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Encore | Membership Application Program: Reviewing and Approving Digital Asset Firms

March 21, 2023

This podcast originally aired in November 2022.

The market for crypto assets has seen continued growth and firms are looking for ways to get involved in the digital asset space. So far, about two dozen firms have been approved by FINRA to provide services in securities backed by digital assets. And more firms are looking to follow in their footsteps.

On this episode, we hear from Armando Valdes, an application manager with FINRA’s Membership Application Program (MAP), and David Aman, a senior advisor with the Office of Financial and Operational Risk Policy within the Chief Legal Office, about the role FINRA’s MAP team is playing in the digital asset space, some common sticking points in these new and continuing member applications and how FINRA is working to support innovation while protecting investors in this dynamic environment.

Resources mentioned on this episode:

SEC’s September 25, 2020 No-Action Letter, “ATS Role in the Settlement of Digital Asset Security Trades”

SEC/FINRA July 8, 2019 Joint Statement on Broker-Dealer Custody of Digital Asset Securities

SEC Statement on the Custody of Digital Asset Securities by Special Purpose Broker-Dealers

Have questions? Email: [email protected]

Listen and subscribe to our podcast on Apple PodcastsGoogle PodcastsSpotify or wherever you listen to your podcasts. Below is a transcript of the episode. Transcripts are generated using a combination of speech recognition software and human editors and may contain errors. Please check the corresponding audio before quoting in print. 


00:00 - 00:43

Kaitlyn Kiernan: We are dipping into the archives for a look back at an episode that originally aired in November 2022. We will be back with new episodes in two weeks. The market for crypto assets has seen continued growth and firms are looking for ways to get involved. So far, about two dozen firms have been approved by FINRA to provide services and securities backed by digital assets, and more firms are looking to follow in their footsteps. On this episode, we hear about the role FINRA's Membership Application Program team is playing in the digital asset space, some common sticking points in these new and continuing member applications and how FINRA is working to support innovation while protecting investors in this dynamic environment.


Intro Music

00:53 - 01:22

Kaitlyn Kiernan: Welcome to FINRA Unscripted. I'm your host, Kaitlyn Kiernan. I'm excited to welcome two new guests to the show today to talk about a hot topic, the regulation of crypto or digital assets. Joining me today are Armando Valdes, an Application Manager with FINRA's Membership Application Program, or MAP team, within Member Supervision. And we have David Aman, a Senior Adviser with the Office of Financial and Operational Risk Policy within the Chief Legal Office. Armando and David, welcome to the show.

01:23 - 01:24

David Aman: Hello, Kaitlyn.

01:24 - 01:33

Kaitlyn Kiernan: To kick us off, can you both start by introducing yourselves and telling us about your background and more specifically, what you do at FINRA? Armando, can we start with you?

01:34 - 02:00

Armando Valdes: I joined FINRA and MAP in 2015 as an Associate Principal Examiner. I am currently an Application Manager in MAP retail group. During this time, I have worked on numerous applications filed by prospective and existing members related to complex and novel business models, including those involving fintech firms and digital assets and related products. Prior to joining FINRA, I was in private practice as a securities attorney.

02:00 - 02:03

Kaitlyn Kiernan: Thanks, Armando. And David, how about you?

02:04 - 02:44

David Aman: I'm also an attorney. I spent most of my career at Cleary, Gottlieb, Steen and Hamilton. I joined FINRA in 2017, but in private practice and also with FINRA, I focus on broker dealer regulation in general and in particular the financial responsibility rules and requirements applicable to broker dealers. The group that I'm in, the Office of Financial and Operational Risk Policy, serves to develop and interpret FINRA and SEC standards for financial responsibility and as a resource and advisor to other groups within FINRA, including the Membership Application program.

02:44 - 02:57

Kaitlyn Kiernan: Now, Armando, at a high level, can you tell us more about the role MAP plays? Why would a firm come through MAP if they wanted to get involved in the crypto or digital asset space?

