FINRA Examines Fintech Including Blockchain

On July 30, 2018, the Financial Industry Regulatory Authority (FINRA) published a Special Notice seeking public comments on how FINRA can support fintech developments including those related to data aggregation services, supervisory processes, including with the use of artificial intelligence, and the development of a taxonomy-based, machine-readable rulebook. The Special Notice, and fintech in general, necessarily includes blockchain technology, a topic FINRA has been examining for a few years now. Last July, FINRA held a Blockchain Symposium to assess the use of distributed ledger technology (DLT) in the financial industry, and earlier in January 2017 FINRA issued a report entitled “Distributed Ledger Technology: Implications of Blockchain for the Securities Industry” on the topic (see HERE).

Also, on July 6, 2018, FINRA sent Regulatory Notice 18-20 to its members asking all FINRA member firms to notify FINRA if they engage in activities related to digital assets such as cryptocurrencies, virtual coins and tokens. FINRA informs members that it is monitoring the digital asset marketplace and as part of its efforts and wants all firms to notify FINRA if it or its associated persons engage in any activities related to digital assets. FINRA has requested that it be kept updated on firms’ digital asset matters through July 31, 2019.

FINRA Special Notice on Financial Technology Innovation

Clearly financial technology innovation (“fintech”) offers benefits to investors and the financial marketplace as a whole, but also creates challenges for regulators to adapt rules and supervision that support the innovations while continuing to satisfy their goals of investor protection. In addition to blockchain, technological advances have been affecting how financial service providers conduct their business and interact with clients for years. For example, fintech applications related to digital advice including robo-advisors and algorithmic trading platforms, and the use of social media in wealth management, have been hot topics of several years now. Furthermore, the use of artificial intelligence, natural language processing and social media have impacted market research and analytical coverage on a wide scale.

FINRA’s special notice provides a succinct summary of the actions FINRA has taken to date involving fintech developments, including:

  • Created an external website dedicated to fintech-related matters (see HERE).
  • Formed Fintech Industry Committee with large and small member firms, non-member fintech service providers and SEC and NASAA representation. Topics of focus for the committee include: (i) the potential impact of innovation on FINRA’s investor protection and market integrity objectives; (ii) challenges to the adoption of fintech-based products or services; (iii) opportunities to improve interactions with FINRA; and (iv) FINRA fintech-related initiatives.
  • Have held 4 blockchain and/or fintech symposiums;
  • Fintech representation at the annual FINRA conference;
  • Issued reports and investor alerts related to blockchain, cryptocurrencies digital investment advice and other fintech matters;
  • Working with other domestic and foreign regulators to share insights and address fintech-related issues.

The special report generally seeks comments that can help identify FINRA rules or administrative processes that could be modified or improved to support fintech innovation while still protecting investors and market integrity. In addition to the general request for comments, FINRA specifically requests comments on (i) the provision of data aggregation services through compiling information from different financial accounts into a single place for investors; (ii) supervisory processes concerning the use of artificial intelligence; and (iii) the development of a taxonomy-based, machine-readable rulebook.

Data Aggregation

Many investors have started using data aggregation services that compile their financial data from different financial institutions, including broker-dealers, into one place, often using a dashboard on an Internet-based platform, in order to offer a variety of services such as financial planning, portfolio analysis, budgeting, and other types of financial analysis or advice. In order to compile the data, personal information, including passwords, must be provided to these service providers. Generally, the system is automated such that a program or computer code utilizes the passwords to access various financial institutions and obtain data that is then presented to the investor. In this case the aggregation service provider and financial institution to not have a contractual relationship.

As an alternative, some financial institutions now offer services called “application programming interface” (API) in which there is a direct transfer of data from the financial institution to the aggregator. The consumer client sets the access authorization and level. In this case there is a contract between the aggregator and the financial institution including provisions related to responsibilities and technical requirements to safeguard data and privacy.

Broker-dealers can be on both sides of these transactions. That is, the broker-dealer may be one of the financial institutions from which data is being aggregated and broker-dealers can act as the aggregation service provider as well. FINRA is exploring ways to address this increasing consumer option including through the development of standards and protocols. FINRA has provided a notice to members with some guidance on data aggregation services, including that consolidated reports are communications with the public subject to anti-fraud parameters. FINRA also provided some guidance on supervisory and internal control systems; however, with the increase use of these services, more robust rules and guidance may be necessary. Blockchain, including the use of smart contracts, could be utilized in data aggregation services.

Supervision Related to Artificial Intelligence

There is a growing interest in applying artificial intelligence, including machine learning and natural language processing, to financial markets and broker-dealer processes and services. Artificial intelligence is used in areas such as anti-money laundering/know-your-customer compliance, trading, data management and customer service.

