Tuesday, June 04, 2019

Custody of digital assets, evolution of DLT top issues discussed at SEC’s FinTech Forum

By Amy Leisinger, J.D.

Investment management issues including the applicability of existing regulation and custody concerns with respect to digital assets, as well as distributed ledger technology (DLT) sparked lively discussion in the afternoon panels at the SEC’s FinTech Forum. According to the panelists, funds getting into digital assets need to remain vigilant with regard to the requirements of the Investment Company Act and the Advisers Act, and regulators must be diligent in their efforts to protect investors while avoiding stifling innovation. Separately, another panel explored developments in DLT and the potential for a shift in the numbers and types of public and private blockchains and for new combinations and interconnections.

Investment management. IM Director Dalia Blass opened the panel on issues facing asset management firms and investment advisers by noting that while the SEC staff recognizes the importance of innovation, stakeholders need to remember that the Investment Company Act and Advisers Act, as well as attendant regulations, still apply and should not be sacrificed to promote new technologies. At present, the director explained, the staff works to apply “tried and true” existing requirements concerning valuation, custody, and liquidity and to provide guidance regarding, and request comments on, compliance practices and challenges in connection with digital assets and blockchain technologies. Blass urged industry participants to engage with the SEC staff on potential concerns or solutions the governance of investments in cryptocurrencies.

Regulatory issues, challenges. According to Shearman & Sterling partner Jay Baris, the first thing to focus on when considering investments in digital assets is what the client is trying to accomplish and whether the client is a fund, bank, or other type of specifically regulated service provider. It is also crucial to determine the level of understanding the client has with regard to digital assets and underlying technologies; he noted; varying degrees of sophistication may warrant different approaches, Baris noted. John D’Agostino, managing director at DMS, agreed, noting that engaging in a digital asset class can involve a level of complexity that is good for private fund managers.

Deloitte partner Amy Steele also stressed the importance of regulatory considerations and applying traditional principles to digital assets. In particular, with regard to audits, asset “existence” can be a challenge, she explained; the asset is not tangible, and the only way to prove its existence is to go back to the blockchain, Steele noted. Rights can also raise issues with regard to ownership and control, according to Steele, and this can also necessitate specific blockchain review.

Steele also explained that auditors want to be comfortable that an asset custodian has controls in place to track assets and engage in reconciliation. Baris noted that custody can be a “vexing issue,” given the intangible nature of digital assets. He urged regulators to be wary of negative effects on innovation when dealing with custody regulations; the focus must be on principles because, when efforts are made to regulate technology, “a minute and half later, it will be outdated.” D’Agostino suggested, however, that custody is the “most solvable issue” and that, eventually, firms will get best practices. As digital assets and blockchain technology move toward increased encryption and more anonymity, it is important also to consider potential challenges with regard to anti-money laundering and “know your customer” requirements, he said.

The panelists concluded by noting that cryptocurrencies and blockchains are here to stay and urging industry participants and regulators to embrace technological changes and understand the risks while maintaining a dual focus on innovation and investor protection.

In prepared remarks, Office of Compliance Inspections and Examinations Director Peter Driscoll highlighted OCIE’s efforts to do just that. At the outset, OCIE staff seeks to understand what a given technology or digital asset is designed to do with recognition that markets spur innovations that help investors, he said. OCIE tracks new technology through exams, according to the director, and portfolio management and internal controls get evaluated. When examining a platform trading in digital assets, OCIE staff will assess if it needs to register as exchange, Driscoll stated. OCIE strives to embrace potentials for increased efficiencies and cost reductions, he concluded.

DLT innovations and trends. According to Christopher Ferris of IBM, governance of a permissionless, public blockchain system is the system itself with clients defining and developing governance. However, trust can be increased when a participant knows who he or she is dealing with, he explained; closed systems have identifiable transactions, and “proof of work” and even “proof of stake” are unnecessary. Similar benefits can arise in connection with semiprivate permissioned systems, Ferris noted.

Kevin Werbach of The Wharton School, University of Pennsylvania, suggested that, eventually, there may be no distinction between public and private, and permissioned and permissionless blockchains—just many variants in between. He also opined that something like an “internet” of permissioned blockchains relying on the same security could develop, with blockchains taking advantage of the benefits of each type. However, Todd McDonald of R3 argued that people may not build on top of a permissionless blockchain; like Bitcoin, the particular blockchain already does what it was designed to do, he explained. The panelists agreed that there is a proven benefit to maintaining open source—more eyes on the system means more eyes searching for potential problems, they opined.

The panelists also considered issues surrounding dispute resolution in connection with blockchains. Werbach noted that an arbitration or similar provision possibly could be built into a smart contract, and McDonald concurred that a smart contract could point back to the legal world: the main issue is to coordinate with an existing system while simultaneously trying to change it, he explained. Ferris agreed, suggesting that, moving forward, efforts will be made to more directly integrate blockchain technology with existing systems and separate blockchains with one another. This shift could assist in strengthening identity management and privacy, particularly with regarding to “zero-knowledge proof” of certain information, such as evidence to show you are over 21 without showing a specific age or birthdate, according to Ferris.

Blockchain technology can increase accuracy and efficiencies and decrease costs while still potentially reaching new customers, according to the panelists. Expect to see more blurred lines and integration as the technology continues to evolve, they concluded.