02:57 - 03:37

Armando Valdes: Any prospective member that wants to become a registered broker dealer must submit a new member application, or NMA, to MAP. Similarly, existing members filing continuing membership applications or CMAs when they are looking to make a material change as part of the application process, they are required to provide detailed information about their financial operational supervisory and compliance system. MAP works to ensure that each prospective member can meet the standard of admission that can be found in FINRA Rule 1014 for the standard and that existing members can continue to meet the standards once the material change has been effective. For every prospective or existing member that is looking to engage in the digital asset will have a touchpoint with MAP.

03:37 - 03:56

Kaitlyn Kiernan: So, I believe there are two dozen approved firms and another two dozen firms in the pipeline that are involved or looking to get involved in this space. Are these primarily new firms filing NMAs or existing firms filing for new business lines, so a CMA?

03:57 - 04:12

Armando Valdes: Approved applications are actually evenly split between NMAs and CMAs for new members and also our existing members. And then there are approximately two dozen applications in the pipeline. There are slightly more new members than existing members.

04:13 - 04:23

Kaitlyn Kiernan: Like I said, we have two dozen or so approved firms in this space. Can you give us an overview of how they are approaching this business line? What kind of role are they playing?

04:24 - 05:51

Armando Valdes: Members that have been approved to engage in digital asset securities fall into non- or limited-custodial buckets. The first non-custodial bucket is acting as placement agent in private placement digital asset securities offerings in alignment with the July 8th, 2019 SEC and FINRA Joint Statement. The second bucket, which has two sub buckets, is operating an alternative trading system or ATS, which facilitates secondary transaction of digital asset securities in alignment with either the four-step process also outlined in the July 8th, 2019 SEC and FINRA Joint Statement, or the non-custodial bucket, or the three-step process outlined in the SEC's September 25th 2020 No-Action Letter, the limited custodial bucket. We can speak further to what that means in a minute. In addition, there is a recent guidance from the SEC for a third custodial bucket, which relates to the custody of digital asset securities by a special purpose broker dealer or SPBD. The business activities of a special purpose broker dealer are limited to only those involving digital assets that are also securities. So this would not include traditional non-digital assets securities or non-security digital assets. At this time, no member firm has been approved to act as a special purpose broker-dealer custodying digital asset securities.

05:52 - 06:25

Kaitlyn Kiernan: You mentioned a lot of guidance that is out there. So, we will link to all of those in our show notes for easy access. And I do want to dig in more to each of those three groups to hear about some of the challenges you are encountering as you work through the new or Continuing Membership Applications. But before that, I want to take a step back and think big picture. What are some of the common issues or sticking points that apply to these applications broadly, regardless of the type of applicant?

06:25 - 07:03

Armando Valdes: I think the most common issue or sticking point for these types of applications is lack of detail and consistency in describing the proposed business activities involving digital assets, cryptocurrencies, distributed ledger or related products. Firms need to explain in detail how they determine that the transaction flows and business model involving digital asset securities comply with the business model described in the available guidance, and even then the available guidance is very prescriptive in that firms wishing to engage in this space need to ensure that functions can be performed by the broker dealer are done as described in the Joint Statement SEC No Action Letter or the SEC release related to SPBDs.

07:03 - 07:10

Kaitlyn Kiernan: So, they need to provide more detail throughout the application. Sounds like that's the issue?

07:10 - 07:20

Armando Valdes: Yeah, and I think it also ties to, and I guess somebody phrased it really well, you know, show the work. Show how you reached the conclusion that your business model fits within the guidance provided.

