By Anne Sherry, J.D.
A morning session of the SEC’s Investor Advisory Committee tackled cryptocurrencies and distributed ledger technology (DLT) and the implications of these emerging technologies on the securities markets. A group of industry professionals and academics converged around the concept of these emerging technologies as tools that industry participants and regulators can use to shape or refine the way markets operate. But not all committee members were satisfied with the lack of a clear answer as to where they fit in the legal landscape.
An ex-regulator’s perspective. Jeff Bandman (Bandman Advisors) discussed the challenges regulators face and the potential that DLT offers. Bandman, a former FinTech Advisor at the CFTC, observed that regulators do not regulate technologies themselves, but rather their application. Regulators must remain neutral, not just between competing companies, but also competing technologies. He added that blockchain tends to be developed in the open, so it is more visible to regulators than some other technologies. It offers the potential to see events as they unfold—through the windshield—rather than through the rear-view mirror a day or two later.
Bandman also lamented well-intentioned rules that have unintended consequences for regulators. Procurement and ethics rules can stand in the way of progress, he said, giving the example of innovators offering nascent technology at below fair market value, which could constitute a gift that government officials are unable to accept. Officials may also be unable to become members in technology groups: if they get in free, it’s a gift; if they pay, it’s a procurement. CFTC Commissioner Quintenz has responded by promoting technology prizes and hackathons, but this is a workaround, not a solution, Bandman emphasized. Just as innovators have sandboxes in which to develop new technologies, Congress should give regulators a sandbox for applying them.
The SEC’s July report concluding that DAO tokens were securities is the agency’s digital Marbury v. Madison, Bandman concluded. Just like that seminal Supreme Court case, the report is a landmark declaration of the agency’s jurisdiction in the digital space. He praised the report for putting the market on notice that these tokens can be securities while avoiding a blanket, one-size-fits-all approach.
Four years of exploration at Nasdaq. Fredrik Voss (Nasdaq) described some of the half-dozen or so DLT implementations that Nasdaq has publicized since it started its blockchain initiative in 2013. Nasdaq focuses its work on the securities markets, the relationship between the issuer and investor, and enhancing societal awareness of what is happening in the capital markets. With one project, Nasdaq leveraged Chain’s blockchain protocol to enable peer-to-peer transfers. The firm also worked on a voting application whereby a company can digitize votes and submit tokens to investors on a blockchain network. This allows tracing, which is good not just for investors, but also intermediaries because they can indisputably prove they followed voting instructions, he said.
Cryptocurrencies distinguished. Chain’s cofounder and CEO, Adam Ludwin, offered an overview of the technology itself. Ludwin said that it is important to define the terms involved and avoid conflating distinct concepts. In particular, he emphasized that cryptocurrency like bitcoin is an asset class in service of something broader, just as securities are in service of the corporate form of organization. In a decentralized system, he explained, you need to create an incentive for entities to contribute resources to make the service possible. Bitcoin as an asset class (he believes “currency” is a misnomer) is a secondary market, he said. Its primary function is to compensate the computers and entities processing transactions on the market, also known as miners.
On virtually every dimension, Ludwin said, centralized services are superior to decentralized ones. They are faster, lower cost, more scalable, secure, and have a better user experience with less drama. The one advantage of decentralized services is their resistance to censorship. There are two groups for whom this advantage outweighs the disadvantages: people who are off the grid, such as in developing countries—and people who want to be off the grid.
Committee responses. The panel’s sometime reluctance to delve into the technology’s implications for the securities markets frustrated committee member Damon Silvers (AFL-CIO), who tried to pin panelists down as to whether the purchase of cryptocurrency is a contract and, if so, who is answerable if anything goes wrong. Silvers referred to Ludwin’s description of coin mining and said that cryptocurrency looks a lot like the definition of an investment contract—investing money with the expectation of earning profits from the efforts of third parties. Nancy Liao (Yale Law School) allowed that an investor may be able to sue the creator of the code, if that person can be found. Ludwin extended the mining hypothetical, asking, if you mine gold, “Do you have a contract with the Earth?” “I’m interested in the law,” Silvers retorted, “and you haven’t said a single thing that is legally relevant.”
The SEC’s Investor Advocate, Rick Fleming, asked specifically how the securities markets would change under distributed ledger technology. He posited that street name would go away, as would proxy overvoting and failures to deliver on short sales. Instead of a T+2 settlement, the market would be headed to T+0. He asked the panelists if they agreed with this list and whether they would add anything to it. Voss remarked that these questions are answered by the people who organize the markets; the underlying technology is just a tool. He also pointed out that T+0 is already supported today and is in use in some markets in the Middle East. Bodson concurred, adding that DTCC sometimes settles orders on a same-day basis, it just is not the market convention for the bulk of transactions.