By Mark S. Nelson, J.D.
A no-action letter issued by the SEC’s division of Trading and Markets to Paxos Trust Company, LLC will allow Paxos to conduct a 24-month test of its Paxos Settlement Service (PSS) using distributed ledger technology (DLT). Paxos had raised the possibility that, absent no-action relief, its production test of the PSS could make it an unregistered clearing agency without a relevant registration exemption. The exact role of the SEC’s clearing agency regulations in the DLT/blockchain space was not directly addressed in the SEC’s key documents on digital asset securities, such as the DAO Report or the SEC’s "Framework," both of which focus on investment contracts, although several other divisional statements strongly hint at the requirements for clearing agencies. As a result, the Paxos no-action letter will serve as one example of how DLT/blockchain activities might be addressed in the clearing agency context, but it remains to be seen if such relief can be scaled up for a larger group of securities with much higher trading volumes on a permanent basis.
A Paxos press release emphasized that the PSS would be the first settlement system for U.S. equities that was not part of the legacy market infrastructure developed nearly 50 years ago. "The U.S. equities business continues to face unprecedented consolidation and economic pressures, requiring a comprehensive transformation of market structure," said Paxos CEO and co-founder Charles Cascarilla. "This is an important first step on our journey to reimagine the entire post-trade infrastructure, and one that creates immediate benefits for market participants." Cascarilla added that the PSS could be scaled up for other asset classes and clients.
Paxos’s website explains its business as that of attempting to "democratize access to a new, global, frictionless economy." The company also boasts several prominent directors, including former Senator and Democratic presidential candidate Bill Bradley and former FDIC Chairwoman Sheila Bair.
PSS production test. The PSS is designed to test the feasibility of using DLT to settle equity trades. Specifically, the PSS leverages multiple accounts at Paxos and The Depository Trust Co. plus wire transfers from participants to a Paxos bank account to create a "digitized security entitlement" that is credited to a participant’s account within the PSS on the Paxos ledger. However, the PSS trial, at least initially, will not attempt corporate actions processing (e.g., dividend payments), so PSS participants will have to transfer their securities from their PSS Accounts to their DTC accounts nightly. The PSS will utilize a private, permissioned DLT.
Paxos argued in its no-action request letter that its PSS would be consistent with the Congressional findings expressed in Exchange Act Section 17A(a)(1)(C): "New data processing and communications techniques create the opportunity for more efficient, effective, and safe procedures for clearance and settlement." Paxos, for example, said its PSS would bring several benefits, including faster settlement through the use of T+0 or T+1 and not just the current standard of T+2. The PSS also would facilitate enhanced intraday liquidity by employing a simultaneous delivery versus payment process that results in settlements that are irrevocable and unconditional.
According to the Division of Trading and Markets, its staff will not recommend enforcement against Paxos if Paxos conducts a test to gauge the feasibility of operating a settlement system for U.S.-listed equity securities without registering as a clearing agency. The SEC’s reply to Paxos’s request emphasized that the no-action relief would be granted for a limited time for the purpose of processing a de minimis volume of trades in a small number of equity securities, which themselves will subject to multiple selection criteria. Paxos must begin to wind up the test one month before the end of the 24-month test period.
More specifically, the PSS trial will adhere to a number of parameters, including: (1) a limit of seven participants; (2) securities will be public securities registered under Securities Act Section 6 or Exchange Act Section 12; (3) a security must satisfy six criteria, including being a component of the Dow, S&P 500, or the Russell 1000; and (4) trading must comply with volume limits. Paxos said it will monitor for compliance with the parameters of the test period.
Registration looms without no-action relief. The SEC has on at least two occasions warned securities markets participants that some entities engaged in the business of digital asset securities may have to comply with the regulations for clearing agencies. The SEC’s guidance on whether digital asset securities are investment contracts, however, is far more detailed than its several statements on market participants such as exchanges and clearing agencies operating in the same space.
In its November 2018 Statement on Digital Asset Securities Issuance and Trading, the Division of Trading and Markets along with the Division of Corporation Finance and the Division of Investment Management, expressed numerous concerns about the trading of digital asset securities. The last footnote to the statement observed that regulations applicable to clearing agencies also could be relevant in this context. In March 2018, the Division of Trading and Markets and the Division of Enforcement also had warned that some entities may need to register as clearing agencies in a Statement on Potentially Unlawful Online Platforms for Trading Digital Assets .
Exchange Act Section 17A(b)(1) mandates that clearing agencies be registered. Under Exchange Act Section 3(a)(23), a "clearing agency" is any person who, among other things, acts as an intermediary in making payments or deliveries in connection with securities transactions. The statutory definition also provides a long list of entities that are excluded from the definition, including national securities exchanges, national securities associations, or broker-dealers solely because they perform certain specified activities.