With the growth of artificial intelligence comes concerns about how the processes fit within existing FINRA regulations, and the need for new regulations. For example, FINRA is examining how a firm can adequately supervise algorithmic trading, including suitability requirements for specific customer transactions. However, more information is needed and the Special Report indicates that FINRA needs to develop a better understanding of artificial intelligence applications in the industry.  Smart contracts built on the blockchain are a form of artificial intelligence.

FINRA specifically requests comments on the following:

  • For what purposes are members using, or considering, artificial intelligence tools—including chat bots and robotic process automation (RPA) tools—in their brokerage businesses and what benefits will it serve?
  • Do firms’ governance practices for the development and ongoing operation of artificial intelligence tools differ from those used for tools or processes that use more conventional operational techniques?
  • What forms of quality assurance do firms use in developing artificial intelligence?
  • What are the greatest regulatory challenges in adapting artificial intelligence, including those related to supervision?
  • Are there specific regulatory issues that the use of artificial intelligence tools in the context of algorithmic trading strategies raises?

Development of Taxonomy-based, Machine-readable Rulebook

The UK Financial Conduct Authority (FCA) and the Bank of England (BoE) have launched an initiative to examine how to simplify regulatory compliance through the digitization of rulebooks, making them “machine-readable” – in other words, the creation of a rulebook that is structured in such a way as to make it more easily processed by a computer such as a rulebook built on the blockchain using smart contracts. FINRA is reviewing the possibility of machine-readable rulebooks for compliance policies, procedures and transaction databases.

According to the FCA and BoE, such efforts have the potential to “fundamentally change how the financial services industry understands, interprets, and then reports regulatory information,” through the mapping of regulatory obligations. The reduction of compliance costs and elimination of human error would benefit both firms and regulators.

Obviously, such a dramatic change in the industry will not happen overnight, but as FINRA indicates, it has to start with a first step. As such, FINRA is considering the feasibility and desirability of developing a type of machine-readable rulebook through the creation of an embedded taxonomy (i.e., a method for classification and categorization) within its rules.

FINRA specifically seeks comments on:

  • Who will benefit the most and who will utilize a machine-readable rulebook?
  • In what way will it make compliance more efficient and effective?
  • Is there a risk of “over-reliance”?
  • What are the benefits of developing machine-readable rulebooks that interact with other US-based and foreign regulators’ machine-readable rulebooks?
  • What role should vendors and regulated firms play in the adoption, development and ongoing taxonomy maintenance?

Regulatory Notice 18-20

The market for digital assets such as cryptocurrencies, tokens and coins continues to grow significantly and as such, fraud in their issuance and secondary trading continues to be a focus for regulators including FINRA. On July 6, 2018, FINRA sent Regulatory Notice 18-20 to its members asking all FINRA member firms to notify FINRA if they engage in activities related to digital assets such as cryptocurrencies, virtual coins and tokens and to continue to update FINRA on such activities through July 31, 2019. FINRA informed members that it is monitoring the digital asset marketplace and, as part of its efforts, wants all firms to advise FINRA if it or its associated persons engage in any activities related to digital assets.

Member firms are specifically requested to notify FINRA of any of the following activities:

  • Purchases, sales or execution of transactions in digital assets;
  • Purchases, sales or execution of transactions in a pooled fund investing in digital assets;
  • The creation of, management of, or provision of advisory services for a pooled fund investing in digital assets;
  • Purchases, sales or execution of transaction in derivatives tied to digital assets;
  • Participation in an initial or secondary offering of digital assets including ICOs and pre-ICOs;
  • Creation or management of a platform for the secondary trading of digital assets;
  • Custody or similar arrangement involving digital assets;
  • Acceptance of cryptocurrencies from a customer;
  • Mining of cryptocurrencies;
  • Recommending, soliciting or accepting orders in cryptocurrencies or any digital assets;
  • Displaying indications of interest or quotations in cryptocurrencies or any digital assets;
  • Providing or facilitating clearance and settlement services for cryptocurrencies or any digital assets;
  • Recording cryptocurrencies or any digital assets using distributed ledger technology; or
  • Any use of blockchain technology.

The Regulatory Notice also explicitly reminds member firms to be cognizant of all applicable federal and state laws, rules and regulations, including FINRA and SEC rules and regulations. Furthermore, any material change in the business operations of a member firm requires the submittal of a CMA.  Involvement in cryptocurrencies, digital assets or blockchain would be considered a material change.

FinCEN and the SEC Weigh In

In a speech at a blockchain conference on August 9, 2018, FinCEN director Kenneth A. Blanco was less than positive on the state of compliance of money transmitter businesses such as cryptocurrency exchanges. For more information on FinCEN’s role in cryptocurrency offerings and money transmitter businesses, see HERE.  In particular, Blanco states that the industry lacks adequate anti-money laundering (AML) controls and that most businesses do not even attempt to put better measures into place until after they are reviewed or investigated by a regulatory authority. Furthermore, the victims of improper AML procedures are not investors with money to lose, but rather families who lose loved ones to opioid addictions or terrorist acts, as both of these utilize cryptocurrencies in their operations.

