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Regulators give nod to non-custodial exchanges

A new statement from the SEC and FINRA suggests that non-custodial exchanges may have a headstart when it comes to navigating regulatory issues.

The joint statement was published following “discussions with industry participants" and seeks to clarify how existing securities laws can be applied to the custody of digital assets. The letter focuses on the custodial requirements of Rule 15c3-3 under the Securities Exchange Act of 1934, often referred to as the Customer Protection Rule.

Enacted in 1972, the rule imposes strict standards of custody on broker-dealers; requiring a clear separation to be maintained between exchange assets and customer assets so that funds might be more easily traced and returned to their owners in the event of problems.

"The rule is designed principally to protect customers of a registered broker-dealer from losses and delays in accessing their securities and cash that can occur if the firm fails," reads the statement. "The rule requires the broker-dealer to safeguard customer securities and cash entrusted to the firm. If the broker-dealer fails, customer securities and cash should be readily available to be returned to customers."

According to the SEC, this rule played a key part in the aftermath of the 2008 financial crisis — helping customers get their assets back by assisting with the "orderly liquidation" of collapsed banking firms like Lehman Brothers.

With $365 million stolen from cryptocurrency exchanges in the first quarter of 2019 alone, it’s not surprising that protecting customer funds has risen to the top of the regulatory agenda. But as the letter notes, complying with the suggested requirements might not be so easy.

"The nature of distributed ledger technology, as well as the characteristics associated with digital asset securities, may make it difficult for a broker-dealer to evidence the existence of digital asset securities for the purposes of the broker-dealer’s regulatory books, records, and financial statements, including supporting schedules," it says.

Non-custodial exchanges in the clear

Assuming they don’t place customer assets into custody, and only facilitate transactions without exercising "any level of control over the digital asset securities being sold or the cash being used to make the purchase", non-custodial exchanges should not be affected:

"Generally speaking, non-custodial activities involving digital asset securities do not raise the same level of concern among the Staffs," says the statement.

Non-custodial models highlighted in the statement include over-the-counter (OTC) platforms where "securities do not pass through the broker-dealer," Alternative Trading Systems (ATS), which act only as third parties to help buyers and sellers find each other, and deals similar to private placements, where the broker-dealer acts as a matching agent for a small number of chosen investors.

A non-custodial Coinbase

On the same day that the SEC/FINRA letter was published, cryptocurrency exchange ShapeShift announced that it is emerging from crypto winter in an entirely new form — as a non-custodial exchange, and with a policy that makes KYC/AML mandatory.

Only six months ago the exchange was struggling amidst a prolonged bear market, laying off 10 percent of its staff over financial concerns, falling user numbers, and an uncertain regulatory environment.

With its relaunch as an KYC, non-custodial exchange, ShapeShift has resolved some of these issues. Or as ShapeShift founder and CEO Erik Vorhees put it, Shapeshift’s users are now one step closer to financial sovereignty. “Largely this came from my dissatisfaction with the reality that most of the large companies are custodial,” Voorhees told Yahoo. “The new platform offers many services that a company like Coinbase would provide but on ShapeShift it’s done in a much more secure and self-sovereign way.”

ShapeShift’s new platform joins several non-custodial exchanges, including the Binance DEX which launched in April, and Bitfinex’s decentralized spinoff Ethfinex. Despite offering user interfaces that are a world away from the clunky first-generation of decentralized exchanges, low trading volumes suggest these non-custodial platforms are yet to achieve widespread use. Binance DEX claims a mere 1.6 percent of the volume traded on its custodial parent, and Ethfinex even less, trading only 1 percent of the volume of Bitfinex.

However, with Shapeshift’s focus on a simple seamless user experience aimed at the retail market, this could change. As Voorhees says, “Growth is great, but having seen the existential risks of the status quo custodial model (broadly in the great financial crisis, and then specifically in the Mt. Gox disaster), we designed ShapeShift — first and foremost — to protect users. This principle manifested in two notable features of the original product: no custody of user funds, and no personal information extracted from our customers. Looking ahead, we see digital crypto finance integrating further into — and then consuming — traditional analog fiat finance. The world’s financial infrastructure is, right now, being recast upon a borderless, digital foundation.”


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