Unpacking the Paxos “No Action” letter and the trust company as a gateway between blockchain and regulated capital markets
By Bharat Gupta & Julian Jacobson
Paxos received a no action letter from the SEC last fall in response to its plan to settle equities trades of public securities through the use of a private permissioned blockchain. In a step for regulators that would have been unthinkable just a few years ago, the SEC has capitulated to the idea of inserting a blockchain into the fiduciary framework that allows for trade finality and securities ownership in the public markets.
While the news of the ‘no action’ letter was highly reported, there has been little meaningful analysis about the underlying methodology and its significance to the broader adoption of blockchain in regulated capital markets. Infosys and Fundamental Interactions will use the SEC’s letter as a looking glass into the industry’s state of progress and to highlight the essential nature of Trust Companies as gateways between Blockchain and the US legal and financial system.
History of the Limited Purpose Trust in Blockchain
Paxos / itBit and Gemini both registered in 2015 as a New York Limited Purpose Trusts “LPT’s” under the New York Department of Financial Services while operating retail crypto currency exchanges. While the overwhelming majority of their domestic exchange competitors were rendered un-bankable by FinCen guidance passed in 2013, the LPT allowed these exchanges to be among a select few that could secure and maintain relationships with FDIC insured banks. This allowed them to accept USD deposits nationwide as exclusive gateways for dollar based crypto trading.
Later these same firms leveraged the LPT designation to become issuers of billions of USD worth of stable coins backed one to one by customer deposits. This has shown a template for how to use a trust to tokenize assets, providing an on-ramp from a bank ledger into a blockchain ledger. As we will describe below, the Paxos settlement platform has a similar on / off ramp. In this case it allows DTC eligible securities to be deposited into a managed Blockchain settlement system operated within the Paxos LPT.
Settlement and the Central Clearing Model
Settlement is the transfer of cash for securities after a trade has been executed on a venue like an exchange or an ATS (Alternative Trading System). DTCC (Depository Trust Clearing Corporation) settles the vast majority of trades that take place in the United States. It sits as an umbrella over DTC (Depository Trust Company) and NSCC (National Securities Clearing Corporation), both self regulatory organizations whose function in capital markets is to provide a legal and operational framework for securities ownership and the resulting cash transfer between the member participants.
DTC is a LPT that acts as a central custodian of securities, holding a ledger of accounts where official legal ownership of securities is recorded electronically in book entry. Post trade information is reported from all regulated US exchange venues through FINRA to the NSCC for centralized processing. NSCC handles the multilateral netting of trades and subsequently stands in as the seller for every buyer and as the buyer for every seller. As members, clearing brokers settle cash directly against NSCC in a process that reduces total payment obligations in the system by as much as 97%.
The central depository trust ledger is where the rubber meets the road in terms of the legal ownership of shares. The shares sitting in your brokerage retirement account aren’t really sitting in your brokerage retirement account. They’re sitting in a trust at DTC under your brokerage’s name. This ledger is what we might call a ‘center of truth’ or ‘golden copy’ from which a vast supply chain of downstream participant ledgers is informed after a period of trading.
PSS ‘Paxos Settlement Service’
Paxos Settlement Service digitizes securities and cash on a blockchain and facilitates immediate bilateral settlement between buyer and seller. Every trade is settled in real time digitally, rather than being accumulated, netted and allotted by an institution standing in between. But the settlement system doesn’t exist within a vacuum. Paxos uses its DTC account as a member to provide an on / off ramp to allow other DTC members to deposit securities into its system. They have used the existing rails of central clearing to build a sub-system inside Paxos’ omnibus DTC account. This is a common structure as it relates to how custodians establish their own trusts within the DTC system, but in the instance of the Paxos Settlement System, there is an ‘inception’ like quality to the use case. It situates a trust within a trust; a settlement system within a settlement system. When you drill down past the DTC layer into the Paxos layer, the data model operates very differently for the participants. Instead of a three day settlement period, participants expect real time settlement with immediate access to settlement proceeds and constant transparency.
