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.
Paxos is a New York limited purpose trust company regulated by the New York State Department of Financial Services and a participant of The Depository Trust Company (DTC). DTC is a registered clearing agency with the SEC that operates as a securities depository as that term is defined in Section 3(a)(23)(A) of the Securities Exchange Act of 1934 (the Exchange Act).
To evaluate the potential benefits of the Paxos Settlement Service, Paxos plans, for a limited period of 24 months, to operate the Paxos Settlement Service (as further described below) in a production environment for the clearance and settlement of listed US equity securities trades, without being registered as a clearing agency.
See Paxos Trust Company, LLC, SEC No-Action Letter (Oct. 28, 2019) (the No-Action Letter); Letter from Charles G. Cascarilla, CEO, and Daniel M. Burstein, GC & CCO, Paxos Trust Company, LLC, to Jeffrey Mooney, Assoc. Dir., SEC (Oct. 25, 2019) (the Request Letter).
In seeking relief, Paxos noted that as the operator of the Paxos Settlement Service it will be acting as a clearing agency under the definition of Section 3(a)(23) of the Exchange Act because it will be “an intermediary in making payments or deliveries or both in connection with transactions in securities” and will also be providing “facilities for comparison of data respecting the term of settlement of securities transactions.” Request Letter at 2. Section 17A(b)(1) of the Exchange Act states in relevant part that “it shall be unlawful for any clearing agency, unless registered in accordance with this subsection, directly or indirectly, to make use of the mails or any means or instrumentality of interstate commerce to perform the functions of a clearing agency with respect to any security.” Paxos sought no-action relief regarding this registration requirement in connection with its operation of the Paxos Settlement Service under the terms specified in the Request Letter.
Each Participant in the Paxos Settlement System will operate an account on the Paxos Settlement System (PSS Account), where it can hold cash and eligible securities. A Participant funds its PSS Account by transferring an “eligible security” from its DTC account to Paxos’ DTC account. Upon receipt of the security by Paxos, Paxos will create a digitized security entitlement, which is a digital representation of the security deposited into Paxos’ DTC account. This securities entitlement is in turn credited to the Participant on Paxos’ ledger. A similar “digitization” process occurs with cash when the Participant transfers funds from its bank account to the specified Paxos bank account, and a “reverse” digitization process occurs to transfer funds from Paxos’ DTC account to a Participant’s DTC account. See Request Letter at 6.
To satisfy its settlement obligations, each Participant must have the required securities or cash in its PSS Account by the settlement date, although prefunding is not required. Assuming all conditions are satisfied (e.g., sufficient securities are in a Participant’s PSS Account), the Paxos Settlement System will automatically settle the obligations on the settlement date by simultaneously causing the security entitlements or cash, as the case may be, to be simultaneously transferred between the Participants’ accounts on the Paxos Ledger.
For example, no more than seven Participants will be eligible to use the Paxos Settlement Service, and each must be registered as a broker-dealer with $100 million or more in excess net capital. In addition, securities eligible for settlement on the Paxos Settlement Service will only include certain publicly traded equity securities that remain at all times eligible for listing and trading on a national securities exchange. See No-Action Letter at 3.
Testimony on Virtual Currencies: The Roles of the SEC and CFTC, Jay Clayton, SEC Chairman (Feb. 6, 2018).