SEC's Custody Volley, Smart Contracts in C# and Top 20 Crypto Projects

Off the Blocks | Vol 75, July 9, 2019

This newsletter is our weekly roundup of some of the significant blockchain news, that provides an overview of the rapidly changing blockchain landscape to help you map your blockchain strategy and be aware of regulatory announcements globally. Get your friends to Subscribe Here.

SEC, FINRA and Crypto Custody

The US Securities and Exchange Commission (SEC) and the Financial Industry Regulatory Authority (FINRA) jointly released a Statement on Broker-Dealer Custody of Digital Asset Securities. In this statement, they articulate various considerations relevant to questions concerning the application of the federal securities laws and FINRA rules to the potential intermediation—including custody—of digital asset securities and transactions., particularly under the SEC’s Customer Protection Rule applicable to SEC-registered broker-dealers.

There seem to be too many open questions for the SEC and FINRA. They recognize that the application of federal securities laws and FINRA rules to digital assets, digital securities and related innovative technologies raise novel and complex regulatory and compliance questions and challenges. In short, their concerns stem from three areas:

  1. Traditionally, the ability of a broker-dealer to comply with aspects of the Customer Protection Rule is greatly facilitated by established laws and practices regarding the loss or theft of a security. This ability may not be available or effective in the case of certain digital assets.

  2. Record keeping requirements for broker dealers impose some constraints on digital assets and broker dealers may find it challenging to comply without putting in place significant technological enhancements and solutions unique to digital asset securities. 

  3. In case of a broker dealer failure, investors may not be protected since digital assets may not comply with the definition of securities as defined by the Securities Investor Protection Act (SIPA).

Hester Peirce, an SEC commissioner, acknowledged the minefield of issues that the agency is dealing with in putting forth guidance for the ecosystem:

The real issue seems to revolve around consumer protections that are taken for granted in the traditional securities world. The SEC emphasized a 50 year track record of recovery of assets for investors when their broker-dealers have failed. In the digital assets world, their concern seems to be:

The Customer Protection Rule requires broker-dealers to safeguard customer assets and to keep customer assets separate from the firm’s assets, thus increasing the likelihood that customers’ securities and cash can be returned to them in the event of the broker-dealer’s failure.

FINRA’s dilemma in addressing membership applications comes from both incumbents and new businesses. While some companies would not involve the broker-dealer engaging in custody of digital asset securities, others include the custodying of digital asset securities, and therefore implicate the Customer Protection Rule. In light of shifting business models it is almost impossible to provide for a common set of rules.

Generally speaking, noncustodial activities involving digital asset securities do not raise the same level of concern as custodial activities. However, there are many significant differences in the mechanics and risks associated with custodying traditional securities and digital asset securities.

For example, if a broker-dealer holds a private key, it may be able to transfer securities reflected on the blockchain or distributed ledger.  However, the fact that a broker-dealer maintains the private key may not be sufficient evidence that the broker-dealer has exclusive control of the digital asset security (e.g., it may not be able to demonstrate that no other party has a copy of the private key and could transfer the digital asset security without the broker-dealer’s consent).  In addition, the fact that the broker-dealer (or custodian) holds the private key may not be sufficient to allow it to reverse or cancel mistaken or unauthorized transactions.  These risks could cause securities customers to suffer losses, with corresponding liabilities for the broker-dealer, imperiling the firm, its customers, and other creditors. Consequently, a broker-dealer must consider how it can, in conformance with Rule 15c3-3, hold in possession or control digital asset securities.

Further, the nature of distributed ledger technology, may make it difficult for a broker-dealer to evidence the existence of digital asset securities for the purposes of financial statements and they should consider how the nature of the technology may impact their ability to comply with the broker-dealer record-keeping and reporting rules. 

Finally, traditionally, a broker-dealer that fails and is unable to return the customer property that it holds is liquidated in accordance with SIPA. Customers are eligible for up to $500,000 in protection if the broker-dealer is missing customer assets, providing some protection for investors. In the case of a digital asset security that does not meet the definition of “security” under SIPA, and in the event of the failure of a carrying broker-dealer, SIPA protection likely would not apply and holders of those digital asset securities would have only unsecured general creditor claims against the broker-dealer’s estate. Further, uncertainty regarding when and whether a broker-dealer holds a digital asset security in its possession or control creates greater risk for customers that their securities will not be able to be returned in the event of a broker-dealer failure.

