Dozens of startups that want to make the leap from unregulated cryptocurrency dealer to licensed brokerage are waiting for regulators to open the door so they can proceed.
Around 35 to 40 companies involved in digital assets have applied with U.S. securities regulators to become brokerages, with many hoping to launch electronic trading platforms, according to the Blockchain Association, an industry group. None of the applications has been approved since regulators stepped up enforcement actions against issuers of cryptocurrencies in early 2018.
The roadblocks faced by the startups suggest that other companies pushing into cryptocurrencies, such as
may also need to grapple with skeptical regulators and potentially extensive delays.
The Securities and Exchange Commission remains concerned that investments based on the technology behind bitcoin would introduce new risks for investors, many of whom could be mom-and-pop traders. The SEC and the Financial Industry Regulatory Authority—Wall Street’s industry-funded overseer, which is partly responsible for issuing the licenses—are scrutinizing how the startups can serve as gatekeepers, the role brokers traditionally provide.
“Membership applications from firms proposing to engage in digital-asset businesses present new, complex issues and we are in the process of working through them,” Finra spokesman Ray Pellecchia said.
In many cases, applications have languished for months beyond the standard six-month period for making a decision, according to lawyers involved in the process.
Without a brokerage license, the firms can’t set up platforms for trading securities based on the blockchain—the technology underpinning bitcoin—or sell such securities to investors. Blockchain proponents say the regulatory limbo has prevented a promising new technology from making financial markets cheaper and more efficient.
“In all the decades I have been practicing law I have not seen this much paralysis in Washington,” said Linda Lerner, an attorney at Crowell & Moring LLP representing firms seeking regulatory approval. “With digital assets there are a tremendous amount of problems that need to be solved.”
The industry has been awaiting guidelines from the SEC that would clarify how decades-old rules to protect brokers’ customers apply to cryptocurrency investments.
The agency’s staff has drafted guidelines and shared them with SEC Chairman Jay Clayton, according to people familiar with the matter. Mr. Clayton, who clamped down on cryptocurrencies and related investments soon after coming to Washington in 2017, has warned startups that they can’t fundraise by selling digital assets without following SEC rules. Companies heeding his call have rebranded their tokens as digital securities so they fall under the SEC’s regulatory umbrella.
Release of the SEC guidance doesn’t necessarily mean all the applications will be approved, one of the people said.
Initially, creators of cryptocurrencies hoped to displace banks and other financial institutions, allowing people to transact instantly, without intermediaries and across national borders. But the newer breed of crypto startups now want to join the ranks of Wall Street’s old guard, either because of regulatory pressure or demand from customers who prefer to deal with regulated brokers.
“We don’t want to come in and do things and have to apologize later. We want to do it right the first time,” said Edward Woodford, chief executive of Seed CX, a Chicago startup seeking to build cryptocurrency trading platforms for large investors.
Seed began the process of obtaining a brokerage license just over a year ago. In December, Finra said the company’s application was mostly complete, triggering a six-month deadline to act on it. But Finra has indicated to Seed that it needs more time, the company said.
Under U.S. law, brokers with customers must become members of Finra, which examines them and can enforce rules on behalf of the SEC. A few brokers with licensed trading platforms disclosed they would begin trading digital assets in early 2018, around the time the SEC said it was concerned about widespread fraud in cryptocurrency markets and warned that many deals should follow federal regulations.
Since then, the SEC’s staff has raised questions about how digital-asset brokers would comply with key rules. Industry lawyers say the door has slammed shut on new applicants.
One of the most difficult questions is how digital-securities firms will prove their ability to safeguard investors’ funds and assets, given the hacking threat that pervades the cryptocurrency business and the ease of losing passwords, known as private keys, which represent ownership.
In an original WSJ documentary, markets reporter Steven Russolillo ventures to Japan and Hong Kong to explore the universe of cryptocurrencies. His mission: create WSJCoin, a virtual token for the newspaper industry. Image: Crystal Tai. Video: Clément Bürge
Currently, most records of securities ownership are kept in electronic form by brokers, which maintain assets in accounts at specified locations, such as clearing corporations or banks. Because these repositories don’t exist in the world of digital assets, brokers would likely have to verify they can safeguard a customer’s private key and that no outside party has a copy of it.
Possession of the private key should satisfy the safekeeping rule, said Ethan Silver, a partner at Lowenstein Sandler LLP who represents several firms seeking to become brokers.
“You have this disconnect between digital securities that people are willing to treat like securities, and the core regulator not feeling like they can appropriately protect people under the laws as they are written,” Mr. Silver said.
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In addition to the way assets are safeguarded, a function known as custody, the SEC is reviewing how to value and audit digital tokens for accounting purposes, and how to handle customers’ digital assets in the event of a broker’s bankruptcy.
“There are a lot of rules and regulations about acting as a custodian, because the whole point of being a custodian is being able to return that asset to someone at some point in time, no questions asked, no strings attached,” Valerie Szczepanik, head of the SEC group that focuses on cryptocurrencies and digital assets, said at a recent Finra-sponsored conference.
The SEC’s silence so far has undercut the development of digital securities in the U.S., said Hester Peirce, a Republican SEC commissioner whose views toward cryptocurrencies are friendlier than many other regulators’.
“The SEC has yet to provide guidance to the public or Finra on any of the core questions,” Ms. Peirce said in a May 9 speech. “The result is that many would-be brokers and trading platforms are stuck in a frustrating waiting mode.”