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Regulators confront technology that may upend securities trade

Distributed ledgers may remove the need for intermediaries such as stock exchanges.

Distributed ledger technology, including the blockchain system that backs bitcoin, could remove the need for such intermediaries as stock exchanges, regulators and experts say. (Jack Taylor/Getty Images file photo)

New technology could change the way the securities industry has worked for decades by removing the need for trusted central parties such as stock exchanges.

The potentially disruptive technology is known as the distributed ledger, a decentralized database run by its users rather than a single authority. Current and former financial regulators, academics and trading industry experts said during a recent financial technology panel that these ledgers, which in theory can’t be changed, may remove the need for such intermediaries as stock exchanges.

The panelists spoke Friday at the Fintech Forum sponsored by the Securities and Exchange Commission.

Today’s securities markets rely on exchanges and broker-dealers to bring customers to a central venue for trading, a system of trusted intermediaries that evolved over decades. People wishing to buy or sell stock normally call a broker, as it would be difficult to seek out a trading partner on their own. The broker will, in turn, submit the order to a stock exchange. The traders place their trust with the broker and the exchange and don’t have to trust anyone on the other side of the trade to deliver the securities or cash.

Distributed ledger technology, including the blockchain system that backs bitcoin, could challenge this model.

Indeed, much of the emphasis behind the new technology is the goal of removing the need for a trusted third party, Neha Narula, director of the digital currency initiative of the MIT Media Lab, said during the SEC event. Distributed ledgers provide benefits over the existing system. For one, ledgers don’t necessarily have custody of the assets being traded, so they don’t have the same need for capital that existing stock exchanges have. Stock exchanges are also vulnerable to hacking, she added.

This custody issue is also a challenge. Bitcoin and other cryptocurrencies aren’t physical assets, raising the question of how the accounting and auditing industry should address them. According to Amy Steele, an audit partner at accounting giant Deloitte LLP, auditors require proof of control of the asset before allowing it into the financial statements.

It’s an issue the SEC has on its long-term agenda, said Dalia Blass, the agency’s director of the Division of Investment Management.

Other U.S. regulators have taken steps to address proof of control. The Commodity Futures Trading Commission, for example, issued guidance on when a cryptocurrency transaction has occurred on the basis of how many participants in the ledger agree, according to panelist Mark Wetjen, a former commissioner of the agency.

Another challenge, he acknowledged, is how to correct errors after they are recorded on a distributed ledger. The process of “cancel and correct” is common in trading, according to Elizabeth Baird of the SEC’s Division of Trading and Markets. Yet it runs counter to the design and purpose of a blockchain-based system.

Wetjen is a managing director and head of global public policy at the Depository Trust & Clearing Corp., which handles the settlement for most trades in U.S. stocks. Settlement is the process in which the correct payment is exchanged for stock. Wetjen said he doesn’t anticipate that the new technology will eliminate the need for his organization.

While ledgers offer the promise of quicker settlement than the norm, they wouldn’t result in an entirely new capability. Securities traders have already been able to achieve quick settlement by using cash, the SEC’s Baird said.

Establishing ownership and custody of assets on a distributed ledger isn’t the only challenge, Deloitte’s Steele added. Auditors seek to establish that transactions are legal and made at what is known as arms length, where payments are at market rates. When trades aren’t arms length, there is the possibility of tax fraud, improper revenue or the illusion of more trading than is actually occurring. If auditors don’t know the identity of the other party to a trade, Steele said, it can be difficult to establish that the activity was done at arms length.

Another risk is that customers will lose access to their investments because of hacking, theft or loss of encryption keys. Larger sophisticated investors will find a way to incorporate this risk into their price, according to John D’Agostino, the global leader of investor engagement of DMS Governance, which provides advice to investment funds.

For individual investors, the situation is less rosy.

Investments in cryptocurrency have fewer protections than most others. The Securities Investor Protection Act, a federal law, provides protection against the theft of securities, or in a case in which a broker goes bankrupt. This protection may not extend to cryptocurrencies, according to the SEC’s Baird.

That law has a narrow definition of what constitutes a security and does not consider bitcoins or similar assets to be a form of cash, thus depriving investors of the protection that they have for losses held by traditional brokers, Baird continued.

Absent at the SEC’s all-day event were representatives from stock exchanges or large broker-dealers, whose operations would be at risk because of the new technology. Some of these companies have launched technological efforts incorporating blockchain or other distributed ledger technology to keep pace.

Regulators aren’t planning to sit still through these changes. Any platform that provides trading opportunities to U.S. parties is subject to the SEC’s jurisdiction, according to Brett Redfearn, head of the Division of Trading and Markets. This is still the case if the platform is located in another country. Even if the organization doesn’t conduct trading itself and uses ledgers, the SEC still has authority, he said.

The agency may also consider whether these new platforms should provide added disclosure, especially if they are providing services similar to those of brokers, which are heavily regulated, according to Redfearn.

A goal of the SEC is to consider what regulation is proper as activity moves away from traditional entities such as stock exchanges and brokers, and to decentralized ledgers, he said.

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