On Monday, November 14, 2016, the Securities and Exchange Commission (SEC) hosted a forum to discuss financial technology (FinTech) innovation in the financial services industry. The summit discussed several topics, but the second panel, titled “Impact of Recent Innovation on Trading, Settlement, and Clearance Activities,” specifically addressed blockchain-enabled distributed ledger technology and its applicability in corporate environments. The panel provided an opportunity for the SEC to highlight blockchain’s potential for assisting companies in meeting compliance requirements, cutting costs with respect to record keeping and tracking assets, and disintermediating transactions.
Corporations have begun to seriously examine the opportunities made available by blockchain-enabled distributed ledger technology beyond digital currency, in areas ranging from financial services and retail supply chains to art and music. Unlike Bitcoin, where the blockchain provides a transfer mechanism and ledger for the intangible currency, digital ledger technology also may provide a distributed, often a privately managed system of records for a wide variety of transactions.
The advantages of using the blockchain as an organizationally-managed distributed ledger are distinct. First, the blockchain provides ledger technology that distributes the cost of maintaining and validating a record among multiple parties. This removes the need for a single point of failure, and reduces expenses and risk associated with entrusting a centralized intermediary. Second, organizations can use blockchain technology to provide a permanent shared or public record, which allows third-party individual or organizations and regulators to access the blockchain, validate transactions and ensure compliance on an independent basis.
In the diamond industry, for example, a retailer may process the purchase or sale of a diamond by hashing the physical aspects of a diamond along with the ownership information and then submitting the hash as a new “block” for inclusion in the blockchain. A network of organizations designated as validators then independently processes the “block” and arrives at the consensus on the validity of the transaction. A transaction may be invalid, for instance, if the hash of the diamond and the seller’s information does not match the blockchain hash corresponding with the previous owners. Through this process, diamond retailers can generate a decentralized, verifiable chain of ownership and record of provenance. Likewise, law enforcement agencies or diamond insurers, in turn, may verify the authenticity and ownership of a diamond by similarly hashing its physical characteristics and ownership information and comparing it with hashes already recorded in the blockchain.
The blockchain is equally useful in ensuring the integrity and authenticity of business records. Fields such as financial markets, insurance and mortgages often require parties to reconcile key legal documents and other artifacts. By hashing a document and comparing it to previous document hashes recorded in the mutually-shared blockchain, parties can guarantee the authenticity of the documentation and the integrity of their processes. During an SEC FinTech Forum, for example, Digital Asset’s Chief Business Development Officer Chris Church noted that they are working with the Australian Securities Exchange (ASX) to build a new clearing and settlement system for cash equities utilizing distributed ledger technology to drive down internal and external costs, provide increased transparency to regulators, and reduce systemic risk, such as during the settlement cycle. Likewise, Depository Trust & Clearing Corporation (DTCC) Global Public Policy Head Mark Wetjen noted that DTCC is exploring ways to leverage distributed ledger technology to improve efficiencies in its current service offering that provides data storage and lifecycle processing for credit default swaps, as the market has shrunk since the financial crisis.
In addition, many start-ups, particularly those in creative industries, have pioneered novel and innovative uses for the blockchain. Several start-ups have applied the blockchain to record and validate the record of provenance for art. For digital art, dealers could use digital hashes of the art piece itself to invalidate digital copies made surreptitiously and shared online. Several start-ups have applied blockchain technology to record ownership rights for digital music purchases.
Currently, little regulation applies to the use of the blockchain as privately-managed distributed ledger technology (as opposed to a publicly managed cryptocurrency). Nevertheless, companies may use blockchain technology to address industry-specific corporate, statutory and regulatory compliance requirements. Banks, for example, must maintain and report certain currency transactions pursuant to the Anti-Money Laundering rules under the Bank Secrecy Act and submit to compliance audits on an annual basis. To the extent that banks use the blockchain to record and guarantee the integrity of currency transactions, then their implementation of that technology will likewise fall under the Anti-Money Laundering rules. Similarly, many state money transmitter laws require companies licensed as money transmitters to undergo periodic investigations to verify the company can account for the money transmissions they processed and that such transmissions were conducted in a lawful manner. (See, e.g., N.Y. Banking Laws § 641, Cal. Fin Code § 2032) Blockchain technology may play a key role in meeting these requirements by providing a shared, unalterable and easily verifiable account of transmissions processed.
In addition, some agencies are seeking to regulate the use of blockchain in financial services. Recently, the SEC released a notice for proposed rulemaking to modernize the regulations governing the role of transfer agents in security clearance and settlement processes. Among other issues, the notice seeks comment on what utility a distributed public ledger system would have for transfer agents and what regulatory actions would facilitate that utility.
Industry experts note that blockchain technology currently may be constrained in the speed in which it can process transactions and that its advantages are heavily dependent in how the technology is implemented and governed. Researchers estimate that, due to the computational and validation requirements, blockchain technology currently only processes a few transactions per second processed in batches ten minutes apart. Blockchain’s cryptographic technology is also relatively complicated to implement. Accruing the benefits of sharing the task of validating and maintaining a blockchain would require several organizations in an area to possess both the requisite technical knowledge and the will to maintain a mutual blockchain.
Accordingly, participants in the SEC’s forum on financial technology noted that many companies are currently examining the blockchain as an alternative technology, one that can bring efficiencies to financial markets, compliance audits and other business processes, but that also poses challenges. Organizations interested in leveraging the blockchain should carefully assess their readiness before incorporating it into their processes. Blockchain provides a novel and effective tool for improving the transparency and verifiability of key processes and may greatly reduce the costs of relying on or acting as centralized intermediaries. However, important factors to consider include the organization’s technical competence in implementing distributed ledger technology, the potential need by multiple parties or organizations to share and update mutually-owned information, potential over-reliance on a centralized intermediary, the time-sensitivity of transactions, and potentially applicable regulations. For more information regarding the opportunities and considerations involved in blockchain-enabled distributed ledger technology, please contact Reed Smith at mailto:KLarsen@reedsmith.com.