On Friday, May 31, 2019, the US Securities and Exchange Commission (SEC) hosted a forum (the FinTech Forum) to discuss financial technology developments, including blockchain and distributed ledger technology and cryptocurrencies such as Bitcoin and Ether.
The FinTech Forum was hosted by the SEC’s Strategic Hub for Innovation and Financial Technology (FinHub), which was launched in 2018.1 FinHub was formed with the goal of serving as a resource for public engagement on financial technology developments, including not only blockchain and cryptocurrencies, but also automated investment advice, digital marketplace financing and artificial intelligence or machine learning. In addition, FinHub serves as a portal for the financial services industry to engage directly with SEC staff on these new financial technology developments through publications and events such as the FinTech Forum.
Although this was the first FinTech Forum hosted by the SEC since the launch of the FinHub group, the SEC did hold a similar forum in November 2016, addressing technology innovations in the financial services industry.2
This FinTech Forum featured a total of four panels as well as remarks by SEC leaders, including Chairman Jay Clayton, Commissioner Hester Peirce and Valerie Szczepanik, head of FinHub.3 The first panel focused on capital formation considerations, the second focused on trading and markets consideration, the third was on investment management considerations, and the fourth panel emphasized certain industry trends and use cases related to blockchain.
In addition to covering the panels in real time on Twitter (@SecuritiesAttys), we closely followed each panel with respect to how financial technology developments might impact the financial services industry. We noted the following key takeaways from each panel discussion.
Panel 1: Capital Formation Considerations
- Panelists observed a current trend of moving away from initial coin offerings and more interest in general security token offerings, as issuers also consider other forms of assets that may be recorded on a distributed ledger.
- There was discussion about the growing focus on programming digital assets to enable regulatory compliance, including compliance with anti-money laundering (AML) rules or know-your-customer (KYC) requirements, lock-up periods, transfer restrictions, tax liability calculations and payment flows. This emerging trend essentially embeds regulatory compliance into the underlying code of the digital asset, and panelists were optimistic about the potential for these “RegTech” solutions.
- Panelists noted that regulatory disclosures regarding a particular digital asset might not align with the asset’s underlying code. In order for digital asset classes to continue capital-raising activities, investors will need to better understand and validate the digital asset’s underlying code and compare the code to the plain-English disclosures.
Panel 2: Trading and Markets Considerations
- Panelists addressed the potential for blockchain to allow for noncustodial exchanges, where the investor would retain custody of his or her assets. Since exchanges generally take custody of investor assets for matching and execution purposes, they are frequently the subject of hacks and cyber-attacks. If blockchain were to allow for noncustodial exchanges, where there would be no need to forfeit custody of the asset to a centralized exchange, then the concerns and costs associated with cyber-attacks would decrease.
- Panelists speculated that digital wallets used to store digital assets might be more smoothly integrated into national securities exchanges, alternative trading systems, or other securities market participants, particularly as digital assets are distributed on more traditional trading platforms. Panelists from the Depository Trust & Clearing Corporation (DTCC), a centralized clearing and settlement organization, noted that DTCC has been approached to retain custody of private keys associated with different cryptocurrencies. Despite the decentralized potential for cryptocurrencies, it appears that many institutional and retail investors alike still value (and even prefer) a centralized third-party having direct custody of digital assets.
- Regarding the future role of SEC-registered transfer agents, panelists noted that blockchain and distributed ledger technology have the potential to disrupt the current need for transfer agents. However, before widespread adoption of blockchain technology in our securities markets, regulators should verify that shorter settlement cycles and elimination of transfer agents would improve the investor experience.
Panel 3: Investment Management Considerations
- According to panelists, two areas of focus for the SEC’s Division of Investment Management are (1) the development of cryptocurrency-related funds and (2) the custody of digital assets. For any fund seeking approval from the SEC’s Division of Investment Management, the key considerations still remain valuation, liquidity, custody, arbitrage opportunities and the potential for manipulation of the underlying digital asset.
- There is an increased willingness for private fund managers to engage in this new digital asset class. Although this is a new asset class, panelists stated that digital assets generally behave much like complex derivatives, so asset allocators have been focused on valuation, custody and AML concerns.
- Panelists noted that AML and KYC concerns are still an issue for institutional investors and large fund managers that may wish to invest in digital asset classes. The AML and KYC concerns remain challenging because the built-in anonymity of digital assets, particularly those such as Bitcoin and Ether, is in conflict with the underlying principles of AML laws and regulations.
- With respect to custody, it has been challenging for the SEC to come up with a rule that would be appropriate for all types of digital assets, specifically a rule that offers protection and is not overly burdensome. Panelists observed that the technology itself should not be regulated, but instead has to be based on principles that utilize controls and a combination of physical and procedural custodial safeguards.
Panel 4: Distributed Ledger Technology Innovations: Industry Trends and Specific Use Cases for Financial Markets
- Regarding the distinction between public and permissioned blockchains, panelists speculated that there would be no such distinction within five years, and that all distributed ledger technology would move to a public system not requiring prior permissions. Nonetheless, there is still a great amount of experimentation taking place in distributed ledger technology, and it is difficult to determine which form of distributed systems will gain traction in the financial services industry.
- According to panelists, securities arbitration (for instance, FINRA arbitration) represents an innovative use case for distributed ledger technology, such as “smart” contracts. For these smart contracts, the arbitrator would have a separate private key and the capability to resolve contractual disputes in real time.