Fintech 2020 Comparisons

Last Updated March 02, 2020

Law and Practice

Authors



Skadden, Arps, Slate, Meagher & Flom LLP & Affiliates advises businesses, financial institutions and governmental entities around the world on their most complex, high-profile matters, providing the guidance they need to compete in today’s business environment. The financial technology industry presents businesses and private equity, venture capital and other investors with extraordinary opportunities as well as challenging legal and regulatory issues. Skadden has helped clients to navigate this complex environment since the industry’s inception. The FinTech practice draws on the firm’s global platform and market-leading corporate finance, financial regulation and enforcement, intellectual property and technology, privacy and cybersecurity and M&A capabilities, making it uniquely qualified to offer clients exceptional depth of experience and full-service capabilities. Skadden would like to thank complex litigation and trials partner Alex Drylewski; M&A and financial institutions partner Jon Hlafter; financial institutions regulation and enforcement counsel Collin Janus; derivatives of counsel Jonathan Marcus; investment management associate Prem Amarnani; financial institutions associate Patrick Lewis; financial institutions associate Tim Gaffney; financial institutions associate Han Lee; and M&A associate Marcel Rosner for their invaluable contribution to this chapter.

"Fintech", the intersection of finance and technology, is a term that has enduringly entered the financial services lexicon. The term originally referred to the back-office operations of established financial institutions, but now refers to a broad range of activities designed to change and improve the delivery of financial services through the use of technology, encompassing every subsector of finance, including banking, non-depository lending, insurance, broker-dealer and investment adviser activities.

Deal-making activity in the fintech space increased in 2019, building off a strong 2018. Volume in venture capital investing and M&A activity reached new highs. Notably, the US fintech market showed signs of maturing, with venture capitalists focusing on later-stage funding rounds and M&A activity concentrated around larger deal sizes.

Venture capitalists continued to invest heavily in US fintech companies in 2019, including in the second quarter when a record high was set for quarterly venture investments at USD4.3 billion. Venture capitalists invested a total of USD6.8 billion in US fintech firms in the first half of 2019, continuing the upward trend from 2017 and 2018, when the total venture investments in the first half of the year were USD3 billion and USD5.7 billion, respectively. The trends show that – importantly – venture investment is continuing to pour into US fintech firms. The US fintech market is showing signs of maturing, as 2019’s 18% annual growth rate is more measured compared to 2018’s 90% annual growth rate.

Another sign of maturation in the US fintech venture market is the dominance of later-stage funding rounds. Deal activity increased for post-Series D venture investments in 2019 as compared to the first half of 2018. But deal volume decreased markedly for angel/seed and Series A-D ventures over the same time period. Now that venture capital-backed firms have had the opportunity to utilise the capital to grow, winners and losers are emerging. And venture capitalists are eager to continue to back winners. Carta, a leading player in the valuation software space, raised a USD300 million Series E round, while Affirm, a leading player in instalment loan consumer financing, raised a USD300 million Series F round after previously raising USD620 million in equity in prior rounds. Most importantly, Plaid, which raised USD250 million in venture capital in a Series C round in 2018, recently announced that it had signed a definitive agreement to be acquired by Visa for USD5.3 billion. The authors expect to see more large funding rounds in 2020, which has the potential to fuel the M&A market for the foreseeable future.

However, the market’s outlook is not entirely rosy. Amidst concerns that some fintech firms may not increase their already high valuation in their next financing round and could be forced to raise funds at a lower implied equity value than in prior rounds (a "down round"), investors are increasingly approaching the fintech sector conservatively. The economic and governance rights of existing investors are becoming of paramount importance as the industry matures because existing investors are seeking to avoid economic dilution and maintain their pre-existing governance rights in a down round. In last year’s version of this article, the authors noted – anecdotally – that they were aware of several fintech companies at risk of down rounds during 2019. The authors suspect this may have contributed to the decrease in early-round venture investment in 2019.

