An Inside Look into FINRA’s Crypto Asset Work

By Jason Foye, Chief of FINRA’s Crypto Hub

FINRA’s core mission is to protect investors and promote market integrity. This mission is at the heart of everything we do. An important example of this mission in action is our work to address the unique regulatory challenges presented by the activities of our member firms that relate to crypto assets—also known as digital assets—which are assets issued or transferred using distributed ledger or blockchain technology.

The crypto market has rapidly grown over the last decade, with a current capitalization of just north of $1 trillion, down from a high of approximately $3 trillion in 2021. This growth has included increased product offerings, retail investor participation (especially among younger investors), and related activities by our member firms. In some instances, bad actors have exploited the crypto market to steal significant sums from investors, such as through phishing scams seeking payment in cryptocurrency and fraudulent offerings. Even with the recent decline in assets, the size of the crypto asset market, retail investor participation in it, and recent events, such as the collapse of FTX, underscore the importance of our work in this area.

Crypto Hub

That is why FINRA started a Crypto Hub, also known as the Hub.

FINRA established the Hub in October 2022 as an enterprise-wide effort to ensure we are prepared to fulfill our regulatory mission regarding the crypto asset-related activities of member firms and associated persons. The Hub includes representatives from nearly every FINRA department working as a nerve center to manage FINRA’s regulatory work related to crypto assets. This includes:

• conducting risk-based examinations and investigations of crypto asset activities being conducted by our member firms and associated persons,
• building for the future and enhancing our capabilities in this area, and
• engaging in blockchain innovation to support and enhance FINRA’s regulatory capabilities across all product types, including crypto assets.

Prior to the Hub being established, FINRA also established the Crypto Asset Investigations (CAI) team and Blockchain Lab, which are specialized units staffed with crypto asset subject matter experts. CAI conducts complex investigations related to crypto asset fraud and collaborates with FINRA’s exam program to conduct risk-based examinations of firms’ compliance with FINRA rules and federal securities laws and regulations related to crypto assets. The Blockchain Lab serves as a central point within FINRA for the development of blockchain-related regulatory initiatives and helps build or source technology solutions to facilitate oversight of blockchain-related activities. Additionally, FINRA recently established a Crypto Asset Surveillance Team, which works in collaboration with the Hub and supports FINRA’s ability to conduct surveillance of the crypto asset markets.

FINRA Member Firms’ Crypto Asset Activities

FINRA requires approval by our Membership Application Program (MAP) for firms’ material crypto asset securities business lines. Firms seeking approval for such a business line must provide specified information to FINRA and meet the applicable requirements under the securities laws and FINRA rules.¹ FINRA follows the SEC’s guidance in assessing a firm’s proposed digital asset securities business line under applicable rules, such as the SEC’s financial responsibility rules and customer protection rule.²

There are currently 26 firms approved solely to engage in crypto asset securities business, including:

• nine firms approved to engage in private placements involving crypto asset securities,
• nine firms approved to operate an Alternative Trading System (ATS) for crypto asset securities,
• seven firms approved to both engage in private placements involving crypto asset securities and operate an ATS for crypto asset securities, and
• one firm approved to be a Special Purpose Broker-Dealer (SPBD) under the SEC’s December 2020 statement regarding Custody of Digital Asset Securities by Special Purpose Broker-Dealers (the SPBD Policy Statement). ³

Each approved firm has agreed to operate in accordance with several requirements that limit the scope of its business. For example, consistent with the requirements set out by the SEC in the SPBD Policy Statement, an SPBD must operate its business in accordance with several SEC requirements that limit the scope of its operations and the assets for which it can provide custody services (e.g., the SPBD must limit its business activities to digital asset securities, which excludes non-digital asset securities and digital assets that are not securities). As another example, consistent with the SEC Staff ATS No-Action Letter, an ATS seeking to facilitate secondary transactions in digital asset securities pursuant to the “three-step model” must meet heightened requirements, including net capital requirements, compared to the “four-step model.”