The DLT Challenge to Central Clearing
Blockchain is a purpose built data structure to solve the same operational task as the central clearing model; a ledger maintaining transactional instrument ownership where final settlement can be ensured under continuous load on a given network. Blockchain scalability is a big consideration as it relates to transaction volume. The daily settlement load of DTCC is estimated to be 115,000,000 trades per day or 6,300 trades per second for five continuous hours; far exceeding the volumes currently possible on public Ethereum. Private instances of Ethereum as with the Paxos solution, could easily scale to meet these volumes.
Despite the vast amount of value cleared through central clearing systems like DTCC, blockchain proponents are quick to identify the comparative inefficiency of the design relative to DLT, citing the effort and cost incurred by its network of intermediaries in order to maintain operational continuity across disparate ledgers. The central clearing model requires all transactional data to flow to a central authority and be re-transmitted after processing to a network of independent downstream ledgers. The blockchain data model, by comparison, situates participants in one ledger that is replicated and validated across many nodes. In the blockchain model, trust derives from cryptography over central authority.
A Sign of Broader Changes to Come?
The Paxos no action letter represents a gradual warming in regulator sentiment about Blockchain. The private permissioned blockchain model proposed by Paxos to the SEC is very different from the public Blockchain model, what we might call ‘Satoshi’s vision’. Today the regulators have come around to centralized use cases of blockchain that resemble what databases do on private networks. But a settlement structure back-ended by a public blockchain could be accommodated by the very same DTCC omnibus trust sub structure used by the PSS. In the future, we will likely see DeFi networks and public blockchains proposed to the SEC and other regulators.
The regulatory climate today is still prohibitive towards the trading of tokenized assets on regulated exchanges. The SEC has yet to produce any guidance for FINRA to enforce in terms of what would be acceptable procedures for the venue, the brokers and the custodians that would operate on such a venue. For now we look to the Paxos example as a discrete advancement in a broader industry effort to use distributed ledgers for tracking securities transactions in regulated markets. Most importantly, it serves as an illustration of how a substructure within a trust can provide a suitable legal construct to move assets in and out of the Blockchain data model.
Implications for Private Markets
There is an increasingly popular vision of a new private market structure that falls out of this marriage of Blockchain and the trust company; one that exists without any connection to the legacy central clearing establishment. Using a trust company as a gateway into a Blockchain, and using that Blockchain to power a settlement system on the back-end of a trading system like an ATS (Alternative Trading System). This is viewed as a path to fuse private placements with secondary trading within closed networks. The model contemplates electronic market making to supply continuous pricing for privately traded instruments that have historically been notoriously illiquid in secondary. Asset instruments that have never existed would be tokenized and traded in such a structure.
In summary, the Paxos no action letter represents a regulatory milestone, mainly because it sets a precedent for use of Blockchain within the bedrock of the settlement infrastructure for the public markets. The approval is provisional and limited in the value that can be transacted, but it indicates the methods by which a proposal can get regulatory relief in an otherwise prohibitive landscape. We can see the state chartered trust increasingly becoming a reliable vehicle for bridging the gap between Blockchain and the US legal and financial system.
About Bharat Gupta and Infosys
Bharat Gupta is Senior Principal with Infosys Consulting, a management consulting arm of Infosys. Bharat is a part of Financial Services and Insurance consulting practice and focusing on digital transformation, cloud platforms and Blockchain. Bharat formerly led senior executive positions with Reliance Group and NEC Corporation and post-graduated from the Indian Institute of Technology Delhi (IIT Delhi).
About Julian Jacobson and Fundamental Interactions
Julian Jacobson is Co-founder, President and Chief Operating Officer of Fundamental Interactions. Founded in 2011, the company is a leading provider of core technology for securities and digital asset exchanges worldwide. The Fundamental Interactions platform is heavily deployed by well known regulated electronic trading exchange operators in a variety of traditional asset classes. It also powers a variety of large crypto-currency and digital asset exchanges. The technology integrates institutional grade matching and exchange infrastructure with enterprise tools for securities issuance, tokenization, custody and settlement.