M&A activity in the fintech sector also continued to grow in 2019. In the first half of the year alone, M&A activity in fintech surpassed USD120 billion in transaction value, almost tripling the USD49 billion in deals announced for the same period in 2018. The surge in M&A activity was largely attributable to three mega-deals in the consolidating payments space: (i) Fidelity National Information Services' USD43.6 billion acquisition of Worldpay, (ii) Fiserv's $22 billion acquisition of First Data, and (iii) Global Payments' USD21.2 billion acquisition of Total System Services.

M&A activity in the first half of 2019 also generally showed a shift towards larger deal sizes, even setting aside the three aforementioned mega-deals. In the first half of the year, over 65% of deals had a disclosed transaction value above USD100 million, compared to 54% in 2018. Median deal size for the first half of 2019 also increased to USD193 million from USD137 million in the first half of 2018. Consistent with the trend in venture capital investments, this indicates maturing of the fintech sector, in that larger established companies are favoured over smaller players.

Emerging subsectors in fintech – such as insurance technology (insurtech), wealth management technology (wealthtech) and property technology (proptech) – experienced different trajectories. Deal value in insurtech was just over USD1.1 billion, compared to USD10 billion and USD7.6 billion in 2017 and 2018, respectively, showing a clear decrease in transactional volume. Wealthtech, on the other hand, rebounded in the first half of 2019 with deal value of USD2.2 billion, showing a marked growth from USD1.8 billion in all of 2018. Proptech, still a small niche sector, continued to grow, with just over USD1 billion deal volume in the first half of 2019 compared to USD1.4 billion in value in all of 2018.

There are several factors that suggest that M&A activity in the fintech sector will continue to be robust in 2020. According to one survey, 85% of banks and other financial institutions stated that fintech M&A is very important to their overall business strategy. Moreover, 79% of existing fintech firms believe that M&A in the industry is critical or transformative to their overall business strategy.

Traditional forms of investment in blockchain projects continued to advance in 2019 as the industry showed signs of maturing from the “initial coin offering” (ICO) rush of 2017 and 2018. Much of the investments continue to be for funding development projects for the underlying blockchain technology, but an increasing number of projects are focused on stablecoins, in which a cryptocurrency is pegged to a fiat currency or other digital assets to stabilise its value or is stabilised through a computer algorithm. Projects to "tokenise" non-digital tangible assets such as real estate and securities are also attracting increased investment by traditional sources of funding. In addition, cryptocurrencies such as bitcoin continue to attract attention, although primarily as a means of speculative investment. It remains to be seen which, if any, of the hundreds of available cryptocurrencies will survive and become true mediums of exchange.

For further discussion of the blockchain and digital asset regulatory environment, see 12 Blockchain.

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Robo-advisers use algorithms based on a variety of inputs, such as the investor’s age, investable assets, investment horizon, risk tolerance and other factors combined with modern portfolio theory-based investment strategies to provide wealth and investment management services without the human element of, and typically at a lower cost than, a traditional financial adviser. Traditional financial advisers and robo-advisers provide similar types of services, and therefore both (to the extent that they provide advisory services in the USA) are typically registered as investment advisers with the SEC or one or more state securities authorities. Both must also comply with the securities laws applicable to SEC or state-registered investment advisers. The staff of the SEC’s Office of Compliance Inspections and Examinations (OCIE) has provided guidance that, as a statutory fiduciary, when an investment adviser has the responsibility to select broker-dealers and execute client trades, each has an obligation to seek to execute securities transactions for clients in such a manner that the client’s total costs or proceeds in each transaction are the most favourable, taking into account the circumstances of the particular transaction.

As a general matter, many robo-advisers tend to focus on ETF investments, which reflects the increasing preference among the next generation of investors for low-cost, passive, diversified investments. The clients of robo-advisers tend to be younger, cost-conscious, hands-off investors who may initially have less capital available to invest. Because of the increased online presence of this next generation of investors, robo-adviser business models focus more on addressing the needs of their clients primarily through a greater online and social media presence. Many legacy players themselves are building their own robo-advisers, so they are able to offer a comprehensive set of products and services that appeal to a wide variety of investors.

