The meteoric price spike of bitcoins has piqued the interest of investors, alarmed regulators, and fired up corporate interest in blockchain, the distributed ledger technology chugging away behind the scenes.
As would be expected, a meeting earlier this month of the Securities and Exchange Commission’s Investor Advisory included a discussion on how to protect retail investors lured by the siren call of emerging technology.
Those conversations, however, also fed into an intriguing consideration for the SEC and its regulatory brethren. Could they utilize blockchain for their own oversight and enforcement efforts?
What, exactly, is blockchain? Blockchain, in very simplistic terms, is a storage and transfer mechanism for assets. It is a decentralized and distributed digital ledger that can facilitate any digitized asset (securities, cash, photos, music, books, intellectual property, etc.) recording and verifying transactions across a large network of computer “nodes.” The distributed nature of the system facilitates secure online transactions while ensuring that no single bad actor in the network can tamper with the rules, timing, and execution of a given transaction.
By comparison, centralized payment services are better known, with examples that include MasterCard, Visa, PayPal, and the SWIFT network for banks.
Proponents have touted the technology like an army of smitten carnival barkers. Properly deployed it can, we are told, mitigate the climate crisis, ensure fair and tamper-proof elections; solve the Syrian migrant crisis; and combat world hunger. Separating signal from noise on these prognostications, however, can prove challenging.
The hype surrounding blockchain and distributed ledger technology (DLT) is largely a byproduct of bitcoin buzz and fervor for digital currencies. Startups have raised a record $1.3 billion in the first half of 2017 alone in initial coin offering, SEC Commissioner Kara Stein reported at the Oct 12 Investor Advisory Committee meeting.
No matter the future of bitcoin, blockchain is likely to survive in one form or another. A comparison was made at the SEC meeting to the Linux operating system: While it never really achieved widespread consumer demand, it has thrived as the behind-the-scenes foundation of Apple, Android, and many other commercially successful software platforms. Blockchain, similarly, may ultimately achieve under-the-hood ubiquity.
A boon for regulators? Beyond the implications of newly possible investment products, the SEC has been urged to consider whether blockchain has the potential to both protect investors and enhance market oversight.
“The SEC is going to have more in-depth, real-time access to data,” said Michael Bodson, president and CEO of Depository Trust & Clearing Corporation, a-trade financial services company that provides clearing and settlement services. “[Fraudsters] can’t hide behind a separate database, because there is a single database.”
“These are all great technologies, but you cannot be Pollyannaish and think you can throw it out there and it will work miraculously. If somebody changes a piece of code upstream, then all of a sudden, things aren’t quite the way they are supposed to be.”
Michael Bodson, President & CEO, Depository Trust & Clearing Corp.
With DLT, Bodson said, “a regulator could work with firms and actually see the entirety of their books across all markets and, in real time, see what their real exposure is … It allows them to ask the questions that need to be asked.”
Barbara Roper, director of investor protection for the Consumer Federation of America, pondered the application of distributed ledger technology to investor accreditation, a process that currently relies on income and financial thresholds. “They do not work to identify a population of investors wo have the sophistication to protect themselves in the private markets,” she said of the SEC’s current process.
While urging the development of approaches that would better serve that regulatory function, Roper conceded they would inevitably be more complex and time-consuming.
“In a market where each issuer is responsible for verifying accredited investor status it becomes hugely inefficient,” she said. “You have to have some kind of third-party verification if you want to have a definition of an accredited investor that is more complex than, ‘what’s your net worth and what’s your income?’ Is there a distributed ledger technology solution to that kind of verification function? Is there a regulatory tool for our toolbox that can provide help?”
“Not yet, but there can be,” answered Bodson. “It could be done right now, by creating a centralized database … It would be one more database that everybody has to reconcile to.”
Another burden for regulators, especially when keeping tabs on multinational investors and companies, is coordinating with their counterparts in foreign jurisdictions, said Nancy Liao, associate research scholar at Yale Law School’s Center for the Study of Corporate Law.
“That’s the attractive notion of having a regulatory node sit on a network, because then you can see across portfolios and across jurisdictions,” she said.
“It is really important for regulators to get their hands on these tools and start working with them to test the data, develop best practices, and learn to collaborate with the industry and one another,” says Jeff Bandman, principal of Bandman Advisors, an advisory practice focused on regulatory strategy.
He is in a unique position to evangelize the regulatory potential of blockchain. He is also a member of the Blockchain for Algorithmic Regulation and Compliance initiative at University College London’s Centre for Blockchain Technologies. Previously, he was at the Commodity Futures Trading Commission, serving as FinTech advisor to Chairman J. Christopher Giancarlo and overseeing its creation of LabCFTC, an initiative aimed at promoting responsible innovation.
In his view, blockchain “offers revolutionary potential for decentralized, distributed systems where users can own and control their own data.”
