Summary of the SEC No-Action Letter Regarding ATS Role in the Settlement of Digital Asset Security Trades

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The SEC recently issued a no-action letter regarding the role of ATS in settling digital asset security trades. Understanding the implications of this letter is essential for FinTech startups and financial service providers who trade in digital asset securities — so, we are here to break it down for you.

First, we will review what a no-action letter means, specifically in the scope of ATS and digital assets — then we will analyze the contents of the SEC’s statement.

What is a No-Action Letter?

Before we get into the details of the recent letter, let’s discuss what a no-action letter is.

If a person or a business is not sure if one of their products or services — or a specific action — would be in a violation of federal securities laws, they can have their legal team request a no-action letter from the SEC.

If the SEC staff grants the request for no action, the letter will include the following:

• A description of the company or individual’s request
• A list of the relevant facts and circumstances as well as applicable laws and regulations
• A statement that the SEC staff would not recommend enforcement action against the requestor

Sometimes, the SEC staff will also respond with an interpretive letter to clarify certain rules and regulations. This ensures that businesses in the finance industry understand the implications of their actions, products, and services concerning SEC compliance.

However, it is important to note that the SEC reserves the right to change their mind on a decision previously issued, and the letter only applies to the specific circumstances and facts described in the original request. The parties other than the requestor may be permitted by the SEC to rely on the no-action relief, but only where their facts and circumstances are substantially similar to those outlined in the letter.

Understanding ATS and Digital Assets

Next, let’s define ATS and try to define digital assets in the scope of the SEC no-action letter.

ATS stands for an alternative trading system. In simple terms, it is a trading venue that enables matching of buy and sell orders of its participants, but it is not registered as an exchange. This exemption from registration is available, so long as it complies with certain conditions under Rule 3a1–1(a)(2) of the Securities Exchange Act of 1934. However, ATS is normally regulated as broker-dealer.

In the context of this letter, the SEC specifically refers to digital asset securities, so they make an assumption that the assets in question are securities. Thus, as most of us already know, these are the assets that are issued or transferred through blockchain technology or distributed ledgers, and they do satisfy the definition of an investment contract.

Summary of the SEC No-Action Letter

The SEC issued a no-action to FINRA — the Financial Industry Regulatory Authority — on September 25th regarding digital asset securities. Based on the no-action letter, the SEC staff does not recommend enforcement action if a registered broker-dealer operates an ATS to trade or issue digital asset securities.

While this is subject to certain conditions, of course, it represents a huge development for FinTech and the viability of digital asset securities trading. The Customer Protection Rule has been a hurdle for broker-dealers to develop trading platforms for digital asset securities because it requires them to maintain physical possession — or control — of all securities in customer accounts.

Since digital assets are recorded in a blockchain system, FINRA had issued a joint statement with the SEC that said they could not adequately control them in this manner. This statement led to a lack of clarity on whether broker-dealers could trade digital assets while remaining in compliance with the Customer Protection Rule.

This no-action letter clarifies this and outlines a potential model that would allow broker-dealers to operate an ATS that does not maintain custody of the digital assets, but rather focuses on matching buyers and sellers.

The Proposed Three-Step Process

Broker-dealers wishing to operate an ATS have requested the no-action letter regarding the proposed three-step process. This process would allow the settlement of digital asset security trades to be passed to a custodian when executed to reduce settlement delays and risks.

1. The buyer and seller send their orders to the ATS and notify their custodians of the orders submitted. They will also instruct their respective custodians to settle the transactions when the ATS notifies the custodians of a match.
2. The ATS will then match the orders submitted.
3. The ATS notifies the buyer, seller, and their respective custodians of the matched trades so that the custodian can carry out the instructions.

In this process the broker-dealer does not maintain custody or possession of the digital asset securities, but rather indirectly causes their movement by reporting that a trade has occurred. The custodians are the ones settling the trade on the behalf of the buyer and seller, so the broker-dealer does not guarantee or have responsibility for settlement.

SEC Response

Based on the facts and circumstances described in the three-step process, the SEC staff will not recommend enforcement action under the federal securities laws.

They went on to add the following additional requirements for a broker-dealer operating an ATS that intends to trade digital asset securities under the three-step process:

• The broker-dealer operator must maintain a minimum of $250,000 in net capital.
• The customer agreements must clearly state that the broker-dealer does not guarantee or have responsibility for settling the trades.
• The broker-dealer must establish and maintain reasonable procedures to determine whether the digital asset security was initially offered and sold with an effective registration or a valid exemption and whether any secondary transactions met the same requirements.
• The transactions concerning the digital asset securities comply with federal securities laws.

The no-action letter noted that this only addresses an ATS trading digital asset securities under these specific circumstances and that it does not otherwise reflect on broker-dealer control and custody of digital asset securities as laid out in Rule 15c3–3.

It was also clear to point out that they are not expressing views about other questions that this kind of activity would raise and is also subject to revocation or modification at any time.

We at LATTUDE will be happy to answer any questions. A copy of the full letter can be found here.