Given the increasing role of electronic advice among providers of wealth and investment management services, OCIE has indicated in its examination priorities for 2020 that one of its areas of focus will be on robo-advisers, in particular with respect to SEC registration eligibility, cybersecurity policies and procedures, marketing practices, and adherence to fiduciary duty, including adequacy of disclosures and effectiveness of compliance programmes.

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Many online lenders are organised as non-bank entities. Lending activities by non-banks are governed not only by federal laws, but also significantly by state laws. Non-bank lenders must be mindful of the jurisdictions where their borrowers and applicants are located, as this factor significantly affects the legal and regulatory requirements applicable to the lender.

It is understandably difficult for regulators to keep pace with the rapid changes in online lending technologies. As such, the manner in which regulatory regimes are applied to online, mobile and other innovative delivery channels is evolving and often uncertain. Some states and federal authorities have amended their laws or regulations in this area, but those changes have often been incremental. The principal objective of these changes is the protection of borrowers and other customers. Although some laws apply only to consumer-purpose or residential mortgage lending, some key provisions generally apply to all types of lending, albeit sometimes with different specific parameters. For example, most types of non-bank lending are subject to maximum interest rates established under state law (usury rates), fair lending laws, data security requirements and the federal prohibition on engaging in unfair or deceptive acts or practices (UDAP).

State laws include non-bank licensing requirements that vary significantly from state to state. Even within a single state, the licensing requirements tend to vary based on the type of lending and the type of activity (eg, lending, servicing, brokering, collections). In many states, licensing of non-banks is required only for consumer or real estate-oriented lending activities. However, there are a smaller number of states (including California) that require licensing even for business-oriented, non-real estate lending.

Licensed non-bank lenders are generally subject to supervision, examination and enforcement jurisdiction of the state regulator where they conduct business, which is typically the state banking authority. The regulatory regime for such non-bank lenders differs from that applicable to banks. For example, licensed non-bank lenders are generally not subject to bank-like regulations regarding capital and liquidity, service to the community under the Community Reinvestment Act and deposit insurance assessments.

Many online lenders in the USA that are organised as non-bank entities have partnered with an unaffiliated bank. This bank partnership model seeks to take advantage of certain regulatory advantages (eg, federal pre-emption of state-by-state licensing and usury limits) and operational features (eg, access to traditional card and payment systems) available to banks. The specifics of each bank partnership vary and must navigate risks related to a complicated and fact-sensitive interplay of federal and state laws (eg, "true lender" risk).

In recent years, online lenders and other industry participants have begun to employ a growing variety of underwriting models. Lenders are implementing advanced algorithms and artificial intelligence (AI) in their underwriting processes to evaluate the credit of consumers, small businesses and other borrowers. These processes rely on a variety of data, such as FICO credit scores, bank transaction data, model-based income, social media, rent history, employment history, phone-number stability, browsing history and behavioural data. Federal and state laws have been slow to keep pace with technological developments used in the underwriting credit models.

Lenders (particularly when lending to consumers) should be mindful that the application of many federal and state laws to new and innovative types of underwriting inputs is evolving and uncertain. For example, the use of non-traditional data sources or automated processes could result in an unforeseen or unintentional "disparate impact" on a protected class of borrowers or applicants and create a potential risk under fair lending laws or a risk of UDAP.

Lenders rely on a variety of funding sources for loans, including deposits, peer-to-peer, lender-raised capital and securitisations.

Non-bank entities are not permitted to accept deposits. Therefore, banks are unique in their ability to accept deposits as a source of funding. Because they are generally insured by the Federal Deposit Insurance Corporation, deposits are generally viewed as a stable and low-cost source of funding. Banks are subject to extensive supervision, regulation and enforcement from the applicable federal and state banking regulators. Nonetheless, non-bank lenders have been exploring bank charters, such as the Office of the Comptroller of Currency’s so-called fintech charter and industrial bank charters, which may provide benefits to their specific business models that outweigh the costs associated with being a regulated bank.

