GUEST BLOG: Of Trust, Lattes and Blockchains by Aegis Frumento Esq

August 23, 2018

Of Trust, Lattes and Blockchains

Sarah Douglas, seven months pregnant, ordered a latte from a McDonald's drive-through.  As she drove away, she took one sip -- and spit it out.  It was laced with cleaning fluid.  Fortunately, she didn't drink the rest of it, and she and her baby were unhurt.  http://www.cbc.ca/news/canada/calgary/lethbridge-pregnant-mother-sarah-douglas-mcdonalds-latte-cleaning-1.4769286

A random event?  I thought so until last week, when I handed a five-dollar bill to a Starbucks barista and ordered a grande, half-caf, skinny vanilla latte.  [Translation:  A medium size latte made with one-half decaffeinated coffee, low-fat milk, and vanilla syrup made with non-sugar sweetener.]  I got back a drink that I expected would taste like vanilla and instead it tasted like -- cinnamon!  Ok, not a big deal -- better than cleaning fluid.  But then questions started piling on:  Is it really half-caf?  Did they really use low-fat milk?  Is there sugar in it?  One can tell cleaning fluid and cinnamon, but how could I know about the rest? 

That's the point:  I couldn't know.  I had to trust there was no whole milk in my latte, just as the barista had to trust that I wasn't passing counterfeit bills.  Even this simplest exchange of food for currency could not happen if the barista and I did not trust each other.  Social life -- economic life --cannot exist without trust.

Trading securities seems removed from buying a latte, but it is not that far removed.  Because trust is so essential, promoting trust and punishing breaches of trust are what the law is mostly about.  That includes securities law.  Financial instruments just have more ingredients than a latte, and any adulteration of those ingredients is harder to detect and will have less predictable effects.  As a result, we have to trust those we deal with even more.  We really don't like it when someone misdirects our trust and we get hurt by it.  We lawyers call it negligence when due to carelessness; we call it fraud when it is intentional.  All securities law aims to prevent the former and deter the latter.

This brief meditation on trust leads right to blockchain technology.  I have yet to find a "simple" explanation.  FINRA has put out a primer that's as good as any -- and that's not saying much.  https://www.finra.org/sites/default/files/FINRA_Blockchain_Report.pdf.  Truth is, it takes a lot more than a thousand words to explain it, so if you are not already steeped in the technology, you'll have to trust me.  Sorry.

Blockchain and its cryptocurrency offspring (Bitcoin and its alts) have generated a bit of hype.  I think blockchain is revolutionary, but not because Bitcoins will replace dollars anytime soon.  As crypto-traders learn from time-to-time, crypto-currencies tend to be faddish.  
https://www.forbes.com/sites/cbovaird/2018/08/07/bitcoin-prices-drop-after-sec-postpones-etf-decision/#2b0829412e67 Blockchain technology, however, is important, because transactions recorded in a blockchain are self-validating. In other words, you don't have to trust they are valid.  The blockchain itself certifies that they are valid, in a very public way that no one can dispute.

What applications this has is something a lot of smart people are working on.  To see just one simple example, let's look at a stock sale.  I order my broker to buy shares.  My broker executes the order on a stock exchange, either directly or through its clearing firm.  The exchange confirms the order to my and the seller's broker's clearing firms and publicly reports it.  My broker debits money from my account so its clearing firm can credit to the seller's broker's clearing firm.  Meanwhile the seller's broker delivers shares to its clearing firm.  The two clearing firms arrange to have the shares transferred through Depository Trust Company from the account of the selling broker to that of my broker.  Maybe the issuer's transfer agent has to reregister shares in the process.  My broker then allocates shares to my account.  At the end of it, my shares are in my account at my broker.  Of course, the shares themselves are recorded at the issuer in the name of DTC.  They are "mine" because DTC allocates them to my broker's (or its clearing firm's) account at DTC, and my broker suballocates them to my brokerage account.

