Straight from the horse’s mouth, US broker-dealers have just been advised about the many ways their use of blockchain could impact their compliance with rules imposed by the Financial Industry Regulatory Authority (FINRA) — including recordkeeping, clearance and settlement, anti-money laundering, trade reporting and customer statements.
FINRA , the US self-regulatory agency for broker-dealers, has issued a white paper examining the uses and implications of distributed ledger technology (DLT), which relies on cryptography and distributed computing to produce unchangeable records shared by all parties. The FINRA report details the impacts DLT may have on market efficiencies, transparency, the role of intermediaries and operational risk. It also raises questions about governance, liability and network security that broker-dealers should consider before using DLT for any applications.
However, for brokerage compliance managers, the most significant element of the report is the cautionary advice FINRA provides on following current rules if DLT is adopted. “Many FINRA rules as well as rules implemented by other regulators, such as the Securities and Exchange Commission, that FINRA is responsible for examining or enforcing with respect to broker-dealers are potentially implicated by various DLT applications,” says FINRA.
The regulatory guidance has been long awaited. DLT has been widely touted as having the potential to reduce operating costs. A recent report from the World Economic Forum estimates that over US$14 billion has been invested in blockchain projects over the past three years. Nevertheless, brokerage compliance managers tell FinOps Report that they have been hesitant to embrace the new technology without clearer regulatory guidance.
So far, the SEC has only suggested that financial firms would have to follow existing rules governing their activities using blockchain. FINRA’s white paper is far more granular in explaining which of its rules and those of the SEC are impacted. They often overlap.
The following represents five categories of rules which broker-dealers must follow if they do business on DLT.
Broker-dealers are subject to recordkeeping requirements under FINRA Rule 4511 and the Exchange Act Rules 17a-3 and 17a-4. The rules outline the minimum requirements regarding the types of records that must be made, as well as the length of time that broker-dealers must maintain the records and other documents pertaining to their business. “To the extent broker-dealers seek to maintain books and records on the DLT network they would need to consider whether this approach would meet the requirements of Rules 17a-3 and 17a-4,” says FINRA.
The agency also says that when using DLT, broker-dealers need to consider what information is maintained on the DLT network, where the information is physically located, who has access to the information, how the DLT network would interact with the firm’s own systems for recordkeeping, how the records would be made available to regulators, and how to protect any required records from loss or damage.
2) Clearance and Settlement
Although DLT supporter see DLT reducing the settlement cycle to virtually real-time, no one expects that optimistic scenario to happen any time soon. There are too many entrenched interests that want to preserve the status quo of clearinghouses and depositories. However, FINRA isn’t taking any chances.
The agency says that clearance and settlement of securities trades under a DLT environment could require two significant changes to a broker-dealer’s contractual obligations. For starters, a broker-dealer would need to consider whether any of their activities would fall under those of a clearing agency. If those functions do, the broker-dealer would have to register with the SEC as a clearing agency.
FINRA also wants broker-dealers to be aware that clearing and settling trades on a DLT platform would affect the contractual relationship between introducing brokers and clearing brokers, otherwise known as the carrying brokers. FINRA says that carrying brokers who use a DLT platform must ensure they comply with FINRA Rule 4311 which requires them to ask FINRA for approval of any new agreements. They might also have to change existing agreements with introducing brokers, whose primary purpose is to maintain customer relationships.
3) AML and Customer Identification
Broker-dealers must follow FINRA Rule 3310 which requires them to maintain a written anti-money-laundering program to comply with the requirements of the federal Bank Secrecy Act. Broker-dealers must also comply with FINRA Rule 2090 which requires them to use “reasonable diligence” in identifying their customers when opening accounts.
Outsourcing AML and know-your-customer requirements doesn’t absolve a broker-dealer from legal liability. Therefore, FINRA suggests that when a broker-dealer uses a third-party centralized identity management utility operating on a blockchain platform, it verify that the central facility’s operations meet FINRA’s AML and know-your-customer requirements. Among the questions FINRA urges broker-dealers to ask themselves are how dynamic is the central facility’s customer verification process and whether they can supervise and test the process.
4) Trade and Order Reporting
Broker-dealers must now report certain order and trade related information into one of several FINRA-operated facilities depending on the type of financial instrument. FINRA says they must make certain to do the same even when the transactions are executed over a DLT-enabled platform. For example, FINRA’s Rules 6100 and 6400 require broker-dealers to report over-the-counter transactions in equities to either the Trade Reporting Facility, the Alternative Display Facility or the OTC reporting facility. FINRA Rule 6700 says that broker-dealers must report transactions in fixed-income securities to FINRA’s TRACE facility.
5) Customer Confirmations and Statements
Broker-dealers using DLT must ensure they comply with two critical FINRA rules affecting their interactions with customers. One of them, FINRA’s Rule 2232, requires broker-dealers to provide customers with details of their trades either before or after completion. The other, Rule 2340, says that broker-dealers must also provide account statements at least quarterly with information on cash balances, security positions and any other activity.
Among the questions broker-dealers must ask themselves, according to FINRA, is whether they will have sufficient access to data on a DLT network to generate confirmation and account statements. Broker-dealers must also know how information on their compensation and fees will be reflected on those statements. If broker-dealers using a DLT network incur extra or increased customer fees they also need to keep in mind related FINRA Rules 2121 and 2122, which require that any commissions and extra fees be fair and reasonable. Of course, broker-dealers need to determine how to structure any new fees incurred as the result of using DLT.
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