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FINRA Seeks Comment on BD Blockchain Implementation

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FINRA issued a report on Wednesday examining the uses and implications of distributed ledger technology in the securities industry. The paper provides an overview of distributed ledger technology, commonly called blockchain, and discusses the ways it could be used in the industry, as well as regulatory considerations for broker-dealers.

FINRA noted it intends the paper to be the first in a series discussing blockchain implications. It is seeking public comment on the paper until March 31.

A 2016 report by the World Economic Forum found that over $1.4 billion has been invested blockchain over the past three years, FINRA noted.

While there is debate over the speed and magnitude of disruption caused by blockchain, “most agree that the technology has the potential to bring additional efficiencies and increased transparency to the industry,” FINRA wrote in the paper.

With those benefits, of course, come risks, namely to data security and privacy, FINRA found. 

A distributed ledger may exist on a private or public network, according to the paper. The information on a public network is still encrypted, but anyone can access it. The lack of a centralized authority makes it an inefficient tool for financial markets, FINRA found.

Private networks have restricted access, set by an operator who may grant different levels of permission to users.

The assets on a distributed ledger may be created on the networks, such as cryptocurrencies, or digitally represented: traditional assets that are “tokenized” but stored offline. All assets in the ledger are secured by a public and private key. The public key gives the location of the asset, while the private key grants access to it.

Transactions on the ledger are verified, cryptographically hashed (meaning they are assigned a unique, non-reversible binary value) and permanently recorded with a timestamp.

(Related: But Is Bitcoin Safe?)

Rules That Could Impede Blockchain Implementation

There are a number of rules that could affect how quickly blockchain is taken up by the broker-dealer industry. Under the Securities Exchange Act of 1934, Rule 15c3-3 requires that brokers “maintain physical possession or control” over customers’ securities. Rule 15c3-1 requires that they maintain a minimum level of net capital, which the SEC has said must include highly liquid assets.

FINRA Rule 4160 and Exchange Act Rule 17a-13 regarding asset verification are also roadblocks if firms can’t assess which institutions hold which assets or develop processes to verify maintenance of those assets.

Exchange Act Rules 17a-3 and 17a-4 and FINRA Rule 4511 set standards for recordkeeping. Brokers need to determine how much they can rely on the records created in the network, as well as how they could comply with the “write once read many” part of the rules.

Brokers that use blockchain for clearing and settlement may find some of their activities fall under Section 17 of the Exchange Act, or FINRA Rule 4311 regarding carrying agreements.

The Bank Secrecy Act of 1970 and FINRA Rule 3310 address anti-money laundering responsibilities, and FINRA Rule 2090 requires that brokers “know your customer.” Firms would have to determine how customer identities would be verified in the blockchain, and who would do so, all without violating SEC Rule S-P, regarding privacy and safeguarding of client information.

Equity trading on a distributed ledger would be subject to FINRA Rule Series 6100 and 6400, as well as Rule Series 4550 on alternative trading systems, and the 5000 series. “Additionally, to the extent broker-dealers participate in a DLT network to facilitate [over-the-counter] securities transactions, they would also need to consider and account for any other applicable order and trade reporting requirements including those for FINRA’s Order Audit Trail System (OATSTM) and FINRA’s equity trade reporting facilities.”

Debt trading would fall under Rule Series 6700, which requires firms to report transactions in eligible fixed income securities.

Trades in a blockchain network could violate FINRA Rules 3110 and 3120 if firms can’t prove they maintained appropriate supervisory policies and procedures and surveillance systems.

(Related: Blockchain-Based Platform Opens After-Hours US Trading: Tech Roundup)

FINRA Rules 2122 and 2121 address fees and charges. Firms would have to consider any fees passed on to clients as a result of the technology, as well as payments made to third-party providers, per Rule 2040.

Exchange Act Rule 10b-10 and FINRA Rules 2232 and 2340 address disclosures made to clients. Compliance could be difficult if multiple providers are involved in transactions, or if firms have limited access to data held by another institution in the network.

FINRA Rule 4370 on business continuity could come into play. And finally, NASD Rule 1017(a)(5) requires firms to file a continuing membership application to FINRA if the firm undergoes a “material change in business operations.”

“Broker-dealers should consider whether the changes in the firm’s operations, capital requirements, carrying/clearing status, and infrastructure when employing DLT are material,” FINRA wrote in the report.

— Read FINRA’s Top 5 Exam Priorities for 2017 on ThinkAdvisor.