At a Glance…
On October 12, 2017, the U.S. Securities and Exchange Committee (“SEC”) held an Investor Advisory Committee (“IAC”) meeting to consider, among other things, blockchain technology and the implications for securities markets.1 The meeting covered a broad range of topics relating to blockchain and distributed ledger technology (“DLT”), including initial coin offerings (“ICO”), post-trade processing, and decentralized applications. In the wake of the SEC’s recent enforcement action alleging that two recent ICOs were fraudulent,2 the SEC is cautiously and carefully approaching these topics in order to better capture the benefits of this new technology while avoiding the potential for fraud and abuse.
In his opening remarks, Chairman Clayton emphasized the need for the SEC to remain “vigilant about this technology” to ensure that it is not used for “pump-and-dump and other fraud.” Commissioner Stein echoed the Chairman’s concerns and explained that while technology “has the potential to revolutionize capital raising . . . the risk of fraud signals a need for clear oversight.”
The meeting featured presentations from five subject-matter experts.
The first panelist, Nancy Liao, an Associate Research Scholar in Law and the John R. Raben/ Sullivan & Cromwell Executive Director at the Yale Law School Center for the Study of Corporate Law, provided an overview of the mechanics of blockchain technology. She analogized the term “blockchain” to the term “phone.” Both concepts have several meanings. For example, “phone” may connote the idea of a phone network, a specific phone network, or a specific use of a phone network. Similarly, “blockchain” may refer to the idea of a blockchain, a specific blockchain such as the Bitcoin blockchain, or a specific use case such as Filecoin, Zcash, or Ethereum. She emphasized that shared-ledger technology is not new. What makes blockchain and DLT unique from Google docs and other document-sharing applications is cryptography, which enables distributed control of a financial ledger. She also explained to the IAC that participation on the blockchain might be open to the public (open, permissionless) or limited to a consortium or select group (closed, permissioned).
Jeff Bandman, Principal of Bandman Advisors and former FinTech Advisor at the U.S. Commodity Futures Trading Commission (“CFTC”), delivered remarks on the role of the regulator and obstacles to effective regulation of blockchain technologies. He spoke to the IAC about his vision for a collaborative environment between the SEC and members of industry. He explained that blockchain could potentially allow regulators to harness real-time data from distributed ledgers and offer greater control to investors over their data. However, obstacles such as federal procurement laws and ethics rules might make it difficult for the SEC to obtain and experiment with DLT. He suggested that the SEC and other agencies establish a “sandbox for regulators” that would allow the agencies to study and use DLT without the risk of violating these procurement and ethics provisions.
Michael Bodson, President and Chief Executive Officer of DTCC, spoke about the post-trade landscape and some of DTCC’s innovative projects. He noted that the technology “needs to be proven before it can be widely adopted or considered enterprise ready.” DTCC is working with IBM, Axoni and R3 to retool its Trade Information Warehouse with blockchain technology. The Trade Information Warehouse currently houses data for $11 trillion worth of credit derivatives. Bodson emphasized that this is all new territory. For example, there are currently no common standards or guidelines for smart contracts. Such standards will need to develop before companies can offer securities on a blockchain.
Frederik Voss, Vice President, Blockchain Innovation at Nasdaq, discussed how Nasdaq is leveraging blockchain technology to facilitate record-sharing and voting, among other things. He noted that Nasdaq is primarily focused on post-trade securities processes, the relationship between the issuer of an asset and the investor in an asset, and the possibility for enhancing society’s awareness of what is occurring in capital markets. He discussed Nasdaq’s Link project, which aims to allow companies to record and transfer shares on a blockchain. Nasdaq is also working on a voting application that leverages the mutability and traceability of blockchain technology for investor voting. He concluded with a brief overview of a third project that uses DLT and solar panels to issue renewable energy credits based on energy generation and submit sell orders on a blockchain.
Adam Ludwin, Co-founder and Chief Executive Officer of Chain, encouraged the SEC to look at blockchain as a technology separately from crypto assets, such as bitcoin and either. He explained that these two core markets have been conflated in the press but are very different. Cryptocurrencies are a new asset class that do not exist for their own sake – they exist to enable a new form of decentralized software to function. These “decentralized applications” are a version of services that we already have today, but without a central entity providing the service. He noted that oftentimes the traditional version of an application is better than the blockchain version. According to Ludwin, the key advantage of decentralized applications is that they have built-in censorship resistance, offering everyone unfettered access.
Ludwin emphasized to the IAC that blockchain is a separate technology from crypto assets. He defined “blockchain” as a storage and transfer mechanism for assets.
Questions and Answers
The question and answer period included discussion of the future of crypto assets and blockchain technology, the legality of ICOs, and the pace of technological growth relative to regulation.
A few IAC members asked the panelists whether blockchain is simply another “tulip mania” or fad. Ludwin explained that there is an economic incentive for crypto assets to exist and therefore they will not disappear. He compared blockchain as a technology to Linux, which is the underlying framework for Mac OS X, and iOS, but is essentially running in the background. Blockchain might power securities exchanges and other platforms in the future but the average person would not necessarily know it. Voss agreed, adding that “the general public will never have to think about blockchain.”
Some of the IAC members expressed concern that promoters are issuing unregistered securities to the retail public under the guise of the “ICO” label. Ludwin and Laio retorted that the underlying blockchain technology should be distinguished from crypto assets issued by a promoter, which may qualify as “investment contracts.”
One IAC member asked whether concepts such as “street name” for securities and T+2 settlement will become extinct in the age of blockchain. Voss explained that rules may be crafted for the benefit of the public, and technology will have to conform to those rules. For example, regulators agreed to T+2 rather than T+0, even though the technology exists to support T+0.
Based on the discussion at this meeting, the SEC is currently considering both the merits and risks attendant to blockchain technology. IAC members are clearly concerned about the risk of fraud and abuse. Various members of the IAC vented their frustrations during the questions and answers session, accusing companies of issuing unregistered securities and defrauding investors. While the CFTC has brought a number of enforcement actions against industry participants for not being properly registered or for alleged fraud, it continues to frame blockchain technology as offering potentially significant technology advancements to the commodities industry. The SEC, on the other hand, has issued an Investigation Report declaring jurisdiction over those crypto assets that qualify as “securities”;3 released an Investor Advisory warning investors about ICOs; suspended trading in the shares of blockchain-related companies;4 brought an enforcement action against a promoter of two ICOs;5 and generally messaged caution to the securities industry. This IAC meeting did not signal that the SEC will change its tune and be approaching the technology from the same perspective as the CFTC. However, the Commissioners’ remarks demonstrate that the SEC will be open to weighing the benefits of the technology against its downsides.