07:20 - 09:14

David Aman: And this isn't just a digital assets matter. Every applicant needs to be able to show that it's capable of complying with FINRA rules and the U.S. federal securities laws and regulations. And so, every application will need a detailed description of the business and an understanding of the firm and consistent documentation with that business plan and understanding that sets out how they are going to be able to comply with the applicable rules and regulations. It's just the digital assets base is somewhat new. And so, the firms, their attorneys and consultants, won't necessarily have a template that they can use, a sort of known way for compliance. Added on top of that, a number of the applicants are firms that have experience maybe in the technology space and not necessarily in the broker dealer or compliance space. And so, they come in with a description which is at a level of detail appropriate for building technology or maybe even using that technology, but not necessarily focused on the legal and compliance niceties. So Armando and the MAP team often spends a great deal of time after receiving the application, trying to get clarity from the applicants about exactly what their plans are, what the relationships between the different parts of the business, what the transaction flows will look like as a legal and process matter from the compliance standpoint, even if they're obvious to how it's going to flow from a technology standpoint, that doesn't necessarily answer what the legal significance of each of the technological steps are and then much less have documentation to back that up.

09:16 - 09:33

Kaitlyn Kiernan: Okay, so now let's dig in and let's start with private placement firms, since that's the first area, I think that we saw a digital asset firm approved. What are the most important things for firms to know if they're applying as a private placement firm?

09:33 - 10:08

Armando Valdes: I think it's important for them to be familiar with the joint statement, which is an example of this type of business model, and also identify areas of risk related to digital assets and distributed ledger or blockchain. And also, I think it's so important that they understand the limited nature in which the broker dealer can be involved in this activity. Basically, everything has to happen away from the broker dealer, but issuers and investors that'll transaction directly with each other or through the use of an escrow account established by the issuer. In each instance, this is all happening away from the broker-dealer so the broker-dealer is not custodying digital asset.

10:08 - 10:55

David Aman: But the broker dealer is, of course, involved in placing the digital assets. And so, we do look for these firms to make sure that they understand what they're talking about when they're talking about a digital asset security, what the risks are, how they plan to disclose risks, how they plan to review the offering documents. And then they will also need to be aware of their responsibilities under our advertising rules, particularly in their first year. But the private placement business, because it's a non-custodial business where the firm doesn't handle the customer's funds or securities, doesn't control them, doesn't receive them, there's not a lot of financial responsibility concerns. So, it's not so much in my specialty.

10:57 - 11:02

Kaitlyn Kiernan: And what are some of the common issues or sticking points coming up with private placement firm applications?

11:02 - 11:19

Armando Valdes: You know, I think, again, detail specificity related to the roles and functions of the broker-dealer in these transactions. Having procedures that are specific to digital asset securities and the distributed ledger. And the experience of principals specific to private placement and digital asset securities and blockchain.

11:19 - 11:27

Kaitlyn Kiernan: Now let's move on to alternative trading systems. What's the most important thing for applicants to know here?

11:28 - 14:34

David Aman: Here we do tend to focus on the financial responsibility steps. As Armando said, there's two non-custodial models that the SEC has laid out for these ATSs. And so, if the ATS proposes to fit into one of these non-custodial models then the most important thing is getting clarity about the operation of the ATS and confirming that they fit into one of those models. The first of the models, the so-called four-step process, was set out in the joint statement that Armando mentioned earlier. In that process, the buyer and seller submit orders to the ATS. The ATS matches those orders and notifies the buyer and seller of the match of the transaction, and then the buyer and seller settle that transaction away from and without the involvement of the ATS because the buyer and seller exclusively control their funds and securities. This is said to raise no custodial issues, which simplifies the financial responsibility analysis. And so, the biggest focus here is making sure that the operation of the firm and the ATS is clearly laid out and is clearly consistent with that model. The second model, the so-called three-step process from the No-Action Letter, has a little bit more involvement of the broker-dealer. That model, again, the buyer and seller begin by submitting orders to the ATS, but at the same time they also give their custodians conditional instructions to settle the transaction consistent with those orders if they're notified by the ATS of a match. And so then of course the ATS will match the buyer and seller’s orders, notify the buyer and seller and the custodian of the match, and then the custodian follows those conditional instructions. Essentially, the customers begin in the first step by giving conditional instructions to their custodians. Those instructions are completed by the match information that the ATS provides, and the custodians settle based on the customer's conditional or incomplete instructions and the information that the ATS provides to complete those. And so because the broker-dealer does, you know, influence the disposition of the customer funds and securities by telling the buyer's custodian who the funds are to be paid to and telling the seller’s custodian who the securities are to be delivered to, this is considered to be a higher degree of control, and so the No-Action Letter has a number of conditions, including a higher minimum net capital applicable to the broker-dealer in the three-step model.

