Keyword: blockchain

The Beat Goes On: Division of Investment Management Seeks Input on the Impact of the Custody Rule on Digital Currency – and Vice Versa

As part of its ongoing examination of the Custody Rule, the SEC’s Division of Investment Management is seeking views from the securities industry members and the public on two issues regarding the Custody Rule: (1) the application of that rule to trading that is not handled on a delivery versus payment basis, and (2) the application of the rule to digital assets. In a March 12, 2019 letter to the President and CEO of the Investment Adviser Association published on the SEC’s website (“the Custody Release”), the Division seeks input to expand on its Guidance Update from early 2017. Both issues are important in view of the increasing complexity of types of securities that registered investment advisers are purchasing on behalf of their customers and, as discussed below, the issues overlap in a way that might predict an important use case for blockchain technology.

The Custody Rule

The Custody Rule under the Investment Advisers Act of 1940 provides that it is a fraudulent, deceptive or manipulative act, practice or course of business for a registered investment adviser to have “custody” of client funds or securities unless they are maintained in accordance with the requirements of the Custody Rule. The definition of custody includes arrangements where the adviser has authority over and access to client securities and funds.

By way of context, we note that although the Custody Rule applies only to registered investment advisers, its concepts are relevant for non-registered advisers and other intermediaries as well, since their clients or customers have a practical interest in assuring that: managed assets are appropriately safeguarded; and the absence of appropriate custody arrangements may preclude a client from investing with a particular adviser.

Also, as the Custody Release notes, the Division previously issued a letter inviting engagement on questions relating to the application of the Investment Company Act of 1940, including the custody provisions of that Act, to cryptocurrencies and related products.

The Custody Rule and DVP Arrangements

The Custody Release points out that when an investment adviser manages funds pursuant to delivery versus payment arrangements – that is, when transfers of funds or securities can only be conducted together with a corresponding transfer of securities or funds – then it provides certain protections to customers from misappropriation by the adviser. The Release seeks to assist the Division in gathering information on payment practices that do not involve delivery versus payment, seeking input on, among other things: the variety of instruments that trade on that basis; the risk of misappropriation or loss associated with such trading; and how such trades appear on client accounts statements.

The Custody Rule and Digital Assets

The Custody Release also asks about the extent to which evolving technologies, such as blockchain/distributed ledger technology, provide enhanced client protection in the context of non-delivery versus payment trading. That question presents a good lead-in to the second part of the Custody Release, which seeks to learn “whether and how characteristics particular to digital assets affect compliance with the Custody Rule.” These characteristics include:

– the use of distributed ledger technology to record ownership;

– the use of public and private cryptographic keys to transfer digital assets;

– the “immutability” of blockchains;

– the inability to restore or recover digital assets once lost;

– the generally anonymous nature of DLT transactions; and

– the challenges posed to auditors in examining DLT and digital assets.

With these characteristics in mind, the Division asks are fairly open-ended about the challenges faced by investment advisers in complying with the Custody Rule with respect to digital assets, including:

– to what extent are investment advisers construing digital assets as funds or securities?

– are investment advisers including digital assets in calculating regulatory assets under management in considering with they need to register with the SEC?

– how can concerns about misappropriation of digital assets be addressed?

– what is the process for settlement of digital asset transactions, either with or without an intermediary?

The most forward-looking question asked in the Release is whether digital ledger technology can be used for evidencing ownership of securities. The answer to this question – which could represent a direct application of the blockchain’s ability to record ownership and its immutability – could pave the way to resolving custody concerns with respect to any asset class transacted in by investment advisers on behalf of their clients. It certainly points the way to an important possible use of blockchain technology – to demonstrate custody in a way that is immutable, anonymous and auditable. Technologists, get to work!

The Custody Release’s questions are a significant next step in drawing digital assets into the embrace of investment adviser regulation, but a positive step nonetheless.

Getting Smarter: CFTC Publishes Smart Contracts Primer

The Commodity Futures Trading Commission (CFTC) has joined other agencies in explaining the crypto-related products potentially within its jurisdiction. LabCFTC recently released “A Primer on Smart Contracts” as part of LabCFTC’s effort to “engage with innovators and market participants on a range of financial technology (FinTech) topics.” (LabCFTC itself is a “dedicated function” of the CFTC, launched in 2017 to “make the CFTC more accessible to FinTech innovators.”) As summarized below, the Primer provides (i) a high-level overview of smart contract technology and applications, (ii) a discussion of the potential role of the CFTC in smart contract regulation and (iii) a discussion of the unique risks and governance challenges posed by smart contracts.

The Primer describes smart contracts, fundamentally, as coded computer functions that may either incorporate elements of a binding contract (e.g. offer, acceptance and consideration) or simply execute certain terms of an external contract. Smart contracts allow self-executing computer code to take actions at specified times or based on the occurrence or non-occurrence of an action or event. The Primer also notes that smart contracts can be stored and executed on a distributed ledger, which effectively prevents modifications not authorized or agreed by the parties. It describes distributed ledgers as electronic records that are updated in real time and intended to be maintained on geographically disperse servers or “nodes.” (Distributed ledger technology is the innovation underlying blockchains generally, including the bitcoin blockchain.) As an example of a smart contract in the derivatives context, the Primer describes a credit default swap encoded as a smart contract, whereby the code would (i) automatically make quarterly premium payments from an end-user to a dealer, (ii) check an external financial information source (known as an “oracle”) daily to monitor for credit events with respect to the relevant reference assets, and (iii) if the oracle indicates that a credit event has occurred, calculate and transfer payment from the dealer to the end-user. “Oracle” commonly refers to an external source of information, which the Primer describes as “a mutually agreed upon network authenticated reference data provider (potentially a third-party); this is a source of information to determine actions and/or contractual outcomes, for example, commodity prices, weather data, interest rates, or an event occurrence.”

