Members of the SEC’s Strategic Hub for Innovation and Financial Technology (“FinHub”) and experts in Fintech came together on May 31st for the SEC’s public forum focusing on distributed ledger technology and digital assets. As a whole, the panelists grappled with the challenge of regulating an emerging technology that does not fit neatly within the current regulatory regime. The SEC’s stated goal is to regulate without inhibiting innovation. Throughout the Forum, the SEC staff encouraged industry participants to engage with the SEC Staff as partners to achieve that goal.
Setting the Stage
The SEC – in remarks by Valerie A. Szczepanik, Senior Advisor for Digital Assets and Innovation and Associate Director in the SEC’s Division of Corporation Finance and the head of FinHub, Chairman Jay Clayton, and Commissioner Hester Peirce – emphasized the importance of regulators engaging with the industry and innovators in the Fintech space. This type of substantive engagement is necessary to advance the regulator’s knowledge and understanding of the industry in order for it to be an effective regulator and to enhance – and not stifle – innovation and opportunities.
The Forum largely consisted of four panel presentations: 1) Capital Formation Considerations; 2) Trading and Markets Considerations; 3) Investment Management Considerations; and 4) Industry Trends in Distributed Ledger Technology (“DLT”).
Capital Formation Considerations
The first panel focused on the use of digital assets in capital formation. In his introduction of the panel, the Director of the Division of Corporation Finance stated that there is tremendous potential for digital assets to facilitate capital formation. He noted, however, that the Commission Staff would benefit from issuer engagement on many important issues, including disclosure, accounting issues, and the rights of token holders.
The panel covered many issues, including whether or not tokens are securities. They noted that, given the nature of digital assets, there will be instances when digital assets constitute a security and instances when they do not. The Staff referenced its recently released “Framework for ‘Investment Contract’ Analysis of Digital Assets,” which reviews digital assets through the lens of the Howey test. One of the more interesting observations was the concept that digital assets can evolve – that is, they can have characteristics of a security at the outset of a project, but then lose those characteristics as a project is established.
Given the SEC’s framework, many observers questioned whether a digital asset could ever be anything other than a security. On April 3rd of this year, however, the SEC staff issued the TurnKey Jet (“TKJ”) no-action letter. In determining that the TKJ token was not a security, the SEC identified a number of factors including, among others:
- TKJ would not use funds from token sales to develop the Platform, Network or App, which would all be operational when the tokens were sold;
- Transfers would be restricted to TKJ Wallets;
- Tokens would be immediately available to purchase air charter services when sold; and
- Marketing the tokens would focus on their functionality for purchases and not their value as a potential investment opportunity.
Other issues that the discussed included:
- The possible the tokenization of stocks, which could simplify and streamline clearance and settlement.
- The ability to develop smart contracts to facilitate compliance with customer identification and know your customer obligations by programming AML and KYC rules into a smart contract.
- The challenging custody issues that digital assets present and the fact that they are currently managed in different ways, including use of “wallets” (or “under the mattress”) and in a company’s Treasury operations.
Trading and Markets Considerations
This panel focused on the complexities of trying to regulate a secondary market involving digital assets. The SEC regulates all exchanges, regardless of whether the trading platform is centralized, decentralized, or a hybrid platform. All exchanges are required to register with the SEC.
The Director of Trading & Markets set the stage for the panel. He referenced the “Statement on Digital Asset Securities Issuance and Trading” issued on Nov. 16, 2018, by the Divisions of Corporation Finance, Investment Management, and Trading and Markets after a series of enforcement actions involving offers and sales of digital asset securities, investment vehicles investing in digital asset securities, and secondary trading of digital asset securities. The Director noted that technology does not define the regulatory obligations, but rather the activity in which the actor is engaging defines the obligations. Lastly, the Director noted the need for regulators to balance innovation with investor protection.
The panel addressed several issues facing the secondary markets, including finality of transactions, custody, and the presence of numerous state and federal regulators with different regulatory requirements. Some of the panel’s observations included:
- There is a challenge to finality in the secondary market. While the financial markets want a clear idea of finality, the concept is less clear in the realm of digital assets. The panel pointed out that finality in the cryptocurrency space will need to be defined.
- DLT has tremendous potential to reduce the settlement cycle. As the settlement cycle decreases, the volume of securities available to be loaned out decreases. This would likely impact securities financing and collateral management.