As compared to banks, non-bank lenders generally have more limited balance sheet capacity and may rely more on funding from sources like equity raises, long-term debt, secured borrowing, securitisations and peer-to-peer funding. Marketplace lenders have historically employed a peer-to-peer funding model, where specific loans are funded mostly by individual investors. Securitisation is also a significant source of funding for non-bank lenders. Securitisation requires an assessment of applicable federal and state securities law, and generally requires extensive disclosure to prospective and existing investors.

Marketplace lenders generally serve as an intermediary for individuals, institutional investors and others to providing funds for a loan. The processes vary and continually evolve but generally are facilitated by an online platform that connects the potential borrower with investors. These platforms allow the loan funding process – from customer acquisition to underwriting and origination, and through servicing – to be entirely digitised. Borrowers may have reduced borrowing costs, more seamless customer experiences and shorter lead times to closing as a result of electronic delivery channels. As noted above, lending is regulated by a number of federal and state regulators in the USA and the nature of regulation varies across the bodies, and depends on the type of lender. This regulatory environment was generally developed in the context of traditional lending through physical delivery channels and has not necessarily kept pace with electronic or other innovative delivery channels.

Reliance upon existing payment rails is not required for payment processors. However, as consumers and corporations demand faster or “real-time” payments, payment service providers may consider addressing these demands by building upon the existing model or starting anew. The Clearing House's RTP network, for example, uses a Mastercard service to offer a real-time payments platform that US banks are eligible to use. Alternatively, some in the fintech space have chosen to build their own payment systems, such as ATCE Holdings's EtudePay Payments System, which is a real-time payments rail delivered on its own settlement platform for processing transactions.

In any case, banks remain key players in the broader payments industry. Therefore, the ability to convince banks to adopt new payment systems is an important consideration when building upon existing models or starting anew. As the industry evolves, both existing and new payment rails are being employed in novel ways to support traditional payment flows, while facilitating up-and-coming payments technology.

A payment processor based in the USA generally will be under the oversight of multiple regulators, including potentially multiple federal and state banking regulators. The scope of such oversight depends in part upon the services that the payment processor is providing and the types of banks with which it has certain relationships. Compliance with requirements established by the Office of Foreign Assets Control and the Financial Crimes Enforcement Network are particularly important considerations regarding cross-border payments given their requirements related to anti-money laundering practices. Cross-border payments and remittances also must comport with the various operating standards of the industry. For example, the payment card industry issues requirements applicable to merchants who process, store or transmit credit card information in an effort to ensure a secure transaction environment is maintained. A payment processor may also need to comply with the rules or standards applicable to the various credit card networks, such as the interchange fees that credit card networks may charge merchants. In short, there are several rules or standards that a payment processor must be aware of in order to operate in the USA.

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In the USA, blockchain-based assets, such as digital tokens and cryptocurrencies, are currently characterised as "securities" or, broadly speaking, "something other than securities". Blockchain-based assets that are securities (ie, security tokens) are, to the extent traded on an exchange, required to be traded on an SEC-registered national securities exchange or an alternative trading system (ATS). Conversely, blockchain-based assets such as bitcoin and other "pure" cryptocurrencies that are not currently characterised as securities are not subject to such a requirement. Therefore, trading platforms are subject to regulation based upon the type of asset that trades on such platform.

Based on recent estimations, there are hundreds of cryptocurrency exchanges and trading platforms around the world (collectively referred to herein as "trading platforms") and new ones seem to launch regularly. The explosion in number of these trading platforms has recently drawn significant attention from US regulators. Although standards vary, as a general matter, many trading platforms will not list any token that could potentially be viewed as a security, but will instead opt to list "utility tokens" or "pure" cryptocurrencies. This allows trading platforms to avoid the regulatory requirements associated with securities.

