A novel approach
There have been numerous voices urging the Securities and Exchange Commission (“SEC”) to emulate some foreign counterparts and take a “sandbox” approach to permit novel experiments in its regulatory jurisdiction, particularly in the blockchain, or fintech, space. Now, the SEC’s Division of Trading and Markets (“Division”) has taken a “no-action” position that effectively does just that. And, surprisingly, the no-action letter (“NAL”) addresses the issue of clearing agency registration.
This is surprising because it appears to be the first time that the SEC has taken a no-action position approach to clearing agency registration. Previous instances that allowed an entity to perform clearing agency functions without registration have required grants of exemptions. In the present situation, the Division has assured Paxos Trust Company, LLC (“Paxos”) that the Division will not recommend that the SEC take enforcement action if Paxos operates as described in its letter requesting a no-action position.
It also is surprising because Paxos conceded that it would be performing clearing agency functions but was not registered and did not have an exemption to so operate. Section 17A(b)(1) of the Securities Exchange Act of 1934 (“Exchange Act”) states that it is unlawful to operate as a clearing agency without registration or an exemption. A Division no-action position, unlike an exemption, would not shield Paxos from charges that it violated this statute.
Finally, it is also surprising that the SEC has initiated a sandbox approach on an ad hoc basis. Although it has been discussed inside and outside the SEC for some time, the SEC has not established any framework, parameters, or controls to permit such experiments.
Nevertheless, the Division appears to think that it is worthwhile to allow Paxos to conduct a limited experiment to assess the utility of blockchain technology in clearing and settling securities transactions in a production environment, which is referred to as “The Feasibility Study No-Action Phase” of Paxos’s operation. In making it request, Paxos stated that it “believes that the Paxos Settlement Service technology and data processing techniques have the potential to provide unique advancements in the clearance and settlement of securities transactions including facilitation of more efficient settlement, immediacy of access to settlement proceeds, greater data accuracy and transparency, advanced security, and increased levels of availability and operational efficiency,” thus furthering Congressional objectives for the national clearance and settlement system.
Paxos will have an account at The Depository Trust Company (“DTC”), the sole depository for the vast majority of securities traded in the U.S. markets. Paxos will have its own “participants” that will transfer securities from their DTC accounts to Paxos’s DTC account for the purpose of clearing and settling trades between the participants utilizing the Paxos Settlement Service (“PSS”). Participants also will deposit cash with Paxos to fund settlement of their trades submitted to the PSS, and Paxos will deposit the cash in U.S. banks. Paxos will establish a subaccount for each participant, and the securities and cash positions in the subaccount will be represented by digitized securities entitlements on the Paxos “private and permissioned distributed ledger system.” PSS participants will submit trade details to PSS in near real-time, and each participant must have the required securities or cash in its PSS account by each trade’s settlement date.
The experiment is constrained in a number of ways to avoid a significant impact on the United States securities trading markets, including:
- A maximum of seven participants, all of which must be registered broker-dealers, Financial Industry Regulatory Authority members, and DTC participants;
- Participants must meet minimum capitalization standards, and provide financial information to Paxos;
- Participants may submit only certain highly liquid equity securities to PSS for clearance and settlement;
- All trades will be settled bilaterally on a gross trade-by-trade basis without any netting of the gross trades;
- Daily volume limits are designed to constrain expected volume and exposures between participants;
- Paxos has established risk controls, including daily mark-to-market margin collection;
- Paxos will monitor activity for compliance with the eligibility criteria;
- Paxos will provide regular and ad hoc reports to the Division about activity on the system; and
- The operation of the PSS will terminate after 24 months.
As suggested above, the Paxos NAL raises a number of questions, such as:
- Is the SEC now open to other sandbox approaches in the clearing agency space or otherwise?
- Is the SEC willing to allow registrants to rely on the blockchain for recordkeeping purposes? The source records for trades settled through PSS appear to be blockchain based. Could a broker-dealer, for example rely on a blockchain to maintain its records pursuant to Rule 17a-4(f) under the Exchange Act?
- Is the ad hoc approach workable in this or other regulatory contexts?
We hope to see the SEC and its staff approve more experiments in the regulatory sandbox like PSS.
 See, e.g., Transcript of “FINTECH FORUM: THE EVOLVING FINANCIAL MARKETPLACE (November 14, 2016) (“I encourage the panelists to tackle the difficult regulatory questions that Fintech presents. We should also explore various constructs that have been proposed, both domestically and internationally, such as regulatory sandboxes, to encourage Fintech innovations without creating undue risks to the marketplace or imposing artificial limits on activities.” Remarks of SEC Commissioner Piwowar).
 If the SEC had contemplated issuing an exemption, the request would have been published for public comment.
 A staff no-action position would not preclude the SEC from instituting an enforcement action alleging a violation of Section 17A.
 It does not appear that Paxos is registered in any capacity with the SEC. The NAL notes that Paxos is a New York limited purpose trust company that is regulated by the New York State Department of Financial Services.
 However, participants are not required to fund its securities or cash in advance of settlement date, and so there is a possibility that a settlement would fail. That could result in a default by the participant and Paxos would use the participant’s margin cash to settle outstanding obligations. The request letter is not clear on what would happen if the amount of margin cash were insufficient.
 Paxos indicates that, if the feasibility study is successful, it would seek authorization to operate more broadly by submitting a Form CA-1 to the SEC (which could be an application for clearing agency registration or exemption).
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Blockchain technology utilizes a distributed digital ledger to record and track information, and can be leveraged to gain transparency and certainty in transactions ranging from cryptocurrency to supply chain tracking. This blog provides information on the legal developments surrounding implementation of blockchain technology, with an initial focus on the financial services sector.