Blockchain and distributed ledger technology (“DLT”) applications outside of the bitcoin context are attracting the attention of financial entities, prompting regulators to become increasingly focused on these possible applications. Recently, for example: (i) potential financial and securities applications of DLT were discussed in depth at a “FinTech Forum” held at the Securities and Exchange Commission (“SEC”); (ii) the Federal Reserve Board published a paper titled “Distributed Ledger Technology in Payments, Clearing, and Settlement”; and (iii) the Financial Industry Regulatory Authority (“FINRA”) published a paper titled “Distributed Ledger Technology: Implications of Blockchain for the Securities Industry.” Each of these recent developments is discussed in turn below.
1) DLT Discussion at the SEC FinTech Forum
The DLT portion of the FinTech Forum featured panelists from a financial institution, academia, a major accounting firm, and a software company focused on DLT.
The panelists covered the following topics, among others:
- DLT may offer an alternative to the varied recordkeeping systems used by various financial intermediaries and, in such capacity, provide enhanced efficiencies and technological capabilities.
- Smart contract technology may supplant certain middle and back office functions by enabling the transfer of digital assets and automating the steps that trigger the occurrence of particular lifecycle events.
- As an example of an early adopter, the Australian Stock Exchange Group is in the process of changing its current clearing and settlement system for equities to incorporate DLT. The technology is expected to reduce costs for both the Exchange and its member firms, primarily by eliminating certain reconciliation-related processes. The incorporation of DLT is also expected to provide increased transparency, which should benefit regulators, among other parties. The Australian Stock Exchange Group is also considering using DLT to change its current T+2 settlement cycle to a more optimal settlement cycle.
- Another potential early adopter, the Depository Trust & Clearing Corporation, recently tested DLT and smart contract software that would handle data storage and lifecycle processing services for credit default swaps. Again, the technology is expected to reduce costs and eliminate various reconciliation-related processes.
- Others exploring DLT applications include: participants in the health sector (applications for recordkeeping for clinical trials and other information); state governments (public recordkeeping, including registration of certain assets); energy companies (creation of virtual grids to track distribution of energy); intergovernmental agencies (digital identification of people globally to track availability of resources); industrial companies (tracking cash for specific suppliers and customers); financial services (real-time payments, corporate loans, trade finance, etc.); custodial banks (collateral tracking and usage); and insurance companies (management of claims).
The panelists also discussed opportunities and benefits that DLT may present to regulators and auditors, including the possibility of regulators and auditors themselves acting as “nodes” on a distributed ledger, which would enable them to effectively monitor the market and market participants. According to certain panelists, DLT potentially could allow real-time, ongoing auditing, and examining data “as it moves” may offer advantages over the current general auditing practice of examining and providing assurance opinions on the systems and control environments in which relevant data are created and maintained.
2) Federal Reserve Paper
The Federal Reserve paper contains a substantial section on legal considerations relating to DLT applications in payments, clearing, and settlement (“PCS”). This section of the paper emphasizes at the outset that the laws and regulations applicable to PCS may affect the manner, speed, and extent of adoption of DLT for a particular use case, and, therefore, the legal framework should be carefully considered as the PCS industry further develops DLT use cases. The paper then discusses the following issues within the existing legal framework:
- DLT purportedly allows an auditable record of information that is simultaneously updated and distributed among market participants. However, distributed ledgers should be designed to provide assurances that, under existing laws, information stored on the stored ledgers has a sound legal basis and complies with applicable recordkeeping requirements. Alternatively, existing statutes and rules may need to be modified to accommodate recordkeeping through DLT.
- Under current legal frameworks, ownership interests in securities, negotiable instruments, and other assets are often represented using physical or book-entry records. Whether the digital representation of ownership interests on a distributed ledger is consistent with these current legal frameworks requires detailed legal analysis, and contractual agreements or new laws and regulations may be needed.
- The automated nature of “smart contracts” may conflict with various doctrines under contract law, such as voiding unconscionable contracts or amending contracts due to changed circumstances. Accordingly, the legal basis and evidentiary status of certain smart contracts is currently unclear.
- Emergent firms that act as traditional financial intermediaries but incorporate DLT into their business likely will require a charter or license for holding and transferring assets on behalf of households or businesses. Lawmakers and regulators may need to consider whether existing financial institution licenses are sufficient, or whether alternative licenses should be developed, similar to the New York State “BitLicense” in the cryptocurrency space.