Regarding the role of the CFTC in regulating smart contracts, the Primer does not state or suggest that the CFTC intends to impose any requirements that would be specific to smart contracts. Rather, noting that derivatives in many cases “may be readily digitized and coded,” the Primer then lists the following types of derivatives products that are subject to CFTC jurisdiction, and states that a given smart contract could constitute any one of them “[d]epending on its structure, operation, and relevant facts and circumstances”: commodities, forward contracts, futures contracts, options on futures contracts and swaps.

The Commodity Exchange Act and related CFTC regulations impose various requirements and restrictions on such transactions, depending on product type. A credit default swap based on a “broad-based” security index, for example, constitutes a “swap” and, as such, may implicate or be subject to swap dealer registration, clearing and execution, reporting and recordkeeping, and other CFTC requirements. Accordingly, absent further guidance or regulations from the CFTC specific to smart contracts, it appears that the Primer’s credit default swap smart contract example described above (assuming it was based on a broad-based security index) would be regulated by the CFTC as a swap, similar to an ordinary, non-smart contract credit default swap based on a broad-based security index. The Primer further clarifies that: “Existing law and regulation apply equally regardless what form a contract takes. Contracts or constituent parts of contracts that are written in code are subject to otherwise applicable law and regulation.”

The Primer also notes that, depending on their “application or product characterization,” smart contracts may be subject to various other legal frameworks, including, among others, federal and state securities laws and regulations; federal, state, and local tax laws and regulations; the Uniform Commercial Code (UCC), the Uniform Electronic Transactions Act (UETA), and the Electronic Signatures in Global and National Commerce Act (ESIGN Act); the Bank Secrecy Act; etc. Finally, the Primer discusses operational, technical, cyber security, and fraud and manipulation risks unique to smart contracts, as well as possible governance standards and frameworks (such as assigning responsibility for smart contract design and operation and establishing mechanisms for dispute resolution).

Recent Reports Show UK and EU (Slowly) Progressing Towards Virtual Currency Regulation

Currently there is no EU-harmonized approach for the specific regulation of virtual currency. In September 2018, the UK’s Treasury Committee released a report on crypto-assets as a part of its ongoing Digital Currencies Inquiry, in which the Committee strongly and unanimously recommended that the UK regulate virtual currencies and initial coin offerings (“ICOs”) as a matter of priority. It will be important for the UK not to be too restrictive as this could drive innovative business away from the UK. The EU Parliament’s All-party Innovation Group has drafted a proposal examining potential new rules that would bring ICOs within the scope of the EU-wide harmonizing crowdfunding regulation that is currently being drafted. While it is certain that any regulation needs to be carefully considered, the lack of a harmonized approach to regulation of ICOs will lead, as is happening currently, to a piecemeal approach across member states that will hamper blockchain developments.

Learn more from this recent Orrick-authored alert.

What FINRA’s Cryptocurrency First Disciplinary Action Means for Employers

The Financial Industry Regulatory Authority (“FINRA”) made it a 2018 goal to monitor and supervise the cryptocurrency market, which has been largely unregulated to-date. In September 2018, FINRA filed its first disciplinary action involving cryptocurrencies alleging securities fraud. What should employers, in particular start-ups or legacy companies with new industry sectors, be aware of regarding legal issues related to these emerging issues?

Learn more from this recent employment law post.

 

Just Another Week on the Blockchain: September 10-16, 2018

The week of September 10th was particularly eventful and saw a rather large number of recent enforcement and regulatory developments, even by blockchain industry standards. Notable actions seen during the week included the first time the SEC has issued an order against a cryptocurrency company for operating an unregistered broker-dealer; the first time the SEC has brought and settled charges against a hedge fund manager that invested in cryptocurrencies while operating as an unregistered investment company; the first FINRA disciplinary action involving cryptocurrencies; a decision by EDNY Judge Raymond Dearie in U.S. v. Zaslavskiy; the authorization of two stablecoin cryptocurrencies pegged to the U.S. dollar by the New York Department of Financial Services; and the release of Chairman Clayton’s “Statement Regarding SEC Staff Views.”

For summaries of these developments, read our recent Blockchain and Cryptocurrency Alert.

SEC Finds Digital Tokens Issued in Exchange for Services Can Still Constitute Securities

In a recent settled enforcement action, In the Matter of Tomahawk Exploration LLC and David Thompson Laurance, the SEC found that the issuance of digital tokens in exchange for services, rather than money, can still constitute an offering of securities.

Learn what this decision might mean for the future of initial coin offerings from this recent Blockchain and Cryptocurrency Alert.

CFTC Chairman Includes Fintech and Virtual Currency in Agency’s Priorities

On July 25th, 2018, CFTC Chairman Giancarlo addressed the House Committee on Agriculture regarding the agency’s priorities and recent work. A significant portion of his testimony focused on the CFTC’s oversight of fintech and cryptocurrencies.

Learn about the CFTC’s regulatory approach to cryptocurrency and distributed ledger technology in this recent derivatives post.