Guest post: Matthew Comstock, Shareholder, Murphy & McGonigle, P.C.
Regulators and industry groups continue their efforts to understand blockchain technology and its implications for the securities, futures and related financial sectors. Importantly, regulators and industry groups have not yet advocated for or against any particular type of blockchain technology. Rather, efforts have largely centered on defining what, in the view of those regulators and industry groups, blockchain technology is, how it may be used in the financial services industry, and what the regulatory implications are for its use.
The various financial industry regulators and industry groups have not coalesced around a single definition of blockchain technology. Their definitions, however, typically describe blockchain as a technology that involves a type of distributed-ledger technology that includes a decentralized, public or private peer-to-peer network that records transactions that occur through the network in shared digital ledger.
The U.S. Securities and Exchange Commission (SEC), the primary federal regulator for the securities industry, appears to have begun formal work on blockchain-related matters with the establishment of the Digital Currency Working Group, which started around 2013. Since that time, the SEC has been asked to clarify whether digital currencies are securities; approved a registration statement to become effective that permitted a company to sell digital securities to the public; and held a FinTech Forum in the fall of 2016, which included a panel on blockchain technology (panelists included members of Hyperledger). In March of this year, the SEC issued two separate controversial blockchain-related orders. It disapproved proposed changes to the rules of two securities exchanges that would have permitted the Winklevoss Bitcoin Trust to trade on one exchange, and the Solid X Bitcoin Trust to trade on another. Each trust would have traded as an exchange traded product, with bitcoin as its the underlying asset. In disapproving the proposed rule changes, the SEC essentially took the position that lack of regulation surrounding bitcoin markets made bitcoin, and thus the trusts, susceptible to fraud and manipulation.
The Financial Industry Regulatory Authority, Inc. (FINRA), which oversees securities brokerage firms (subject to the ultimate supervision of the SEC), recently issued a report (the “FINRA Report”) on blockchain technology. The FINRA Report (1) described blockchain technology; (2) discussed potential applications of blockchain technology to the securities industry (e.g., issuing and trading public company stock on a blockchain-based platform, and centralizing customer identity management functions); (3) identified potential impacts on the securities industry, such as increased transparency (e.g., by maintaining a database containing the complete histories of securities transactions, and altering or eliminating the roles of financial intermediaries); and (4) addressed implementation considerations, such as governance (e.g., “trustless” network open to the public with no single party responsible for the proper operation of the system, versus a private network with parties known and trusted, and transaction validation (consensus-based versus single-node verifier).
Finally, the FINRA Report discussed certain regulatory implications arising out of securities brokerage firms’ use of blockchain technology, particularly with respect to financial responsibility requirements. For example, FINRA raised an issue as to how brokerage firms could meet their regulatory obligations to take custody of “cryptosecurities” held on a blockchain network on behalf of customers. Moreover, FINRA asked whether cryptosecurities held by a brokerage firm would have a “ready market,” i.e., a liquid market, so that firms’ holdings of such securities would be allowable (liquid) regulatory capital. The FINRA Report also noted the brokerage firm records that are maintained electronically must be kept in a non-rewriteable, non-erasable format (also referred to as “write once, read many” or “WORM”). Although blockchain is arguably a superior recordkeeping technology, FINRA nevertheless asked whether a brokerage firm records maintained on a blockchain network would meet the SEC’s WORM requirement.
An organization that primarily represents brokerage firms and asset managers, the Securities Industry Financial Markets Association (typically called “SIFMA”), is in the process of drafting a comprehensive response to the FINRA Report. SIFMA members have indicated that SIFMA’s response will advocate that any guidance regulators provide, or principles that regulators formulate with respect to blockchain, be technologically neutral.
The International Organization of Securities Commissions (“IOSCO”) recently issued the “IOSCO Research Report on Financial Technologies (Fintech)” that included a discussion of distributed ledger technology. IOSCO noted that blockchain is one subset of distributed ledger technology, distinguished between permissioned and permissionless systems, described proof-of-work and proof-of-stake consensus algorithms, and emphasized the role tokenization and smart contracts are likely to play in applying distributed ledger technology to the financial services industry. The IOSCO report also identified potential application of distributed ledger technology to the financial services industry in areas such corporate recordkeeping; trading and settling transactions in certain types of financial instruments; ensuring that certain regulatory requirements are met (e.g., compliance with anti-money laundering rules); creating individual IDs to be used in financial transactions; and improving the speed, efficiency and security of financial transactions, among other things.
The U.S. Commodity Futures Trading Commission (CFTC), the federal agency tasked with overseeing futures intermediaries, among other things, recently proposed to modernize the CFTC’s recordkeeping rules for such intermediaries. The proposed rules are intended to be technology neutral, and would take a principles-based approach to recordkeeping. Among other things, futures intermediaries would be required to maintain security, signature, chain of custody elements and data as necessary to ensure the authenticity of the information contained in regulatory records.
The efforts described above built upon, among other things, earlier white papers from The Depository Trust & Clearing Corporation and the Board of Governors of the Federal Reserve System. Expect regulators and industry groups to continue their efforts around blockchain technology.