Daniel S. Alter is a Shareholder in the New York, NY office of Murphy & McGonigle P.C. and is the WLF Legal Pulse’s Featured Expert Contributor, Legal & Regulatory Challenges for Digital Assets.
Three cheers for the Securities and Exchange Commission! On October 28, 2019, the SEC’s Division of Trading and Markets issued a no-action letter to Paxos Trust Company, LLC, a New York State chartered trust company (Paxos), essentially permitting Paxos to operate a blockchain-based settlement system without first registering as a clearing agency under Section 17 of the Securities Exchange Act of 1934 (“No-Action Letter”). This may be a baby step for the agency, but it’s nevertheless a very big one.
The No-Action Letter is a baby step because it gives Paxos a license to test its blockchain prototype for only two years and under very limited conditions. Described by the SEC, these conditions are “reasonably designed to ensure that activity remains de minimis through operating parameters designed to limit the scope of operations and manage financial and settlement risk, using, among other things, participation requirements and limits, securities eligibility criteria, margin collection, volume limits, ongoing monitoring, and regular reporting to [SEC] Staff.” In other words, the agency will be keeping a tight rein on the project.
But that’s great! It’s exactly what the SEC should be doing—and much more of it. As with anything else, blockchain applications will improve through trial and error. Given how high the stakes are for the proper clearing and settlement of trades in the securities market, however, it’s critical to work out the kinks of any new technology before handing over the keys. Although entrepreneurs may find excitement in the concept of disruption, the idea of it is pure dread for regulators.
Viewed from that perspective, the SEC’s decision finally to go down this path at all is a very big baby step. And for others looking to make similar headway with the agency, there are at least two important lessons to be learned here:
First, packaging matters. In its request for no action relief, Paxos sought permission from the SEC to conduct a short-term “Feasibility Study.” This was an invitation for the SEC to become proactively involved in determining whether the Paxos system can work to the agency’s satisfaction. It was not a declaration of theoretical superiority with an implicit charge of Luddism. A little humility can go a long way.
The second point is simultaneously both subtle and glaring. So far, commentators have not focused on the fact that the No-Action Letter hinges on a Paxos account at the Depository Trust Company or DTC. The DTC is a “central securities depository”—a common utility that holds securities in certificated or uncertificated form so that they can be transferred between buyers and sellers more quickly via book entries rather than through physical delivery. It is one of the cornerstones of our present market infrastructure.
Paxos proposes to use its own DTC account to hold its clients’ securities in subaccounts. Once a client deposits its securities into the Paxos subaccount, Paxos will create “a digitized security entitlement, which is a digital representation” of the clients’ assets. Paxos will then use those digital representations to clear and settle securities trades on a blockchain, thereby allowing the instantaneous swap of assets for cash in those client subaccounts. The Paxos system purports to reduce clearing and settlement time to 0—an accomplishment that would vastly reduce financial risk in the market and release significant amounts of capital held in reserve pending trade completion.
Ironically, to the blockchain evangelist preaching the good news of disintermediation, this solution is the devil’s design. Instead of removing the inefficiencies and risks associated with trusted financial middleman (like DTC)—which is the fundamental peer-to-peer promise of blockchain technology—Paxos intends to add itself as another layer to the clearing and settlement process. Heresy.
Or is it faithful pragmatism? This model may be a necessary step in the infrastructure evolution. Surely, the SEC found comfort in the idea that client securities will remain at the DTC, a familiar and reliable custodian. And perhaps that backstop convinced the agency to take a big baby step.
Consider, also, there may be other existing market structures onto which blockchain technology might be grafted—at least at first—to accomplish a great benefit. The No-Action Letter reaffirms something obvious yet important; perhaps innovators not so much, but Commissioners need to walk before they can run.