That's at least a dozen steps by a half-dozen players.  Even if the odds against fraud or mistake are 99% for each step, a simple probability calculation shows at least a 10% chance that a misstep occurs somewhere.  If you doubt that, just look at the number of customer and intra-industry arbitrations on FINRA's docket involving screwed up stock transactions.  That's why each of those institutions has policies and procedures designed to prevent fraud or mistake, and staff tasked with designing, implementing and monitoring those policies and procedures, and why a small army of regulators is ever on alert to oversee it all.

Now look at that same transaction using a blockchain mechanism.  The issuer converts its equity from conventional shares to "coins," and registers them to a coin exchange as their nominal owner (much like DTC, or the depositary of an ADR).  I open and fund an account at that coin exchange.  I place an order with the coin exchange to buy the equity coin.  The coin exchange arranges a private trade between me and another member who wants to sell that equity coin.  The coin exchange records the trade on the blockchain of that equity coin.  The blockchain acts as a public registry, proving to all the world that I am the new owner of the equity coin.  That's it. 

Of course, someone could still have defrauded me into choosing to buy that equity coin in the first place.  I'm also at risk that the coin exchange will collapse like Mt Gox did.  https://www.wired.com/2014/03/bitcoin-exchange/  I'll be in trouble if I can't readily sell that equity coin and receive back real-world money to buy, say, real-world lattes.

Those remaining risks suggest regulation, but under what rubric?  Maybe a coin is like a security, sometimes.  https://www.sec.gov/news/public-statement/statement-clayton-2017-12-11.  But is a coin-exchange like a trust company, or a securities dealer, or a securities or commodity exchange, or an alternative trading system, or an investment company-or what?  Answers come by fits and starts, and all are tentative.

I think it's a good thing, then, that the Winklevoss twins have sponsored a self-regulatory organization just for coin exchanges.  https://virtualcommodities.org/.  Just this week, four major exchanges joined the effort and the CFTC voiced its support.  https://coinjournal.net/cryptocurrency-exchanges-join-hands-to-form-self-regulatory-organization/  Let's face it:  This business is going to be regulated.  It might as well establish its own regulatory theories and best practices before someone else does, because I can guarantee that "someone else" will be less knowledgeable.

It may be some time coming, but don't underestimate what blockchain technology might do to the securities industry.  In our example, a self-validating blockchain allowed one coin exchange to replace all of the brokers, clearing firms, the stock exchange, DTC and the transfer agent that we otherwise would have had to trust with accomplishing our simple stock sale.  That's pretty revolutionary, and I think that's just the start.

ABOUT THE AUTHOR

Aegis J. Frumento
Stern Tannenbaum & Bell
Co-Head, Financial Markets Practice

380 Lexington Avenue
New York, NY 10168
212-792-8979

Aegis Frumento is a partner of Stern Tannenbaum & Bell, and co-heads the firm's Financial Markets Practice. Mr. Frumento represents persons and businesses in all aspects of commercial, corporate and securities matters and dispute resolution (including trials and arbitrations); SEC and FINRA regulated firms and persons on regulatory compliance issues and in SEC and FINRA enforcement investigations and proceedings; and senior executives of public corporations personal securities law and corporate governance matters. Mr. Frumento has also represented clients in forming and registering broker-dealers and registered investment advisers, in developing compliance policies, procedures and controls, and in adopting proper disclosure documents. 

Prior to joining the firm, Mr. Frumento was a managing director of Citigroup and Morgan Stanley, a partner and the head of the financial markets group of Duane Morris LLP, and the managing partner of Singer Frumento LLP. 

He graduated from Harvard College in 1976 and New York University School of Law in 1979. Mr. Frumento is a frequent author and speaker on securities law issues, and is often quoted in the media on current securities law developments.

NOTE: The views expressed in this Guest Blog are those of the author and do not necessarily reflect those of BrokeAndBroker.com Blog.