While blockchain has made in-roads in the financial world, when it comes to the U.S. securities market, much work remains to increase adoption, a recent conference sponsored by the U.S. Securities and Exchange Commission (SEC) revealed.
Outstanding issues in the adoption of blockchain, the innovative distributed ledger technology (DLT), include transparency over what digital entrepreneurs are promising, and the technical code supporting such efforts. According to experts, many investors are limited in their understanding of the code and whether it will actually deliver what is promised.
“People say one thing on paper, and another thing in code,” said Aaron Wright of Cardozo Law school during a panel focused on capital formation.
Initial coin offerings (ICOs) have been the primary way entrepreneurs have sought to gain funding for their projects which use blockchain in a variety of ways. For the SEC, there has been a struggle to determine whether such offerings are in fact securities investments and therefore subject to U.S. securities rules.
The SEC has diligently sought to clarify what entrepreneurs should consider in an ICO to determine whether they need to register with the agency. Most recently, FinHub, the agency’s division dedicated to interacting with the fintech community, announced a new “framework” to help market participants assess whether a digital asset is an investment contract, and if it falls within the definition of a security under the U.S. Federal securities laws.
However, some legal experts see the framework putting an onus on entrepreneurs to go the securities registration route, a path that some say hinders the ICO process. “Even with FinHub’s new framework, in most cases, companies issuing digital assets to raise funds are unlikely to avoid the registration and disclosure obligations of the securities laws,” said the law firm King & Spalding in a recent analysis.
The framework, the firm added, does not “signal dramatic changes in the path forward for blockchain companies seeking to access U.S. capital markets.”
That view appeared to be supported by market practitioners at the SEC conference, applying not only in capital-raising, but also in how blockchain and digital technology can be applied in financial markets.
Clearing & settlement
One area that has been often cited as a natural home for blockchain has been the clearing and settlement process in equity markets. Proponents have argued that the process could be made more efficient and provide a golden record of a transaction, helping the audit trail process as well as providing regulators with a real-time view of market forces and trends.
Part of this vision includes the emergence of “decentralized exchanges,” essentially eliminating the need for third parties such as the Depository Trust & Clearing Corporation, which provides clearing and settlement for securities and other markets.
Mark Wetjen, head of global policy at DTCC, questioned the notion of decentralized exchanges at the SEC forum, calling them perhaps “the most difficult from a policy standpoint.” Wetjen, a former CFTC commissioner, also wondered what the benefits would be of moving traditional exchanges onto a DLT, or blockchain platform.
A major sticking point, in his view, is the notion of what constitutes “settlement finality.” Currently, securities transactions have a two-day settlement period, and blockchain advocates argue that transactions could be settled on the same day. But others argue that the two-day settlement owes more to industry convention and preference rather than a technological bottleneck.
The “settlement finality” issue involves knowing precisely when a security has settled — a specific date and time. This is critical for the investors, particularly institutional money managers. “In the case of institutional money management, finality is tremendously important,” said Wetjen, adding that one needed to have a very clear idea of what finality means in a blockchain world before one could see it displacing current processes.
“I don’t think finality translates very well in this space,” added Neha Narula of MIT’s Media Lab.
Foreign regulators also express doubts
Doubts over the ability for DLT to revolutionize markets have emerged on the other side of the Atlantic as well.
A trial project using blockchain to transfer and settle securities and cash proved more costly and less speedy than the traditional way, according to Germany’s central bank president, Jens Weidmann.
The experiment, launched by the Bundesbank together with Deutsche Boerse in 2016, concluded late last year that the prototype “in principle fulfilled all basic regulatory features for financial transactions.” However, Weidmann said the project did not bear those out. “The blockchain solutions did not fare better in every way: the process took a bit longer and resulted in relatively high computational costs,” Weidmann said in late-May according to Bloomberg. “Similar experiences have been made elsewhere in the financial sector. Despite numerous tests of blockchain-based prototypes, a real breakthrough in application is missing so far.”
In addition, the Financial Stability Board (FSB), in a new report, added its own concerns over stability issues in markets and settlement finality. “Whereas risk management, record-keeping and decision-making in traditional cross-border payments take place in a loose (relatively decentralized) network of correspondent banks, initiatives using DLT increase speed and efficiency by automating reconciliation, reducing operational costs or increasing the availability of ‘know-your-customer’ (KYC) data,” the FSB said.
“There remain, however, uncertainties around operational and security aspects of DLT, as well as questions concerning settlement finality, legal underpinnings and governance arrangements. A potential lack of interoperability of some DLT payment systems with existing processes and infrastructures might also decrease overall financial efficiency.”
Solutions are available but more time is needed
All of this is not to suggest that blockchain will not eventually realize the benefits many advocates have preached. “There are solutions to these problems,” David Forman, an executive at Fidelity Brokerage Services, told the SEC gathering.
For its part, SEC officials at the conference offered their own guidance to the blockchain and fintech world. William Hinman, director of the division of corporation finance, said entrepreneurs needed to be able to be clear about where they were in their stage of development. In addition, fintech firms should be able do demonstrate their accounting procedures for digital assets; the capitalization of their enterprises; how their digital coin offerings, or tokens, would be governed and the security of the “private keys” for such tokens.
SEC Commissioner Hester Peirce, meanwhile, emphasized how the agency could work with innovators to reshape securities markets. “The opportune moment is now to work with the developers of new technology to ensure that a well-intentioned legal framework is not an unnecessary barrier to the achievement of something good for society. The legacy that we ought to leave to the next generation is a robust legal framework within which people can explore, experiment, and express themselves in ways that make our society more exceptional,” Peirce told the conference.
The issue, it seems, is simply one of time, effort and patience.