In addition to the material crypto asset securities lines for which FINRA MAP approval is required, FINRA has asked member firms to notify us if they or their affiliates engage or plan to engage in crypto asset-related activities, including activities related to crypto assets that are not securities.⁴ To date, FINRA has identified approximately 200 member firms as having some direct or indirect touch point to crypto asset activities, such as proprietary trading and distributed ledger technology initiatives. Notably, many of these touchpoints are indirect in that the activity is being conducted by member firms’ affiliates or parent companies rather than directly by member firms. In other business models, member firms have established relationships with unaffiliated third parties to grant their customers’ access to crypto asset activities. While FINRA has jurisdiction over the activity and conduct of our member firms and their associated persons, it does not have jurisdiction over their affiliates, parent companies or other unaffiliated third parties.

In addition to the types of crypto asset-related business activities that member firms are engaging in directly or indirectly, FINRA has also identified hundreds of associated persons who are engaged in a range of crypto asset-related activities through an outside business activity (OBA) or private securities transaction (PST).

FINRA Oversight and Surveillance

As the crypto market has grown, FINRA has evolved our regulatory program to better understand the market and to oversee member firms and associated persons for compliance with the securities laws and FINRA rules. FINRA has identified potential violations of FINRA rules, and, while not exhaustive, some themes identified with respect to these potential violations are outlined below.

• FINRA has identified potential violations of FINRA Rule 3110 (Supervision) for failures to conduct due diligence on crypto asset private placements sold to investors.
• FINRA has issued disciplinary actions finding violations of FINRA Rules 3270 (Outside Business Activities of Registered Persons), 3280 (Private Securities Transactions of an Associated Person), and 3110 for failures related to the disclosure, approval, and supervision of crypto asset-related outside business activities and private securities transactions.
• FINRA examinations and investigations have also identified potential violations of FINRA Rule 3310 (Anti-Money Laundering Compliance Program) related to failure by member firms to establish AML programs reasonably designed to detect and cause the reporting of suspicious activities in situations where crypto asset activities are occurring by, at, or through the broker-dealer.
• FINRA has also identified potential violations of FINRA Rule 2210 (Communications with the Public) related to crypto asset communications. To assess this risk more broadly, FINRA’s Advertising Regulation department initiated a targeted examination of 17 member firms’ crypto asset-related communications to assess compliance with Rule 2210.⁵ This assessment includes, but is not limited to, assessing whether advertising materials appropriately and accurately address relevant risks and contain appropriate disclosures related to safety and custody.

Additionally, on the market surveillance front, FINRA investigates situations where bad actors are seeking to take advantage of investor interest in crypto assets and blockchain technology to perpetrate pump-and-dump schemes and other forms of market abuse in the equity markets. FINRA also investigates potential market abuse involving crypto asset securities traded on registered ATSs.

Enhancing our Capabilities

At the same time, FINRA is engaged in a variety of initiatives designed to build for the future and enhance our capabilities. Key aspects of this work are our efforts to engage with other state, federal, and international regulators and agencies to discuss crypto asset regulatory efforts and developments, as well as our efforts to engage with member firms and other industry participants to better understand current crypto asset activities and issues. A special summit attended by crypto asset subject matter experts from FINRA and the National Futures Association is one example of this work.

FINRA is also developing blockchain-related regulatory initiatives to explore on-chain data, and building tools and exploring vendor solutions that can support and enhance FINRA’s regulatory capabilities. As part of these efforts, FINRA has:

• established nodes on the Ethereum and Bitcoin blockchains, and explored the use of publicly available crypto asset market data,
• created a method for verifying that member firms or certain associated persons (e.g., those managing investor funds away from their employing broker-dealer in crypto asset private securities transactions) have control over crypto asset wallets they purport to control, and
• tested crypto asset investigative and surveillance tools and in certain instances, deployed tools for use in crypto asset investigations and other regulatory work.

Conclusion

FINRA is advancing our core mission to protect investors and promote market integrity through our critical crypto asset-related regulatory work across the organization. This work includes gathering information about member firms’ and associated persons’ crypto asset activities; reviewing members for compliance with applicable rules and regulations; and pursuing initiatives to build for the future and enhance our overall capabilities in this space. FINRA is committed to this work and our regulatory mission.