Now some significant news form the world this week:

  1. Tech | Huobi to Target Decentralized Finance With New Public Blockchain: Huobi Group is building a public blockchain specifically designed for use cases within decentralized finance (DeFi). For the tech side of initiative, the firm is teaming up with blockchain network Nervos, which offers a base proof-of-work blockchain, over which sits a protocol layer aimed to support scaling and other solutions. The joint project will be made open source, and will provide support for multiple assets, as well as smart contracts, allowing third-party developers to “build and deploy a wide range of DeFi services.”  [… Read More on Coindesk]

    The recent wave of high-profile blockchain projects from traditional institutions such as Libra and JPM Coin is a sign of a bigger shift looming in the financial services industry.

    - Kevin Wang, co-founder of Nervos

  2. Stablecoins | Libra, TON and JPMorgan Coin Compared: The three ambitious projects presented here share among them the idea of an adoption process made possible because they are mediated by a coordinated authority, and hence a corporate strategy with potential profits equivalent to the risk undertaken. All of them affirm the need for some stability as a requisite for wide adoption, even if that means backing everything with fiat. Stability is the key for success: Adoption would be eased through the ability to redeem private currency through fiat at a minimum fixed exchange rate. Besides this, private money must have a real reserve of value, while fiat doesn’t — guaranteeing the possibility to purchase a benchmark basket of goods using an identical amount of private coins. To maintain this “goods-pegged” stability, the issuing company should manage the supply of money and its collateral reserve in fiat. [… Read More on CoinTelegraph]

  3. Shipping | IBM's Blockchain Shipping Platform May Have Just Hit Critical Mass: IBM's efforts in the global container shipping industry may be the company's biggest blockchain success so far. The tech company has been collaborating with shipping giant Maersk since 2017 on a blockchain-based platform for tracking shipping containers. That collaboration led to the launch of the TradeLens platform last year. n May, IBM announced that CMA CGM and MSC Mediterranean Shipping Company, two major ocean carriers, had joined the TradeLens platform. On July 2, the company announced that two more major ocean carriers, Hapag-Lloyd and Ocean Network Express, had signed on. With those additions, five of the world's six largest carriers have joined TradeLens, and more than half of the world's ocean container cargo is now covered by the platform. [… Read More on]

  4. Enterprise | Smart Contracts on Microsoft’s .NET: Developers can now write smart contracts in C# on Microsoft’s .NET architecture. Blockchain development firm Stratis Group Ltd has launched the first smart contracts on Microsoft's .NET architecture. The company has introduced the Cirrus Sidechain Masternodes and Stratis Smart Contracts products designed to enable businesses to develop smart contracts in the programming language C#, a general-purpose language originally developed by Microsoft within its development platform .NET. This will purportedly allow enterprises to deploy smart contracts on one underlying general-purpose blockchain. The product thus targets enterprises, financial services companies, and government organizations whose systems operate within Microsoft’s .NET framework, claiming to provide “a wide range of enterprise use cases, from tokens and lending platforms to provenance and self-sovereign identity solutions.” [… Read More on CoinTelegraph]

  5. Crypto | Open-Source Tool Lets Anyone Experiment With Cryptocurrency Blockchains: SimBlock can simulate the parameters of Bitcoin, Litecoin, and Dogecoin. It mirrors a blockchain's network size, block-generation interval, and Internet communication speeds, taking into account bandwidth and latency between six regions: North America, South America, Europe, Australia, Asia Pacific, and Japan. It also lets users modify simulated communication speed parameters as well as the parameters of the blockchain nodes.   To help users understand how a network behaves after different modifications, the group has created a visualization tool that shows communication between nodes, as well as the length of a blockchain. This is presented as an animated simulation of the network running on a world map. [… Read More on IEEE Spectrum]

The Final Word | Consensys Lists Top 20 Blockchain Projects By Developer Activity

Consensys recently announced its list of the top 20 blockchain projects by developer activity. The list contains 16 projects that are based on Ethereum alone, with Status holding the topmost position. Others in the list include IoTex, Aelf and two more projects, of which one is built on Tendermint, one on EOS. According to the New York-based blockchain software tech company’s post, “The month of June showed significant changes in rankings for activity on Github, with projects like Streamr, Colony, and Truffle all slipping out of the Top 20 after a good showing in the previous month of May. June also saw big moves from perennial developmental leaders like Status and Storj.” [… Find Out More on The Block]

About Proteum
Proteum is a global blockchain advisory firm that works with public, private and start-up companies to help them transition into the world of blockchains and decentralized applications. We help companies strategically build their ecosystem and unique capabilities so that they can own and control their future. ProteumX, our accelerator program, invests in and accelerates the time to market for companies building blockchain solutions. |  | Twitter: @proteumio | ProteumX