The Financial Industry Regulatory Authority released a report
on blockchain’s impact on the securities industry in its efforts to support financial institutions investing in the technology.
Many FINRA rules, as well rules by other regulators such as the Securities and Exchange Commission
, are potentially implicated by various distributed ledger technology (DLT) applications, the report noted. A DLT application that alters clearing arrangements or serves as a source of recordkeeping by broker-dealers could implicate FINRA rules for carrying agreements and records requirements.
FINRA seeks an open dialogue with market participants to proactively identify potential risks or hurdles in order to help realize the full potential of DLT while maintaining the core principles of market integrity and investor protection.
FINFRA Supports DLT
Some have argued that DLT has the potential to revolutionize securities industry operations, while others have said any changes DLT brings to the securities industry are likely to be incremental. But most agree the technology can bring additional efficiencies and improved transparency while also posing risks related to data security and privacy.
FINRA spoke to member firms to better understand their current or potential future use of DLT. The broker-dealers highlighted the potential benefits and challenges, and noted they are considering DLT applications that would function within the current regulatory framework.
Securities industry participants are contemplating various DLT applications. Many have focused on discrete applications within the broader debt, equity and derivative markets. By focusing on discrete applications, they can avoid the risks associated with more wholesale changes.
Many have also focused on sectors that present significant inefficiencies, such as with respect to clearing infrastructure, administrative functions and operational processes.
Discrete applications include the equity market, debt market, derivative market and industry utilities.
Participants are also examining enhancements to DLT networks by developing software applications overlaid on the DLT network. Such applications, referred to as “smart contracts
,” automatically execute agreed-upon terms of a contract on the DLT network based on certain events.
Firms Explore Smart Contracts
Areas where market participants are seeking to apply smart contracts within DLT networks include escrow arrangements (such as the automatic release of funds when requisite conditions are satisfied) facilitation of collateral management (such as exchanging ownership interest in collateral upon a default), and corporate actions (such as coupon payment on a specific date).
DLT can impact various aspects of the securities market, including transparency, market efficiency, post-trade processes and operational risk.
Implications For Operational Risks
DLT has implications for operational risks, such as sharing information over a network of various entities, use of public and private keys to gain access to assets, and the use of smart contracts to automate certain operations.
A key consideration for participants in deploying a DLT network is determining the network’s operational structure. The operational structure would typically include developing a framework for: 1) network participant access and related on-boarding and off-boarding procedures; 2) transaction validation; 3) asset representation; and 4) data and transparency requirements.
Since the technology involves sharing information over a network, it also poses security-related risks. Participants have to consider enhanced security programs related to risks from both internal and external sources.
Security is a key consideration for a DLT network, given the distributed nature of the network and participation from worldwide entities. Participants want assurances the network is protected from external threats and insider risks considering they may be providing private information.
Accordingly, network operators need to know how the system design, testing and maintenance will address concerns about the introduction of security issues, from within and outside the network, via its participants. Fraudulent transactions could be introduced by a participant that falls victim to a cyber attack, and recovering from such an event could result in disruption to the network’s operation.
Certain activities for a firm participating on a DLT network can impact the firm’s net capital requirements. The SEC has stated that Exchange Act Rule 15c3-1 requires broker dealers to maintain a minimum level of net capital at all times.
FINRA Rule 4100 Series has requirements for broker dealers to ensure compliance with the SEC’s net capital rules and related reporting requirements.
Broker dealers typically determine the minimum amount of net capital they must maintain.
If a broker dealer were to hold crypto securities, the firm would have to consider how they would affect its net-capital computation under Rule 15c3-1. Due to the novel nature of these products and the ways product liquidity could be impacted based on the type of DLT network developed, firms will have to consider their own circumstances in determining how to apply the net capital rule requirements.
Protecting Customer Information
Firms in a DLT environment may be connected with unknown parties and their customers on the network, including those domiciled in foreign jurisdictions. They must consider how this will impact their compliance programs associated with anti-money laundering and customer identification obligations.
Protection of financial and personal information is a critical responsibility of FINRA member firms. Regulation S-P requires broker dealers to have written policies to address the protection of customer information.
The reporting framework for over-the-counter (OTC) transactions in listed and unlisted equity securities mandates participants to report information to one of FINRA’s facilities, depending on the type of security involved in the transaction. For trades in listed stock, for example, FINRA reports data to a centralized securities information processor for public dissemination and consolidation.
As the securities industry invests time and resources in exploring DLT, participants and regulators must collaborate early in the process to address potential regulatory gaps that could pose risks or hinder the technology’s adoption. This will enable the industry to reap the benefits of the technology while ensuring protection of investors.
Comments are requested by March 31, 2017.
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Last modified: March 4, 2021 4:53 PM
January 20, 2017 10:16 PM