assets will entail money movements required to settle purchases and sales and to process income and expenses attributable to the investment.
These money movements will likely become a component of custody and asset administration business. We can expect that these movements would be treated along the lines of transactions involving futures commission merchants (FCMs) and brokers in connection with derivatives and traditional asset classes.
Intermediation of digital assets will also likely require a high IT commitment to understand and operate the cryptographic means by which an investor or intermediary can control digital assets.
However, there are several administrative issues when using blockchain or distributed ledger technology (DLT). These include the:
- Impact of any anonymization on AML/KYC.
- Adherence to contract provisions imbedded in the digital asset.
- Identification of digital assets via ISIN or similar security identifier.
- Need for any special conditions in the arrangements between asset owners and asset services clarifying responsibility for performance of imbedded contracts, for inherent flaws in digital asset cryptography, etc.
- Integration and characterization of books and records maintained by intermediaries in connection with digital assets.
For asset managers, there are also concerns that:
- The determination of whether the digital asset is a “liquid asset” as defined under applicable securities laws and regulations such as the SEC Liquidity Rule.
- The determination as to whether the asset is included in any applicable investment mandate.
- Appropriate disclosures in the prospectus of any collective investment vehicle investing in digital assets.
Given the swiftly developing digital asset industry and the inchoate nature of the current regulatory scheme, the danger of fraud is high for both asset managers and intermediary service providers like custodians and brokers. The SEC Office of Investigation and Examination (OCIE) recognizes this in their 2019 Priorities statement:
Given the significant growth and risks presented in this market, OCIE will continue to monitor the offer and sale, trading, and management of digital assets, and where the products are securities, examine for regulatory compliance. In particular, through high level inquiries, OCIE will take steps to identify market participants offering, selling, trading, and managing these products or considering or actively seeking to offer these products and then assess the extent of their activities.
IOSCO has also embarked on a project to deter fraud in the digital asset space and is expected to issue a white paper on the subject later this year. Risk of fraud in custody of digital assets could be mitigated by assuring that any digital asset arrangement was properly registered or regulated according to its nature under applicable securities laws and a procedure for assuring this would be advisable.
You’ll want your experience with digital assets to be just “ducky.”
This article was contributed by BBH Senior Vice President in the Office of General Counsel Thomas Andrew.