14:36 - 14:44

Kaitlyn Kiernan: So, are there any common issues or sticking points with either of these two ATS applicant models?

14:44 - 15:20

Armando Valdes: I would add that it ties back to some of the ones we raised with the private placements. The firms need to explain in detail how they determined the transaction flows and business model involving digital asset securities and the ATS comply with the business models described in the available guidance, either the three-step or the four-step. Again, there are various conditions that need to be met in order for the firms to qualify as a three- or four-step and they need to do things in a very specific way. So being able to take your business model and your transaction flows and explain how they actually fall either into the three- or four-step I think is one of the areas that we spend most of the time trying to seek clarification on.

15:21 - 16:22

David Aman: I think that the two things are detail and consistency. So, they need a detailed business plan that lays out what they're planning to do, a transaction flow and settlement process that's consistent with the business plan and with the non-custodial process or the somewhat custodial process that they're planning to follow and their other documents, their user disclosure, their draft Form ATS, their contracts or disclosures with custodians and other third parties all need to be consistent with that process. And often when we dig into these things, we'll encounter something that the firm hadn't contemplated, an agreement that's not consistent or an agreement that they simply haven't developed yet that they need to do. Then frequently, when we ask questions the firm's business plan will evolve and then they need to update all of their other documents to be consistent with that evolution.

16:23 - 16:41

Kaitlyn Kiernan: So, the third space is newer, and I think, Armando, you said no one has been approved yet as a special purpose broker-dealer. But what is the key to know for that newer avenue of involvement in digital assets?

16:42 - 17:31

Armando Valdes: It's the understanding that the business activities of a special purpose broker-dealer are limited to digital assets that are also securities. No securities that are not digital assets like traditional securities and also not non-security digital assets. But it's very important that the broker dealer understand that this can include operation of an ATS that trades only in digital assets securities or otherwise engage in other business involving digital assets securities. And again, the relief has nine conditions, which I think the firms need to be able to understand how their business model is impacted by the conditions and also be able to explain to staff how it is exactly that they are meeting each of the conditions where we can find information responsive to each of the conditions. And I think that the firms that have done this have found the process move along more quickly and for us to be able to communicate with each other more effectively.

17:32 - 17:51

Kaitlyn Kiernan: So, we've talked a lot so far about how firms have become involved with digital assets that would require broker-dealer registration. But firms are also looking at crypto through arrangements with entities that aren't broker-dealers. David, can you tell us more about that and what FINRA considers in those cases?

17:52 - 20:06

David Aman: Because of perhaps primarily the uncertain net capital treatment of non-securities digital assets like cryptocurrencies, things like Bitcoin, and also the uncertain treatment if a broker-dealer were to have custody of those, these assets have generally been the focus of activity outside of broker-dealers. But broker dealers nevertheless have customers who are interested in investing in these assets. And so, a number of broker dealers have entered arrangements with non-broker-dealer entities where their customers are able to invest in the cryptocurrencies or non-securities digital assets. Sometimes the customers will originally be customers of the cryptocurrency firm who wants to create an affiliate who can allow them to also invest in securities. But when we look at applications that involve these or even a firm that is proposing to enter into such an arrangement, and it's not in the course of the Membership Application Process, our primary concern is to make sure that to the extent that the firm is saying that the broker-dealer, the FINRA member, is not responsible for the cryptocurrency activity, that that is completely clear to the customers. So we look at the disclosures that are given and the reports of portfolio holdings, for instance, that are made to make sure that it's clear at every step along the way that the broker-dealer is responsible for the securities to the extent that they are in custody, but that the cryptocurrency and other assets are not in custody at the broker-dealer, but rather are the responsibility of the third-party firm, whether that third party is an affiliate or not. And so, our main focus is on the separation of these businesses as well as, of course, to the extent that the broker dealer is making any recommendation or things like that, that they are compliant with general rules regarding recommendations for investments and SEC rules for that matter on that subject.

