On October 28, 2019, Paxos Trust Company, LLC (Paxos)1 received a time-limited (two-year) No-Action Letter from the Division of Trading and Markets of the U.S. Securities and Exchange Commission (SEC).2 This No-Action Letter permits Paxos to operate a securities settlement system utilizing distributed ledger technology.3 This relief is subject to a number of conditions aimed at permitting the service to operate in a limited manner to guard against the potential for any negative disruption of the underlying securities markets and to operate in a manner that is transparent to the SEC staff. In addition, the relief is designed to allow Paxos and the SEC staff to evaluate the potential benefits of the service prior to Paxos potentially deploying the service on a broader scale.
Beyond the specific relief provided to Paxos, this No-Action Letter represents a potential path to the broader use of distributed ledger technology in the clearance and settlement of securities transactions. As described by Paxos in its Request Letter to the staff, the proposed use of distributed ledger technology could benefit market participants in a number of ways, such as offering more efficient settlement, the immediacy of access to settlement proceeds, greater data accuracy and transparency, operational efficiency, and increased auditability. It is notable that the Paxos service does not replace DTC, and in fact uses DTC as a part of the service.
The No-Action Letter
The No-Action Letter allows Paxos to operate the “Paxos Settlement Service” (as described herein) for a two-year period without registering as a clearing agency under Section 17A(b)(1) of the Exchange Act.4
The Paxos Settlement Service is a private and permissioned distributed ledger system. The ledger records changes in ownership of securities and cash resulting from the settlement of securities transactions between participants of the Paxos Settlement Service (Participants) and is designed to facilitate simultaneous delivery versus payment settlement of securities for cash. Each Participant of the Paxos Settlement Service also must be a participant of DTC, and securities cleared through the service are held in Paxos’ DTC account. Specifically, each Participant deposits securities into its account at Paxos by initiating a transfer from the Participant’s DTC account to Paxos’ DTC account. Upon receipt of the security in Paxos’ DTC account, a “digitization”5 process occurs where the cash and securities of Participants are converted into a digital form and represented on the Paxos distributed ledger (Paxos Ledger). On a settlement date, funds or securities, as relevant, are able to be simultaneously transferred on the Paxos Ledger between the accounts of the two Participants involved in the transaction.6
In granting the request for relief, the SEC staff noted that the Paxos Settlement Service will be (i) operated only for a limited period of time, and (ii) reasonably designed to ensure that activity remains de minimis through operating parameters designed to limit the scope of operations and manage financial and settlement risk using, among other things, participation requirements and limits, securities eligibility criteria, margin collection, volume limits, ongoing monitoring, and regular reporting to the staff.7
Clearing and settlement in the securities markets is an area that many fintech companies are exploring, and this No-Action Letter is the first step to using distributed ledger technology to conduct activity that would otherwise require Section 17A registration and oversight. In granting the relief, the SEC staff undoubtedly took comfort in the presence of a registered clearing agency, DTC. The tailored relief provides Paxos with the opportunity to evaluate whether its technology is facilitating prompt and accurate clearance and settlement of securities transactions and achieving the above-mentioned benefits prior to Paxos potentially deploying the service on a broader scale by operating as a registered or exempt clearing agency. At the same time, the SEC staff is able to assess the operation and potential risks of the technology in a manner that minimizes potential market disruption.
While the SEC’s focus on retail investors has led it to take a cautious approach toward the regulation of digital assets, Chairman Jay Clayton has recognized the importance of innovation generally and the potential benefits distributed ledger technology in particular may have for the efficiency of US capital markets.8 The Paxos No-Action Letter is evidence of the SEC staff's continued willingness to work with market participants on practical applications for distributed ledger technology.