- As DLT matures, the appropriate governmental agencies likely will need to provide guidance on the application of the Bank Secrecy Act (“BSA”) and anti-money-laundering requirements (“AML”), which subject a variety of intermediaries, including banks, money services businesses, and broker-dealers, to various requirements.
3) FINRA Paper
The FINRA paper examines the regulatory implications of broker-dealers issuing and trading securities, facilitating automated actions such as payment of coupons, and maintaining records on distributed ledgers. The paper discusses the following issues, among others:
- Broker-dealers handling customer funds and securities are subject to various requirements under the securities laws, including the requirement under Rule 15c3-3 to “maintain physical possession or control over customers’ fully paid and excess margin securities.” These requirements may be implicated as broker-dealers use DLT to hold funds and securities.
- Broker-dealers are generally required to maintain minimum net capital (consisting of highly liquid securities) at all times. How cryptosecurities, digital currency, or other cash-based token holdings may affect a broker-dealer’s net-capital computation remains unclear.
- SEC and FINRA rules subject broker-dealers to various recordkeeping requirements. Whether such records would satisfy applicable requirements should be taken into account by broker-dealers considering developing and maintaining records on a distributed ledger.
- Careful analysis may be required to determine whether particular DLT applications fit within the current regulatory framework for clearance and settlement of securities transactions. For example, DLT potentially could blur the distinction between trade execution and settlement. Accordingly, certain uses of DLT may require broker-dealers to be registered as clearing agencies.
- Various market participants are currently testing centralized identity management functions whereby, once the identity of a customer is verified by an entity on the distributed ledger, that information is made available to all parties on the distributed ledger. Such a function potentially could create efficiencies by eliminating duplicative verification of customer identities by various entities. However, this practice may conflict with the BSA requirement that broker-dealers verify the identities of all parties with which they establish a formal relationship to effect securities transactions.
- Information maintained or shared on a distributed ledger (even if encrypted) may implicate various customer data privacy requirements applicable to broker-dealers. For example, broker-dealers must maintain written policies and procedures for the protection of customer information and records, provide periodic privacy notices to customers describing information sharing policies and informing customers of their rights, and, in certain cases, develop identity theft prevention programs.
- Broker-dealers that undergo a material change in business operations are required to file a “Continuing Membership Application” (“CMA”) with FINRA prior to implementing the material change. Filing a CMA with FINRA may be necessary where a broker-dealer employs DLT in its business.
The intense interest of regulators and other agencies in DLT applications suggests that DLT and regulation likely will evolve together, each occasionally being tailored to accommodate the other.
 A previous posting in Derivatives in Review (available here) provides an overview of DLT and also discusses certain Commodity Futures Trading Commission DLT-related developments. As discussed in that posting, all participants in a distributed ledger have their own identical copies of the same ledger, and any changes to the distributed ledger are quickly reflected on all copies. Participants are able to update the distributed ledger with new entries, but cannot retroactively change the distributed ledger. A distributed ledger can include any type of information that can exist in traditional paper form. The security and accuracy of a distributed ledger is ensured through mathematical and computation processes known as cryptology. The “blockchain,” the central innovation that makes DLT viable, enables ledger entries to be aggregated into “blocks” that, through cryptology, are added to an ever-expanding “chain.” Blockchain technology was invented in 2008 to create and facilitate transactions in bitcoin, a type of peer-to-peer virtual currency. However, being essentially an asset database, a distributed ledger also may be used to record financial, legal, physical, electronic, and other types of assets.
 Distributed Ledger Technology in Payments, Clearing, and Settlement, Federal Reserve Board Finance and Economics Discussion Series 2016-095 (2016) (available at: https://www.federalreserve.gov/econresdata/feds/2016/files/2016095pap.pdf); Distributed Ledger Technology: Implications of Blockchain for the Securities Industry, a Report from the Financial Industry Regulatory Authority (January 2017) (available at: http://www.finra.org/sites/default/files/FINRA_Blockchain_Report.pdf).
 Certain distributed ledgers allow a layer of applications called “smart contracts” to be incorporated into the ledger. Smart contracts automate specified transactional events based on the contractual terms, and self-execute as such events occur. For example, a smart contract might be used to automate coupon payments for a corporate bond.
 A “node” generally is an entity that is involved in the computational processes that cause a distributed ledger to operate and that has a local copy of the entire distributed ledger.
 See note 3 above regarding the meaning of “smart contract.”
 Previous postings in Derivatives in Review (available here) have discussed the New York BitLicense.