Trading platforms that advertise themselves to be so-called peer-to-peer trading platforms may fall within the definition of an "exchange" under the federal securities laws (which is broadly defined) and consequently such trading platforms may be subject to a variety of penalties, including monetary fines and orders to cease operations. The rules under the Securities Exchange Act of 1934 (the Exchange Act) provide for a functional test to determine whether a trading platform is, in fact, operating as an exchange.

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See 7.1 Permissible Trading Platforms for information on cryptocurrency exchanges.

The SEC does not set listing standards; rather, the various trading platforms set their own standards for listing and continuing to trade securities. Trading platforms that are willing to list securities tokens will often require that the token be linked to a high-quality, differentiated and value-adding product or service; have high-quality code that is as much as possible not susceptible to hacking; and have detailed information regarding technical specifications and legal rights and restrictions.

Given the rapid growth of the blockchain-based assets market and the risks it poses to retail investors who may not understand the difference between these relatively new assets and more traditional assets, OCIE has reiterated in its examination priorities for 2020 that it will continue to identify and examine SEC-registered market participants engaged in this space.

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See 7.1 Permissible Trading Platforms for information on peer-to-peer trading platforms.

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See 8.6 Rules of Payment for Order Flow.

High-frequency and algorithmic trading strategies (HFT strategies) are increasingly being utilised by proprietary trading shops and hedge funds (trading firms) as an enhancement to implementation of traditional trading strategies. At a high level, HFT strategies involve the application of software-based algorithms to trade in and out of high-volume positions of equities and other financial products at speeds faster than achievable by their human counterparts. HFT strategies vary significantly and can be used for exchange-based and OTC (or off-exchange) trades, as well as trades in currently unregulated markets such as the cryptocurrency markets.

Depending on the role and activities of the particular trading firm utilising HFT strategies, different regulatory regimes may apply to such firm. Hedge funds using HFT strategies are generally treated the same as hedge funds using other strategies and therefore may be regulated as investment advisers and required to register with the SEC or one or more state securities authorities. Such hedge funds must comply with securities laws applicable to SEC or state-registered investment advisers.

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Some trading firms employing HFT strategies operate as market makers or dealers, in which case such a firm would be required to register with the SEC as a broker-dealer. Certain broker-dealers rely on Rule 15b9-1 of the Exchange Act, which exempts them from the statutory requirement to become a member of the Financial Industry Regulatory Authority (FINRA). As a result of the exemption, FINRA has no jurisdiction over these broker-dealers and is therefore unable to enforce compliance with federal securities laws and rules. The SEC has recently proposed amending this exemption, as it prevents FINRA from being able to monitor use of HFT strategies and manipulative behaviour. Despite such trading firms being members of their respective exchanges, the exchanges are not able to regulate OTC activity as typically they only have access to the trade data for trades conducted on their own exchanges.

Trading firms operating as market makers often pay retail brokers in order to compete for retail order flow. Market makers that are willing to provide improved prices, made possible by utilising HFT strategies, may be better able to compete for such order flow. This leads to a potential conflict of interest for retail brokers, who are required to seek out the option that provides the best chance of execution, best speed of execution and best price, rather than selling their order flow to the highest bidder.

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The term "insurtech" covers a wide variety of technological innovations that aim to harness the power of technology to reinvigorate an age-old industry. Disruptors such as Oscar, Root and Lemonade seek to displace the traditional provider-customer relationship for a newer, app-based dynamic. Mature market players in turn have embraced innovations to fill a wide range of niches, ranging from policy pricing to fraud detection. Although the fractured regulatory environment insurance companies are subject to may stymie any one-size-fits-all solution, the inexorable march of progress nonetheless continues.

Underwriting processes often vary by product and industry participants. Innovative participants have begun relying on technologies such as big data, AI, wearables and telematics to improve underwriting and provide more accurate conclusions. That said, regulations in a particular jurisdiction may require that rates be filed with, and approved by, the appropriate insurance regulator. Such regulator may also prohibit specific factors from being considered, or may even prescribe the precise factors that must be considered, sometimes at odds with overall technical trends.