BLOCKCHAIN MADE EASY
The slides below, presented by Nancy Liao, associate research scholar, and the John R. Raben/Sullivan & Cromwell executive director at the Yale Law School Center for the Study of Corporate Law, explained blockchain concepts at a meeting of the SEC’s Investor Advisory Committee.
Source: Nancy Liao, associate research scholar, and the John R. Raben/Sullivan & Cromwell executive director at the Yale Law School Center for the Study of Corporate Law.
“They can determine themselves who is or is not trusted,” he said. “They can determine who has access to their data, their behavioral history, and other information.” This is being explored not just in financial services, but with health records and with digital rights to intellectual property.
A unique risk from distributed or decentralized ledgers is the dispersion of responsibilities. Do parties know they have the risks? Do they have controls in place? How do they monitor them?
“This could be major paradigm shift for regulators,” Bandman said. “We are used to dealing with a central operator, a single responsible adult. Traditionally, regulators regulate registered entities and markets—increased adoption of distributed ledgers, particularly in decentralized models, may require regulators to shift to regulating activities rather than focusing on actors.”
There is, in his view, “transformational opportunities for regulators to harness real-time data” from distributed ledger technology and empower real-time regulation.
“With distributed ledgers, data becomes available on the ledger right away to everyone with access and permission to see it,” Bandman said. “Data becomes available in real-time not only to the parties to the transaction, it can also be made available and visible to regulators, who may have what are called ‘regulator nodes’ or ‘auditor nodes.’ ”
“This is a transformational shift from the way regulators receive data and see markets today,” he added. “It may offer a completely new paradigm of the reporting regulators rely on.”
Currently, most data and reporting comes into regulators at the end of the day, or else the next day, or later (at the end of a month or quarter), Bandman explained, adding that “regulators are seeing events in the rear-view mirror, well after they have already occurred.”
“With this new, next-generation technology, and harnessing real-time data from distributed ledgers, future regulators may be able to monitor events as they unfold,” he said. “To see through the windshield, instead of the rear-view mirror. They may be able to detect wrongdoing, or predatory or deceptive practices, at a much earlier stage.”
Obstacles to regulatory innovation. Bandman conceded that there are “basic obstacles” to regulatory adoption of blockchain technology that may require Congressional assistance.
Most technology startups are have not gone through the process and expense to become approved government contractors, he explained. Regulators are generally a small market, not the primary market, so this process is viewed as a time-consuming distraction, perhaps to be considered at a more mature stage of the business.
Procurement also requires a competitive bid from multiple providers, and there may not be multiple providers of some of these new tools and technologies. Needed waivers could take months to obtain.
Ethics rules “pose another well-intentioned obstacle,” he said.
Startups often license technology to prospective users on a pilot basis at reduced or no cost. Businesses are then able to explore new technologies in a cost-effective way. For regulators, however, accepting technology at below full fair market value can be deemed a “gift” of the amount of the difference, running afoul of ethics laws.
“It may even be seen as thwarting the will of the Congress under the Anti-Deficiency Act, because Congress set the regulator’s appropriations,” Bandman added. “No responsible regulator wants to be thwarting the will of Congress.”
CFTC Commissioner Brian Quintenz described the quandary during a recent speech.
“Interestingly, a legal barrier has actually prevented us as a federal agency from effectively ‘demo-ing’ technology and having the same authorities and flexibilities as some of our foreign counterparts to work on ‘proof of concept’ projects with innovators,” he said. “Ethics rules preclude the agency from accepting ‘anything of value’ without providing fair compensation. However, providing compensation would trigger an arduous and tightly framed procurement process, making sandbox demos enormously burdensome and time consuming.”
Congressman Patrick McHenry (R-N.C.), chairman of the House Innovation Caucus, has said he is working on a legislative fix.
One potential solution is to establish de minimis dollar threshold that would allow regulators to implement small-scale, experimental FinTech and RegTech procurements outside of existing procedures, along with narrowly tailored and proportionate ethics exceptions, Bandman said.
He also expressed support for a Congressionally created “sandbox for regulators,” where they can explore these new technologies while complying with procurement and ethics requirements.
Despite the cheerleading, not all members of the Investor Advisory Committee were won over to the benefits of either bitcoin of blockchain.
Anne Simpson, investment director, sustainability, at the California Public Employees’ Retirement System, said the excitement reminded her of “Tulip mania,” an overvaluing of the flowers that led to a Dutch economic crisis in 1636.
“It’s a Tinkerbell,” she said. “It is a Tinkerbell effect. You all know Peter Pan: You must all believe in fairies because then she will exist.”
DTCC’s Bodson admitted to having his own concerns. “What happens if something goes wrong? Who has the authority to reverse it? Who presses the button because it is a bad code and can turn it off? At the end of the day it is code. People write code, and people make mistakes,” he said. “These are all great technologies, but you cannot be Pollyannaish and think you can throw it out there and it will work miraculously. If somebody changes a piece of code upstream, then all of a sudden, things aren’t quite the way they are supposed to be.”