When the price of a much-publicized asset increases 296% as Bitcoin did in 2020, it’s bound to attract attention from institutional investors, the general public, and the U.S. Securities and Exchange Commission (SEC).
After taking 10 years since its creation as a digital asset to reach $20,000 in value, it took Bitcoin only 17 days to reach $30,000 and eight more days to surpass $40,000.
Motivated by the fear of missing out on Bitcoin’s surging performance, investors have more than tripled the digital asset’s average daily trading volume in recent months. At the same time, hard-luck stories have emerged about Bitcoin investors who have lost everything – one man allegedly lost $220 million! – all because they forgot the password to their digital wallet.
Sensing the need to protect investors and provide long-awaited guidance on the custody of cryptocurrencies, the SEC announced on December 23, 2020, it would allow regulated, crypto-focused broker-dealers to operate for five years without fear of an enforcement action if they can verify they have both possession and control of a client’s digital asset securities, including Bitcoin.
See the SEC Press Release here.
See the SEC Statement and Request for Comment here.
The SEC also said it would “welcome engagement from interested parties” to help the Commission mitigate investor risk and its staff gain additional insight.
What it Means for Broker-Dealers
The focal point of the news on custody guidance is SEC Rule 15c3-3, known as the Customer Protection Rule. It requires that broker-dealer firms maintain secure accounts so clients can withdraw assets at any time. The SEC’s five-year grace period is intended, in part, for broker-dealers to develop practices, policies, and procedures regarding their ability to demonstrate possession or control over digital asset securities.
The custody guidance is considered good news for digital asset custodians, who can now become regulated broker-dealers. By securing federal registration as broker-dealers, firms could offer digital assets for trading.
What it Means for Investors
The prior lack of custody guidance from the SEC had left Bitcoin investors without a federally regulated option to protect their digital assets. Unlike stocks and bonds, Bitcoins were first created in 2009 to be accessed only by a password on a computer hard drive which unlocks private keys to a digital wallet.
Bitcoin’s skyrocketing price has sent many investors into a frenzy searching for passwords created years ago when the new digital asset was virtually worthless. In fact, the first known transaction using cryptocurrency to pay for a product happened in 2010, when a man used 10,000 Bitcoins – then valued at $0.003 each – to pay for a $30 Papa John’s pizza.
When Bitcoin surpassed $40,000 for the first time on January 7, that transaction would have involved $400 million. For one pizza! Worse yet, a number of long-time investors have lost their passwords and will never be able to access any of their Bitcoins.
A variety of industry experts estimate that access to approximately 20% of the 18.5 million Bitcoins in existence - worth a collective $150 billion on Jan. 7 - have been lost forever because of forgotten passwords, malfunctioning or lost computer hard drives, or a similar fate. One business that specializes in recovering lost digital keys said it has recently been averaging about 70 requests a day from horrified investors.
SEC regulation on custody of digital assets should only serve to ignite additional investor enthusiasm over Bitcoin.
What Broker-Dealers and Investors Should Do Next
Watch the news. The custody issue is the first of many cryptocurrency-related headlines the SEC should make in the coming months. Gary Gensler, who news reports say will be nominated to replace Jay Clayton as SEC chair, most recently was professor of blockchain technology at MIT. Gensler emerged as a staunch advocate of investor protection during his tenure as chair of the Commodity Futures Trading Commission (CFTC) under President Barack Obama.
Broker-dealers involved in the trading of digital assets also should begin drafting firm policies and procedures regarding the custody of assets and safeguards put in place for the protection of clients. Interested parties can send comments on the topic to the SEC.
The rapidly evolving digital asset landscape is here, and Core Compliance & Legal Services can assist your firm in developing policies and procedures to warrant confidence among regulators and investors. To schedule a consultation, contact us at 619.278.0020 or at corecls.com.