The Securities and Exchange Commission’s decision to allow Wall Street firms to hold custody of digital assets for clients is a crucial step toward mainstreaming cryptocurrencies within the investment industry, according to law firms and financial technology advocates.

The agency in December launched a five-year trial to give broker-dealers, as stock brokerage firms are known, the ability to work with digital assets as if they were physical investments like cash.

The agency’s decision could lead to broader use of cryptocurrencies or other assets, such as digital tokens, according to many observers tracking the developments.

“The SEC’s commentary on allowing brokers to participate, really, in my mind, is a big step forward,” said Ron Quaranta, CEO of the Wall Street Blockchain Alliance, which promotes adoption of so-called blockchain technology in financial services. 

It is the first time the SEC has addressed brokers and digital assets in a broad way, Quaranta and others said. Previously, there have been only a few limited no-action letters for specific entities.

The agency announced in a brief statement that it won’t bring enforcement actions against brokers holding digital assets on behalf of customers for a five-year period in order to gather data and allow the industry to develop best practices and infrastructure to keep the assets secure. The SEC’s previous rules on so-called custody were written without considering digital assets, and the agency acknowledged that the market for digital asset securities is “rapidly evolving.”

A key question is which digital assets will qualify for securities regulation.

“What’s the bright line that defines whether or not a cryptoasset is a security or not a security?” Quaranta asked.

One object of heavy SEC enforcement in the past was initial coin offerings. They were popular during a burst in financial technology growth, including the first big run-up in cryptocurrency prices a few years ago. But they weren’t registered with the agency, which subsequently clamped down by filing charges against some ventures. It also issued guidance that most of these ICOs, as they are known, fell under the agency’s oversight.

Whether brokers will get permission to hold these and other assets, which could even allow investors to then use them to buy stocks, “is a bridge further out,” Quaranta said. “Some of the rules that apply to securities seem to not easily apply to digital assets, and the industry needs to collectively work with regulators and legislators to understand and develop the rules to meet these innovations.”

The SEC’s five-year time frame provides an opportunity to work on what he calls the “mechanics” of the latest technology. In addition to launching the pilot project, the agency is seeking feedback to answer these questions.

Yellen’s warning

Treasury Secretary Janet L. Yellen told the Senate Finance Committee during her confirmation hearing on Jan. 19 that cryptocurrencies are a particular concern because “many are used, at least in a transactions sense, mainly for illicit financing. … And I think we really need to examine ways in which we can curtail their use and make sure that … money laundering doesn’t occur through those channels.”

Nevertheless, Lilya Tessler, a partner with Sidley Austin LLP, said she expects brokers to allow customers to be able to buy and sell securities with payment in any form — whether with Bitcoin or other cryptocurrency, such as a stablecoin, which is a digital asset tied to a traditional monetary one like the dollar. 

“I believe that is on the horizon,” Tessler told CQ Roll Call. Brokers might have to work with third parties that can facilitate transactions in nonsecurity digital assets, she said.

Jorge Pesok, a lawyer in Crowell & Moring LLP’s blockchain and digital assets practice, noted the challenges: the volatile price of cyptocurrencies like Bitcoin, which makes them risky to accept as payment, and the difference in how digital currencies are stored compared with shares of stock or cash deposits for customers.

But Pesok said he expects the financial community to press ahead. “There is a huge incentive to being the first to market and getting it right. If you have a well-funded entity that wants to get into the industry … then I definitely see it happening,” he said.

Another challenge is the nature of the financial regulatory system. There is no single financial regulator in the U.S., so it can be difficult for many agencies to agree on a coordinated approach, Joseph Hall, a partner at Davis Polk & Wardwell LLP, told CQ Roll Call. The Commodity Futures Trading Commission, or CFTC, has jurisdiction over Bitcoin and other virtual currencies, but it doesn’t oversee stockbrokers.

Current policy on digital assets relies on existing regulations that did not take cryptocurrencies into account.

“We need to regulate it based on what it is, as opposed to trying to analogize it to other things that we are familiar with, and then trying to retrofit old regulatory structures to it,” Hall said. “In the absence of legislation, it is very difficult for the regulators to do that.” His advisory practice includes working with blockchain and cryptoasset companies.

The bounds of regulatory action are ultimately a question for Congress, so clear legislative guidance would be ideal, he said.

“You’re going to need a very tough-willed SEC chair who is willing to put his or her credibility on the line to tackle this, and it could very well end up consuming much of their tenure,” Hall said.

President Joe Biden has named former CFTC Chairman Gary Gensler, who ran that agency from 2009 to 2014, to run the SEC. The nomination is pending in the Senate.

Gensler has previously pointed out that broker-dealers offer more protection than do the specialized crypto exchanges. 

“It is critical to put in place federal requirements for the custody of crypto assets,” he told the House Agriculture Committee in 2018 while working in his current position as a professor at MIT’s Sloan School of Management. “Unlike traditional exchanges, crypto exchanges hold significant customer funds in digital wallets — a state of affairs that directly contradicts the principles of decentralized user-based control of digital assets upon which Bitcoin was initially built.”

When customers use traditional securities exchanges, the broker, and not the exchange, holds the assets, providing more safeguards, he said.

“When considering existing custodial rules, the specifics of blockchain technology, public keys and cryptography will need to be considered.”