The SPBD Regime: A Deep Dive into How It's Shaping the Crypto Regulatory Landscape

The crypto regulatory landscape has been evolving at a solid pace these past couple of years as countries worldwide take steps to establish guidelines, offer clarity, and protect customers.

The crypto regulatory landscape has been evolving at a solid pace these past couple of years as countries worldwide take steps to establish guidelines, offer clarity, and protect customers.

In this regard, about four years ago, the US Securities and Exchange Commission (SEC) introduced a new class for those who deal with the custody of crypto asset securities. Today, we'll take a deep dive into this and just how it is shaping up. 

Breaking Down the SPBD Regime: What It Means for Broker-Dealers

In Dec. 2020, the US SEC introduced “special purpose broker-dealers” (SPBD), which is a registered broker-dealer that can custody and transact in digital asset securities. 

Under the SPBD regime, the securities agency grants the SPBD license to allow broker-dealers to custody and handle digital asset securities in compliance with federal securities laws.

According to the SEC, a Financial Industry Regulatory Authority (FINRA)-approved SPBD can transact in and custody digital asset securities, unlike other broker-dealers and alternative trading systems (ATS), which can only transact in crypto securities after receiving FINRA approval but cannot custody them.

However, an entity registering as an SPBD is subject to a number of stringent compliance requirements, especially around investor protections, disclosures, and operational oversight. These conditions include:

SPBDs can not deal with traditional securities except for hedging and net capital purposes. The regime also limits SPBD's business activities by only allowing them to conduct business involving digital assets that are securities. 

These broker-dealers also need to have access to crypto securities that they wish to hold as well as the ability to transfer them using the associated distributed ledger technology (DLT). If the entity is aware of any material operational or security problems with the associated network, then it must not maintain custody of that crypto security. The SPBD further needs to provide written disclosures to its customers, including any material risks with the asset.

The SPBD registered firm has to enter into a written agreement with each customer and set forth the terms and conditions for transacting in crypto asset securities.

Furthermore, the firm needs to establish, maintain, and enforce policies and procedures to determine whether a crypto asset is a security. 

In addition to analyzing whether the crypto securities it trades were issued in compliance with securities laws and regulations, the firm must have written supervisory procedures to assess the associated network and characteristics of the crypto securities before undertaking custody. These assessments, conducted at regular intervals, should be used to confirm that there are no operational problems or weaknesses in the distributed ledger technology.

Moreover, procedures need to be followed to discover and tackle threats with the associated DLT and networks. An SPBD is also required to notify its customers that crypto securities may not be “securities” to get SIPA protection, which shields customers from lost securities in case the broker-dealer goes bankrupt. 

These policies must be consistent with the best practices of the industry, and the firm must demonstrate that it has exclusive control over the securities it holds in custody. The entity must comply with court-ordered seizures and protect against the loss of the private keys associated with such crypto asset securities.

SPBD Licensing: A Complex and Stringent Process

The SEC's statement on the “Custody of Digital Asset Securities by Special Purpose Broker-Dealers” suggests three brokerage models with respect to digital asset securities, with the broker-dealer custodial (SPBD) model being one. 

As per the SEC's statement, the agency will not commence an enforcement action for a period of five years against an SPBD as long as it establishes, maintains, and enforces written policies and procedures to determine if a crypto asset is a security and sold in accordance with an effective registration statement or an exemption from it.

The second is a non-custodial model where a broker-dealer who does not have custody of crypto securities may facilitate digital asset securities' trading as an ATS. However, the ATS cannot be involved in clearing and settling such trades. These entities are not subject to the SPBD requirements.

Next is the bank custodial model, where national banks may have custody of crypto, including securities. Here, a broker-dealer is allowed to rely on a bank as a control location for its customers' securities and does not need to seek the permission of the Commission. Since the broker-dealer is relying on a bank for the custody of its customers' digital asset securities, it doesn't need to be an SPBD.

SEC's statement is rather limiting, though, and lacks explanations for its restrictions. Also, as we noted above, an SPBD applicant is required to meet rigorous standards set by the SEC as well as FINRA. These regulatory standards further include measures related to custody, anti-money laundering (AML), and cybersecurity.

Some of the conditions that SPBDs must fulfill have made this new class an unattractive option for broker-dealers. 

Many broker-dealers view SPBD as