As the regulation of insurance in the USA is largely state-based, the regulations may vary significantly. For example, while some states expressly permit credit scores to be considered when rate-setting for property and casualty policies, numerous other states apply strong limitations. Some states expressly permit genetic data to be used in the life and disability space. Others expressly prohibit it. Other regulations, including those related to data privacy and anti-discrimination laws, may also impact the underwriting process. As a result, the process is often a bespoke one by necessity, taking consideration of the variances between jurisdictions. The National Association of Insurance Commissioners, consisting of representatives from each US state, has set up a number of workgroups and task forces to consider regulatory changes in response to technological developments in the industry.

Industry participants and regulators treat different types of insurance in significantly different ways. For example, they require different licences and different regulations governing the production of such business. This necessarily imposes impediments to any unified national solution. Instead, market participants often need to tailor their products and services to meet not one but 50 different approaches to insurance regulation.

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Blockchain technology, which uses a distributed ledger system and a consensus protocol to verify transactions, has the potential to transform any industry that today relies on a single trusted third party. Nowhere is this more true than across the financial services sector. Over the last few years, numerous firms in the financial services sector have been building out proof of concept platforms that rely on blockchain technology, with some projects already active. This trend is likely to continue and expand. In most cases, financial services firms are using so-called private, permissioned blockchains when transacting amongst themselves because these ecosystems limit who can join and employing the power of public permissionless blockchains when exploring consumer-facing projects. Potential applications include global payments, clearing and settling, syndicated loans, trade finance, convertible bonds and proxy voting. A number of financial institutions have also filed, and in some cases been granted, US patents on different blockchain applications.

In the USA, regulators are coping with how existing regulations, drafted to apply to centralised ecosystems, apply to decentralised systems where the actors may not be readily identifiable. The concept of blockchain regulation is, of course, anathema to many proponents of the technology who believe that its transparency and decentralisation means that there is no need for regulation. Set forth below are some key developments in the US regulatory landscape, with the caveat that this is a quickly evolving field.

As of the end of 2019, 21 bills addressing blockchain technology have been introduced in the US Congress. Two bills in particular stand out; one would exempt tokenised assets from securities laws, while the other seeks to establish a common definition of blockchains or stablecoins, and seeks to promote new ways of leveraging and innovating the technology. For example, in September 2019, the House of Representatives passed a bill requiring the Financial Crimes Enforcement Network to conduct a study on the implementation and use of blockchain and other technologies.

Although federal laws are still in their relative infancy, close to 30 states have enacted cryptocurrency or blockchain-related legislation as part of efforts to become hubs for blockchain innovation. As of May 2019, upwards of 237 pieces of blockchain-related state legislation had been introduced. Some states – including Arizona, North Dakota, Oklahoma and Washington – have amended laws so that records or contracts secured through blockchain technology are deemed enforceable electronic records. For example, in June 2019, the State of Nevada enacted legislation that revised the definition of “electronic transmissions” to include the use of blockchain technology, and authorised the Nevada secretary of state to adopt regulations that will allow business entities to carry out their duties using the most recent technology available, including blockchain. In January 2020, the Illinois Blockchain Technology Act went into effect, which affirms the contractual enforceability of smart contracts and other records for which blockchain technology was used. The State of Delaware, where more than half of US companies are incorporated, is also exploring a blockchain-based business filing system that will allow corporations to employ smart contract technology to track stocks and collateral assets. It is likely that, from a legislative perspective, states – as opposed to the federal government – will continue to take the lead.

In 2019, the SEC released new guidance regarding how to determine whether cryptocurrencies constitute securities. The SEC relies on the Howey Test as the current regulatory framework, first articulated in SEC v WJ Howey Co, 328 US 293 (1946). Under the Howey Test, courts analyse whether the instrument or offering in question satisfies all three of the following prongs: (i) “an investment of money”, (ii) “in a common enterprise” and (iii) “with profits to come solely from the efforts of others.”

