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How will the SEC Regulate Companies Using Blockchain Technology?

Bitcoin and Blockchain, Finance and Securities

Blockchain technology and bitcoin have been trending topics for the past year. Bitcoin’s value in the past year has jumped from $400 per bitcoin to over $1,300, exemplifying its popularity. Last week, we discussed the blockchain (a digital, decentralized ledger) and whether it can be patented under U.S. Patent Law. Since the Supreme Court case Alice, it seems unlikely that patents filed by financial institutions will be approved since it is difficult to patent software, characterized by the Supreme Court as an abstract idea. However, the looming question is how the Securities and Exchange Commission (SEC) will regulate companies using blockchain technology, whether that is patented or not.

Blockchain has the potential to revamp the way we conduct business and handle our finances. Richard B. Levin and Peter Waltz (authors of “The Devil is in the Details: SEC Regulation of Blockchain Technology”) explain that “blockchain technology can be adapted for use in traditional financial services transactions in a way that could reshape the trading, clearance and settlement of equities, futures, and derivatives, and the processing of loans and mortgages.” The problem for the SEC is that the functions of blockchain technology overlap with SEC jurisdiction. The SEC aims to create a fair and efficient market, however, it is having trouble regulating a technology that by nature is unregulated, but has the potential and capacity to actually influence and directly affect what is traditionally regulated by the SEC.  The same goes for bitcoin. As traditional currencies are regulated by governments (which can be seen in instances of inflation), bitcoin is decentralized and not regulated by any type of entity or government. Governments and securities agencies like the SEC face huge hurdles in attempting to regulate what is known as the ‘dark economy.’ Bitcoin and blockchain technology permit users to interact with each other anonymously, making it infeasible to regulate.  Yet the question remains whether digital or cryptocurrencies, such as bitcoin, should be classified as securities for the SEC to implement regulations.

The SEC’s current obstacle is determining how to regulate and register companies using blockchain technology for the purpose of trading securities. The Securities Act of 1933 and the Securities Exchange Act of 1934 broadly define the scope of “securities” to encompass any stock, bond, future, swap, investment contract and more. Since there are no regulatory guidelines on how to treat bitcoin or blockchain, the SEC has decided that companies using blockchain technology for the purpose of trading securities would need to register as an exchange, Alternative Trading System (ATS), or broker/dealer. To be classified as securities, the company owning cryptocurrencies would need to provide shares. For instance, the SEC held in the matter of BTC Trading, Corp. and Ethan Burnside that because the company allowed users to purchase stock in virtual currency, they violated Sections 5 and 15(a) of the Exchange Act for not registering as a broker/dealer, or as a national securities exchange.

Matthew Comstock (partner at Murphy and McGonigle, PC) explains that blockchain technology “regulation needs to be established to secure the privacy of data held by and transmitted using blockchain.” This month the SEC denied Bats BZK Exchange’s rule change proposal to “list and trade shares of the Winklevoss Bitcoin Trust” (SEC Release No 34-80206). The Commission held that the rule change was inconsistent with Section 6(b)(5) of the Exchange Act, which sets forth that “rules of a national securities exchange be designed to prevent fraudulent and manipulative acts and practice and to protect investors and the public interest” (SEC Release No 34-80206). The SEC continued: “First, the exchange must have surveillance-sharing agreements … And second, those markets must be regulated.” Yet, regulating an unregulated market does not happen at the drop of a hat. The SEC needs to provide clear and appropriate recommendations. Levin and Waltz add that “[b]efore blockchain technology can be deployed across various sectors of the financial services industry, it is imperative the SEC provide meaningful guidance to the industry on whether the use of blockchain technology requires such platform to register as brokers, dealers, ATSs, or exchanges.”

There is currently a regulatory gap between the SEC and new technology that financial institutions, companies, and individuals are eager to implement and utilize. The main issue is that the SEC needs to understand the function and limits of blockchain technology before it can begin to consider regulations. It is pertinent that it also respect the anonymity aspect of bitcoin and blockchain, which makes it exceptionally difficult to regulate compared to traditional trading methods. However, for the time being, if a company uses blockchain technology for the purpose of securities transactions, then the SEC will continue to enforce regulations under its jurisdiction.

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