US Broker Pushes SEC to Make Blockchain Rules

US financial firms, concerned about how to implement blockchain technology without running afoul of future regulations, might soon find some long overdue guidance from the Securities and Exchange Commission.

The US regulatory agency has been called to action by Ouisa Capital, a New York broker-dealer that operates an alternative trading system (ATS) for trading unregistered securities. The financial firm took the bold step of petitioning the SEC for formal guidance on the trading of digital assets. It wants to rely on blockchain technology for its ATS, which enables qualified institutional buyers or accredited investors to display non-binding indications of interest and facilitate the purchase and sale of unregistered securities. Those securities, not registered with the SEC, are usually issued through private placements and employee stock benefit plans.

Any guidance provided by the SEC responding to a formal petition for rulemaking would have far-reaching implications for the financial market. Among the questions Ouisa wants the SEC to address is whether digital assets are securities. If so, under what circumstances do firms operating trading platforms using blockchain technology have to register with the SEC as a broker-dealer, ATS or exchange? Should the firm already be registered with the SEC in one of those categories, Ouisa Capital wanted to know if trading in digital assets would trigger new rules.

Although the SEC’s definition of a security is broad, it has not explicitly included digital currencies or other digital assets. “We believe that digital assets in several contexts are securities and that existing laws provide a mechanism for regulation of the issuance and trading of digital assets,” write Ouisa’s chief executive Vincent Molinari and its president Joseph Latona in their letter to the SEC. “However, we encourge the SEC to publish a concept release on the regulation of the issurance and trading of digital assets to provide suitable guidance to the industry followed by the adopton of a new regulation on the same.”

Ouisa’s recent petition to the SEC follows a February 2017 letter to the Financial Industry Regulatory Authority (FINRA) in response to a white paper issued by the broker-dealer self-regulatory agency examining the uses and implications of blockchain. Ouisa raised some of the same issues as in its letter to the SEC, so FINRA could adopt rules as needed. “Ouisa believes that it is time for FINRA and market participants to further analyze whether existing regulations need to be modified to address distributed ledger technology,” wrote Molinari and Latona in their letter to FINRA. Ouisa is registered with the SEC and FINRA as a broker-dealer.

Filing a formal petition with the SEC is one of several approaches a firm can take when seeking the regulatory agency’s clarification about its future actions, explains Richard Levin, Ouisa’s external legal counsel who chairs the fintech and regulation practice at law firm Polsinelli. A firm could also request an informal consultation or a no-action letter whereby the SEC agrees not to initiate any enforcement action against a particular firm uindertaking a certain activity. The SEC might feel far more pressured to take action on a formal request which is just what Ouisa needs.

So far, the SEC has offered no specific guidance on the use of blockchain technology, which blockchain backers warn could hamper its development. Financial institutions, including market infrastructures and banks, have ramped up investments in blockchain over the past two years, but none of their projects have gone live in the US. Those initiatives include the reporting of credit derivative transctions, proxy voting, bond issuance and settlement of syndicated loans. Backers of those blockchain processes might not have felt the same regulatory risk as Ouisa. Hence, there was no need to file a formal petition with the SEC.

Why Worry

Ouisa officials were unavailable for comment at press time. However, in its petition to the SEC, Ouisa indicates that it is concerned that the SEC’s lack of clarity on how a firm can use digital assets and blockchain technology for trading could pose legal liability.  The SEC, Ouisa notes, hasn’t hesitated to take enforcement actions against firms which have unwittingly violated federal securities laws by selling digital shares to the public without registering as broker-dealers. 

Also known as distributed ledger technology, blockchain first emerged as the system underpinning the cryptocurrency bitcoin. Cryptography and distributed computing are used to produce unchangeable records. Each party given access to the network agrees on its records reflecting assets held in digitized form. The attraction of blockchain is its potential to reduce costs and provide legal certainty in the form of immutable records. “When it comes to trading unregistered securities in digital form using blockchain technology, Ouisa can more easily keep track of who are the buyers and sellers,” says Levin. “Ouisa can also more easily ensure that investors hold unregistered securities for the correct period of time, provide transparency and an audit trail.”

In addition to urging the SEC to clarify its position on the use of blockchain technology, Ouisa suggested that the SEC develop a regulatory sandbox. Such an approach, already implemented in the UK and Singapore, would enable firms to experiment with blockchain technology under limited circumstances without excessive regulation. All they would need to do is register with either the SEC or FINRA as participants in the sandbox.

How would Ouisa like the SEC to rule when it comes to trading platforms using blockchain technology? It didn’t offer any inkling in its petition to the SEC, but its letter to FINRA provides some indication.”Any platform that uses DLT that brings together multiple buyers and sellers and uses established non-discretionary methods… should be deemed an exchange and required to register with the SEC unless it elects to register as an ATS,” write Molinari and Latona.”This approach would be consistent with the Exchange Act and applicable rules and regulations thereafter.”