The SEC first applied the Howey Test to cryptocurrency on 25 July 2018 in its so-called DAO Report, in which the SEC concluded that a particular cryptocurrency called DAO Tokens was a  security subject to regulation. Since then, there have been a number of SEC orders and court decisions applying Howey to analyse other ICOs: Paragon Coin, Inc, Securities Act Release No 10574 (16 November 2018); CarrierEQ, Inc, D/B/A AirFox, Securities Act Release No 10575; SEC v Blockvest, LLC et al, No 18-CV-2287-GPC (11 October 2018). In some of these cases, cryptocurrency developers have been required by the SEC to register under the Exchange Act, pay fines and offer rescission to investors. SEC enforcement action in this space picked up considerably in 2019, with a number of settlements announced. For example, in February 2019, the SEC required Gladius Network LLC (Gladius) to compensate investors and register tokens it offered in an unregistered ICO in 2017, but did not impose a fine on Gladius (see Gladius Network LLC, Securities Act Release No 10608 (20 February 2019)). The SEC's lenience with regard to the lack of a penalty was due in part to the fact that Gladius self-reported the ICO, which raised approximately USD12.7 million, to the SEC in 2018, took prompt remedial steps and co-operated with the SEC's investigation (id). In September 2019, the SEC settled charges against Block.one for conducting an unregistered ICO that raised the equivalent of several billion dollars over approximately one year. The company agreed to settle the charges by paying a USD24 million civil penalty. The SEC highlighted, in part, that Block.one’s offer began shortly before the SEC released the DAO Report of Investigation (the DAO Report) and continued for nearly a year after publication of that report. In December 2019, the SEC settled charges against Blockchain of Things Inc. (BCOT) for conducting an unregistered ICO of digital tokens. Here too, the SEC focused on the fact that BCOT conducted the ICO starting after the DAO Report was issued. The SEC’s settlement with BCOT allowed the company to register the tokens offered in an unregistered “pre-sale” and a “public sale” between December 2017 and June 2018, and to compensate investors (see Blockchain of Things, Inc., Securities Act Release No 10763 (18 December 2019)). The SEC also imposed a fine on BCOT of USD250,000.

The SEC has also focused on trading platforms, seeking to have them register as exchanges and imposing fines (Zachary Coburn, Securities Act Release No 84553 (8 November 2018)). Beyond enforcement, the SEC has also encouraged developers to engage in voluntary discussions with staff regarding their projects and compliance issues. To that end, the SEC established FinHub in October 2018, which is specifically designed to provide guidance to developers in this space.

The CFTC has taken the position that cryptocurrencies are commodities. This position has been supported by multiple federal court decisions. For example, in CFTC v McDonnell, 287 F Supp. 3d 213 (EDNY 2018), a federal district court in New York held that the CFTC can regulate cryptocurrencies as a commodity because they are “‘goods exchanged in a market for a uniform quality and value” and they also “fall well within the common definition of ‘commodity’ as well as the [Commodity Exchange Act’s] definition of ‘commodities.’” Similarly, in CFTC v My Big Coin Pay, 334 F Supp 3d 492 (D Mass. 2018), a federal district court in Massachusetts held that cryptocurrencies are subject to CFTC regulation as a commodity class because futures trading exists on bitcoin, a subset of that class.

If a blockchain asset such as a cryptocurrency is a commodity, the CFTC has enforcement authority to police fraud and manipulation in spot markets for the asset. If there are derivatives contracts on blockchain assets (ie, futures, swaps and options), the CFTC will have full regulatory authority over those contracts. For example, futures contracts on bitcoin currently offered on some exchanges are subject to the full regime of futures regulation under the Commodity Exchange Act.

Thus far, the CFTC has focused its enforcement authority on protecting retail customers engaged in unregulated spot transactions in cryptocurrencies. However, the CFTC will face more complex questions with respect to the scope of its authority over blockchain as innovators begin exploring the use of smart contracts to facilitate decentralised trading in derivatives. To prepare for these types of questions, the CFTC upgraded its financial technology research wing in October 2019. Known as LabCFTC, the wing is dedicated to promoting the development of new financial technologies in order to ensure that innovators can easily access and understand the CFTC’s regulatory framework and the agency’s approach to oversight.