- Custody can be particularly challenging in the digital asset space. The type of controls will evolve. For example, if one agent has a key but needs two other keys to access the asset, the first agent would not have custody of the asset. The panel noted the phenomenon of Air Drops, where someone who holds a particular digital asset might be gifted another asset simply by virtue of holding the initial asset. The panel also noted the challenges with “forks” in various digital assets.
Investment Management Considerations
Many funds have an increased interest in holding digital assets. Funds wishing to do so face numerous challenges, including custody, valuation, transparency, liquidity, and potential manipulation of digital asserts.
Where innovation is important, so are protections. The panel discussed principals-based regulation as the most rational way to apply regulations to ever-changing technology. Points made by the panel included:
- Custody is an issue for any fund wishing to hold digital assets because investment companies and investment advisers have custody requirements and holdings must be custodied with a “qualified custodian.” How does a custodian hold a digital asset without transferring ownership to the custodian? The panel discussed options to answer this question. There was consensus that the custody issue should ultimately be solvable.
- A more challenging issue is meeting AML and KYC requirements. The encryption and anonymity of distributed ledger technology conflict with the central requirements of AML/KYC.
- The panel also discussed issues arising from independent audit requirements. How can an auditor prove the existence of digital assets? Proving ownership of digital assets may require transferring them. Transferring the assets, however, entails some risk, because there is risk every time an asset is moved.
- On January 18, 2018, the SEC’s Division of Investment Management staff published an open letter to the ICI and SIFMA seeking to engage the industry on fund innovation and cryptocurrency. The Staff sought input on several issues facing investment companies and investment advisors seeking to integrate digital assets into their holdings. In its request, the SEC staff sought industry input on the following issues: valuation, liquidity, custody, arbitrage (for ETFs), and potential manipulation and other risks.
Distributed Ledger Technology Innovations: Industry Trends and Specific Use Cases for Financial Markets
The Director of the Office of Compliance Inspections & Examinations (“OCIE”) noted that OCIE reviews technology in examinations by assessing (1) what is the technology designed to do, (2) how is it implemented, and (3) how do the firm’s compliance systems and written supervisory procedures address technology. He noted that OCIE strives to stay ahead of technology issues by: (1) achieving transparency through outreach, (2) using forums to listen to firms, and (3) tracking new technology through examinations. Finally, he noted that advisers are treading carefully in the digital assets space, with only 650 advisers indicating an intent to trade in digital assets.
The panel kicked off with a discussion of the challenges of regulating in this space. In a sense, the panel noted that there has been an attempt to build regulatory controls onto a permission-less system, in effect, tethering back or controlling a system that was not designed to operate in that way. Critical areas impacted are privacy, AML, and dispute resolution.
- Privacy and identity management. The panel explored the privacy and data security aspects of using “zero knowledge proof” and how the ability to provide certain information without handing over the personal confidential information could meet verification goals and actually be more secure and protect privacy interests than current practices do.
- The panel noted that FinCEN had recently reaffirmed the application of its requirements to virtual currency transactions when they issued guidance on May 9, 2019. The panel acknowledged that there was a need to know who one is transacting business with and what they are doing – “regulating the on and off ramps.” But they noted that these are all solvable issues.
- Dispute resolution. While noting that smart contracts are not designed to have a dispute resolution backstop, the panelists noted that there could be a way to build such a mechanism into smart contracts. One example mentioned was to have a third key that goes to an arbitrator. This would enable a code that would tie back to the requirements in the legal world.
The panel also noted the different ways that blockchain and distributed ledger technology come into play regarding assets. The panel discussed: (1) native tokens, where the token is the value (e.g., Bitcoin), (2) asset backed tokens, where the asset is held elsewhere, including in a regulated entity as custodian, and (3) high quality liquid assets (e.g., basket of securities where ownership may change where the technology, custodian arrangement and legal concepts provide nimble transfers and reduce balance sheet drag).
The SEC’s staff’s Fintech conference was a good demonstration of the critical importance that regulator, business, and technology engagement. The potential for this new technology to innovate and revolutionize capital formation and value exchange is undeniable. The success of the technology and the platforms and ultimately reaching their full potential will depend on the participants and the stakeholders ensuring that it works. The business, counter parties, investors, the general public acceptance build off of trust, avoiding systemic breakdowns, and having non-intrusive guardrails. Accomplishing this with engagement by the innovators in this space with the regulators that are responsible for those guardrails – investor and market protection – makes sense.
The full webcast can be found here.