20:07 - 20:22

Kaitlyn Kiernan: And so FINRA doesn't want any room for investors to mistakenly believe that their crypto assets have SIPC protection or that they're held by a firm that is subject to the rigorous oversight of FINRA or the SEC?

20:22 - 20:31

David Aman: Yeah, we believe that there's a risk that customers could be misled, and we want to make sure that they are not. Or do what we can to assure that they are not.

20:33 - 20:47

Kaitlyn Kiernan: So, before we start wrapping up, are there any other best practices you might want to share for anyone listening who might be looking to get involved with an NMA or CMA in the space anytime soon?

20:48 - 21:51

Armando Valdes: I'll piggyback on something that's been said a few times during the course of the podcast, and that's the business plan, right? And a business plan is not something that's required as part of an application, but we’ve found that they are very helpful in these types of applications and others as well. But specifically, in this type of application that's so complicated and complex and having one area where the business is described and can be updated over the course of the application is very helpful and facilitates our review. I'll circle back to some of the items we already talked about. Show your work, right, include detailed transaction flows and analysis explaining how the proposed business model comports with the available guidance, make sure the application and business plan, Form ATS and all of the supporting documentation are consistent. And there is one more thing, I guess, prospective and existing members that are interested in engaging in digital assets are welcome to avail themselves to what we refer to as early firm or pre-file meetings where they can come to us and ask questions prior to filing the application and incorporate those items raised during this meeting in their application. And these meetings can be requested by emailing MAP at [email protected].

21:52 - 21:58

Kaitlyn Kiernan: We will also include that email in our show notes for easy access. David, anything from your side?

21:59 - 22:22

David Aman: I think that Armando hit on it. Being clear at how the firm is going to be achieving compliance with the federal securities laws, SEC regulation and FINRA rules, and having a clear and consistent application and supporting documentation are the most important things to facilitate a review of an application.

22:23 - 22:29

Kaitlyn Kiernan: At the end of the day, what do you see as the role of MAP and FINRA in this process?

22:30 - 22:49

Armando Valdes: It's an exciting and evolving space. However, investor protection concerns exist, including incidences of fraud and other securities law violations involving digital assets in the platforms on which they trade. MAP's goal is to support innovation in the space while ensuring we continue to deliver on our mission of investor protection and market integrity.

22:50 - 23:38

Kaitlyn Kiernan: It is certainly an exciting and interesting new space with lots of questions. So, I'm sure we will have more podcasts on this topic and various angles on it in the months ahead, but that is it for today. Armando and David, thank you so much for joining me to share more about FINRA's Membership Application Program team and what it's doing in this space. Listeners, if you don't already, you can subscribe to FINRA Unscripted wherever you listen to podcasts, stay up to date on all our new episodes, and if you have any comments or questions on today's episode or ideas for future episodes, you can email us at [email protected]. Today's episode was produced by me Kaitlyn Kiernan, with assistance from Hannah Krobock and engineered by John Williams. Until next time.


Outro Music

23:44 - 24:11

Disclaimer: Please note FINRA podcasts are the sole property of FINRA and the information provided is for informational and educational purposes only. The content of the podcast does not constitute any similar amendment or interpretation of such rules. Compliance with any recommended conduct presented does not mean that a firm or person has complied with the full extent of their obligations under FINRA rules, the rules of any other SRO or securities laws. This podcast is provided as is. FINRA and its affiliates are not responsible for any human or mechanical errors or omissions. Parties may not reproduce these podcasts in any form without the express written consent of FINRA.

24:11 – 24:17

Music Fades Out


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