Mr. Blanco’s remarks follow similar comments by SEC assistant director Amy Hartman, who also advised companies planning on an ICO to engage competent securities counsel.

Further Reading on DLT/Blockchain and ICOs

For a review of the 2014 case against BTC Trading Corp. for acting as an unlicensed broker-dealer for operating a bitcoin trading platform, see HERE.

For an introduction on distributed ledger technology, including a summary of FINRA’s Report on Distributed Ledger Technology and Implication of Blockchain for the Securities Industry, see HERE.

For a discussion on the Section 21(a) Report on the DAO investigation, statements by the Divisions of Corporation Finance and Enforcement related to the investigative report and the SEC’s Investor Bulletin on ICOs, see HERE.

For a summary of SEC Chief Accountant Wesley R. Bricker’s statements on ICOs and accounting implications, see HERE.

For an update on state-distributed ledger technology and blockchain regulations, see HERE.

For a summary of the SEC and NASAA statements on ICOs and updates on enforcement proceedings as of January 2018, see HERE.

For a summary of the SEC and CFTC joint statements on cryptocurrencies, including The Wall Street Journal op-ed article and information on the International Organization of Securities Commissions statement and warning on ICOs, see HERE.

For a review of the CFTC’s role and position on cryptocurrencies, see HERE.

For a summary of the SEC and CFTC testimony to the United States Senate Committee on Banking Housing and Urban Affairs hearing on “Virtual Currencies: The Oversight Role of the U.S. Securities and Exchange Commission and the U.S. Commodity Futures Trading Commission,” see  HERE.

To learn about SAFTs and the issues with the SAFT investment structure, see HERE.

To learn about the SEC’s position and concerns with crypto-related funds and ETFs, see HERE.

For more information on the SEC’s statements on online trading platforms for cryptocurrencies and more thoughts on the uncertainty, and need for even further guidance in this space, see HERE.

For a discussion of William Hinman’s speech related to ether and bitcoin and guidance n cryptocurrencies in general, see HERE.

For a review of FinCEN’s role in cryptocurrency offerings and money transmitter businesses, see HERE.

For a review of Wyoming’s blockchain legislation, see HERE.

The Author

Laura Anthony, Esq.
Founding Partner
Legal & Compliance, LLC
Corporate, Securities and Going Public Attorneys
330 Clematis Street, Suite 217
West Palm Beach, FL 33401
Phone: 800-341-2684 – 561-514-0936
Fax: 561-514-0832

Securities attorney Laura Anthony and her experienced legal team provides ongoing corporate counsel to small and mid-size private companies, OTC and exchange traded issuers as well as private companies going public on the NASDAQ, NYSE MKT or over-the-counter market, such as the OTCQB and OTCQX. For nearly two decades Legal & Compliance, LLC has served clients providing fast, personalized, cutting-edge legal service. The firm’s reputation and relationships provide invaluable resources to clients including introductions to investment bankers, broker dealers, institutional investors and other strategic alliances. The firm’s focus includes, but is not limited to, compliance with the Securities Act of 1933 offer sale and registration requirements, including private placement transactions under Regulation D and Regulation S and PIPE Transactions as well as registration statements on Forms S-1, S-8 and S-4; compliance with the reporting requirements of the Securities Exchange Act of 1934, including registration on Form 10, reporting on Forms 10-Q, 10-K and 8-K, and 14C Information and 14A Proxy Statements; Regulation A/A+ offerings; all forms of going public transactions; mergers and acquisitions including both reverse mergers and forward mergers, ; applications to and compliance with the corporate governance requirements of securities exchanges including NASDAQ and NYSE MKT; crowdfunding; corporate; and general contract and business transactions. Moreover, Ms. Anthony and her firm represents both target and acquiring companies in reverse mergers and forward mergers, including the preparation of transaction documents such as merger agreements, share exchange agreements, stock purchase agreements, asset purchase agreements and reorganization agreements. Ms. Anthony’s legal team prepares the necessary documentation and assists in completing the requirements of federal and state securities laws and SROs such as FINRA and DTC for 15c2-11 applications, corporate name changes, reverse and forward splits and changes of domicile. Ms. Anthony is also the author of, the OTC Market’s top source for industry news, and the producer and host of, the securities law network. In addition to many other major metropolitan areas, the firm currently represents clients in New York, Las Vegas, Los Angeles, Miami, Boca Raton, West Palm Beach, Atlanta, Phoenix, Scottsdale, Charlotte, Cincinnati, Cleveland, Washington, D.C., Denver, Tampa, Detroit and Dallas.

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