Regulating Wallet Providers: Focus on Functions, Not Technology

As the services provided by blockchain wallets range from simple key-management tools to service-rich platforms that increasingly resemble brokerage functions, SIFMA believes a clear, functional-based regulatory framework is needed to distinguish wallet types and ensure investor protection while supporting innovation.

Key points:

• Developing a durable approach that is built on the existing robust U.S. securities regulatory framework will provide a powerful impetus for the growth and development of digital wallets, which we see as an important innovation that will support continued innovation in tokenization of securities.
• There are four distinct types of blockchain wallets: basic self‑custody, self‑custody wallets that provide additional services, basic custodial, and custodial wallets that provide additional services. Each wallet type is defined by whether the provider controls customer assets via a private key and whether additional services are offered.
• As wallet functionality expands beyond basic key management, certain services may begin to resemble broker-dealer activities. These activities can lack important protections for investors that existing broker-dealer rules are designed to address.
• Wallet providers that perform activities resembling brokerage functions should be distinguished from those that solely deliver user‑controlled access tools, since similar interfaces can mask fundamentally different economic and operational roles.
• Clear, durable rules created through notice and comment processes are necessary to address the evolving interaction between wallets and tokenized securities, rather than ad hoc exemptive or no‑action relief that may not scale as technology changes.
• A regulatory framework that focuses on the substance of wallet services, their economic incentives, and their relationship to securities activities will enable compliant innovation, protect users, and support constructive partnerships between technology providers and registered intermediaries.

Categorizing Wallet Models

Wallets are the primary way investors access digital assets. In their most basic form, a wallet holds the private key associated with a user’s account, enabling that user to initiate transactions such as sending tokens to another user, or purchasing a digital asset. Wallets are most users’ first exposure to blockchain activity, and while self-custody wallets provide the needed functionality for interaction with the blockchain, they can be complex to use for those new to the technology. Thus, “custodial wallets,” where the wallet provider maintains the private key on behalf of the user, have been developed to allow for easier setup and access to users who may prefer a “full-service” experience without the setup required by a self-custody wallet.

Currently, a range of both self-custody and custodial wallets provide their users with access to various blockchains. In addition to access, wallets may provide additional services to users, such as order routing or providing investment advice. Below, we categorize wallets according to two core attributes: first, who controls the private keys and second, does the wallet provider supply services beyond basic access?

Clear distinctions between wallet types based on their control of keys and the services they offer to clients allow for tailored regulations are necessary to properly protect investors. We recognize that there are a variety of wallets that fall into the “basic-self-custody” category, and believe it is important to provide a framework that identifies when wallet providers are operating in this capacity. This clarity would allow wallet providers who do not provide broker-dealer services for tokenized securities to interact with a registered broker-dealer who does provide those services. This type of integration of wallet technology with regulated broker-dealers may provide a path forward that supports new operating models while preserving the investor protections built into the established securities regulatory framework. However, if a wallet performs functions that resemble those performed by custodians, brokers, or dealers, they should be subject to similar regulatory frameworks.

Broker-Dealer Requirements Mitigate Key Investor and Market Integrity Risks

If a wallet provider exerts control or influences trading behavior in tokenized securities, the wallet provider is acting in an intermediary capacity rather than as a user-directed tool. As discussed in prior blog posts, ¹ the substantive provisions of broker-dealer regulation are critical to mitigate potential risks to investor protection and market integrity raised by those wallet providers that are not otherwise sufficiently regulated (e.g., national banks) holding tokenized securities on behalf of customers. Existing requirements such as best execution, suitability, duty of fair dealing, and other business conduct requirements protect investors and are necessary to mitigate the risk that wallet providers who hold or control customer assets route trades based on conflicts of interest or make inappropriate solicitations to customers. Furthermore, absent the application of Regulation T and FINRA Rule 4210, users may be exposed to levels of leverage that would be impermissible at a registered broker-dealer. Allowing securities transactions through a wallet that effectively bypasses these requirements would create opportunities for regulatory arbitrage. Thus, wallets that enable leveraged securities transactions or arranged financing should be subject to these regulations to limit excessive leverage and protect investors.

Some Wallet Providers May Be Acting as Broker-Dealers

Wallet providers may offer routing services to determine where and how a customer’s trades are executed on a DeFi exchange or with market makers ² . Additionally, they may curate the various venues and market makers it displays to the customer ³. For example, the wallet provider may display prices from a limited number of venues and market makers that have paid the operator for the privilege of being displayed or are affiliated with the provider. When conducted in relation to tokenized securities, wallets that provide routing services or the curation of venues raise the same investor protection concerns that guide the SEC’s registration requirements for brokers, such as the prevention of conflicts of interest, requirements for best execution, and preventing the frontrunning of user’s transactions.

Wallet providers may also facilitate financing for users’ assets, solicit customers to purchase and sell assets, or provide recommendations or other investment advice ⁴. Wallet providers that connect customers to lending protocols are connecting customers to financing providers that can allow customers to invest on a leveraged basis ⁵. This is an example of arranged financing, an activity for which registered broker-dealers are subject to regulation and oversight. With respect to investment advice, many wallet providers not only show quotes from market makers and exchanges but also indicate which are the “best ⁶”. Wallet providers may also engage in advertising or other solicitations for purchasing and selling, telling customers that the wallet software functions as a “one-stop shop” for trading with access to deep liquidity and good prices ⁷. Again, all these activities would normally constitute core broker-dealer functions.

Discretion and Compensation as Key Broker-Dealer Indicators

It is important to separate between circumstances in which the wallet provider is exercising control and / or discretion and where it does not. Where a wallet provider displays quotes or venues based on preferential arrangements, curated lists, promotional labels, or other forms of discretion, the activity constitutes proving investment advice, and the wallet provider should be regulated as a broker-dealer.

The fact that a party earns transaction-based compensation for securities trades does not establish conclusively that the party is a broker ⁸. However, the reason it has been a consistent touchstone of the Commission’s framework for identifying brokers is that it almost always indicates that the services for which a firm is being compensated are transaction specific. If such transaction-based compensation is coupled with order handling, routing, investment advice, or execution services, it becomes clear that the service the firm is providing is the type of activity that Congress intended to subject to the protections of the Exchange Act and the Commission’s regulations. In other words, transaction-based compensation often clarifies whether the service a firm is providing is merely acting as a physical safe or “software” or instead effecting a transaction for others.

Durable Regulatory Clarity Will Support Innovation

Developing a durable approach that is built on the existing robust U.S. securities regulatory framework will provide a powerful impetus for the growth and development of digital wallets, which we see as an important innovation that will support continued innovation in tokenization of securities. Given the increasingly important role that wallet providers will play in these markets, it is essential that the Commission act to clearly delineate between wallet providers that simply provide “disinterested technology solutions” and those that also engage in activities that are appropriately subject to investor protection and market integrity regulations. Clear answers to these questions will enable the development of new technology and operating models that bring together technology providers and regulated entities and will help drive the growth of tokenized securities markets.

Regulatory clarity will also provide a pathway for new market entrants to define and develop their role in the markets while avoiding regulatory arbitrage. Ultimately, distinguishing between wallet categories and analyzing them based on the activities they perform will promote a healthier digital asset market. It will protect customers, support compliant partnerships between technology providers and registered intermediaries, and encourage innovation that aligns with established principles of market integrity and investor protection.

Footnotes