Monday, June 03, 2019

Current state of blockchain technologies, regulatory considerations explored at SEC FinTech Forum

By Brad Rosen, J.D.

Digital ledger technologies (DLT) have captured the world’s imagination over the past decade, observed Valerie Szczepanik, head of the SEC’s FinHub unit, in her opening remarks at the 2019 SEC FinTech Forum. She further noted that we are currently in a build-out phase and are seeing many blockchain-related projects starting to come to fruition. The event, which was hosted by the SEC's Strategic Hub for Innovation and Financial Technology (aka FinHub), attracted some of the nation’s leading experts to discuss the latest trends and developments impacted DLT and digital assets.

Capital formation considerations. The day’s first panel engaged in a lively discussion around capital formation issues in the digital space and was moderated by Jonathan Ingram, Chief Legal Advisor, FinHub, Division of Corporation Finance. The panelists included Joshua Ashley Klayman, Founder and Managing Member, Klayman LLC; Paul Brody, Principal, Ernst & Young; and Aaron Wright, Professor, Cardozo Law School.

In her remarks, Joshua Klayman noted that when digital assets are used for capital formation, the tokens can be structured precisely to the entrepreneur’s liking and requirements. The innovator’s interest doesn’t have to be diluted, nor does control have to be given up. Bespoke negotiations do not have to be entertained with each and every potential investor. With tokens, the entrepreneur is in a better position to say take it or leave it, and that can be very exciting. “The flexibility provided by tokens is tremendous,” observed Klayman.

Aaron Wright sees big interest around STOs (security token offerings which utilize DLT). With STOs, a startup is not limited from raising money from the two coasts, which is often the case now. For instance, he noted that an entrepreneur from Alabama could raise money in Alabama and get funding from his or her own users. In Wright’s view, this could potentially open up the floodgates for funding, and he noted that we have the tools to provide access to capital. “Simply, with STOs, there is the ability to raise lots of capital quickly . . . it’s like putting an investment banker in your pocket,” Wright observed. However, he cautioned that many challenges remain, especially around consumer protection concerns.

Using digital assets to achieve regulatory compliance. According to Paul Brody, digital assets can be used to achieve compliance objectives. He pointed to ERC protocols which can be employed on the Ethereum blockchain such that ownership can be controlled, transfer restrictions can imposed, and anti-money laundering issues can be addressed via the use of smart contracts. Wright concurred, noting that with the power of technology, rules, in effect, can be imposed upon assets. Wright pointed to smart contracts where law is being encoded to effectuate payment flows under legal agreements.

Trading and markets issues. The day’s second panel discussed issues relating to trading and markets in the digital asset space and was moderated by Elizabeth Baird, Deputy Director, Division of Trading and Markets. The panelists included David Forman, Chief Legal Officer, Fidelity Brokerage Services; Mark Weitjen, Managing Director, DTCC; and Neha Narula, Director, MIT Media Lab. The discussion centered around regulatory challenges involving offshore platforms and U.S. persons and disintermediation—the lack of traditional intermediaries in the digital asset space.

Locating risk—in the regulation or technology. According to Mark Weitjen, risk lies both in technology and in regulation. However, with blockchain technologies, redundancies and the consensus mechanism enhance security, in his view. In looking at DLT, or any new technology, Weitjen noted that DTCC asks how that technology delivers a solution, its security, its costs, and the associated risks.

A trustless technology? Baird posed the question whether blockchain technology is trustless and reduces counterparty risk. Most of the panelists expressed their discomfort with the concept. Narula said she was uncomfortable with the term “trustless.” Trust moves around, and you assume market participants are operating in good faith and are motivated by rationality, she observed. David Foreman indicated the concept of trustlessness is somewhat misleading. You have to trust someone, but you don’t need to trust the counterparty to a transaction. Participants should be able to determine the level of trust they are comfortable with, Foreman explained. He added that some participants are only comfortable with keeping their asset under the mattress.

A word about custody. Foreman also outlined the complex issues around digital asset custody. The correct approach depends where the customer is located, who the customer is, who you are, and where the assets are located, he noted. “It’s an alphabet of potential options—and not very efficient…it’s a minefield and easy to get in trouble,” Foreman concluded. He hopes to see progress in this area.