In 2019, the CFTC moved ahead with approving and allowing more digital asset/virtual currency products. For example, the CFTC approved the applications of two entities to register as a designated contract market and a derivatives clearing organisation, respectively, to offer or clear virtual currency derivatives products.

The CFTC approved LedgerX’s DCM application in June 2019 to offer bitcoin spot and physically settled derivatives contracts, including options and futures, to retail clients of any size. LedgerX had previously been registered as a DCO in July 2017 to clear fully collateralised digital currency swaps. The CFTC also approved Eris Clearing’s DCO application in July 2019 to clear fully collateralised virtual currency futures.

In October 2019, CFTC Chairman Tarbert publicly stated that ether, like bitcoin, is a commodity that falls under the CFTC’s jurisdiction. Previously, in December 2018, the CFTC had sought public comments on the Ethereum network and the cryptocurrency ether to better inform the commission’s understanding.

To the extent blockchain assets held by a fund are considered securities, the Investment Advisers Act of 1940, as amended, applies and, to the extent such assets are considered commodities, the Commodity Exchange Act applies. The investment advisers of such funds that invest in blockchain assets that are considered securities are typically registered with the SEC or one or more state securities authorities and must comply with the securities laws applicable to SEC or state-registered investment advisers. In this firm's experience, such funds are exclusively structured as "Section 3(c)(1)" or "Section 3(c)(7)" private funds. A trading platform on which blockchain assets that are securities are traded is required to be a SEC-registered national securities exchange or an ATS.

See 12.2 Local Regulators' Approach to Blockchain for information on classification of blockchain assets.

See 12.2 Local Regulators' Approach to Blockchain for information on issuers of blockchain assets.

See 12.2 Local Regulators' Approach to Blockchain for information on blockchain asset trading platforms.

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See 12.2 Local Regulators' Approach to Blockchain for information on virtual currencies.

Blockchain technology has the potential to revolutionise how personal information is stored and processed. However, the benefits of blockchain technology will need to be reconciled with California’s new privacy law, the California Consumer Privacy Act (CCPA), that went into effect in January 2020. Further guidance might be required on whether one can exercise a right of deletion on a blockchain-based system. US companies building out blockchain applications in the fintech space will need to take privacy laws such as the CCPA into account and monitor this area of the law closely.

Open banking, an emerging space within fintech, can be thought of as a system whereby financial institutions’ data can be shared with third parties, such as data aggregators and app providers, through application programming interfaces. Open banking may be a gateway to providing more services to customers and is generally considered a more secure method for sharing financial account and transaction data than so-called screen scraping, but it also introduces its own concerns.

Relative to Europe and certain Asian countries, the USA lags behind in its development of laws and regulations around open banking. Some have viewed the fragmented nature of financial regulation in the USA as an impediment to the development of a comprehensive regulatory scheme. Some argue that the lack of an industry standard or regulatory framework in the USA for open banking is an obstacle to the development of its full potential. As with many emerging areas, there is a debate as to whether the private sector or the public sector should lead the pathway forward. While the US Treasury and others have advocated for a private sector-led solution to open banking, others have raised concern that a solution determined by financial services companies – rather than consumers – may adversely impact the types of services that fintech data aggregators and consumer application providers may be able to develop. When entering into open banking relationships with financial institutions, data aggregators, app developers and others, it will be important to consider a multitude of data-related issues, including consumer protections, protections for data privacy and security, data ownership, allocation of liability in the event of breach and responsibilities for responding to any breach.

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Law and Practice in USA

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Skadden, Arps, Slate, Meagher & Flom LLP & Affiliates advises businesses, financial institutions and governmental entities around the world on their most complex, high-profile matters, providing the guidance they need to compete in today’s business environment. The financial technology industry presents businesses and private equity, venture capital and other investors with extraordinary opportunities as well as challenging legal and regulatory issues. Skadden has helped clients to navigate this complex environment since the industry’s inception. The FinTech practice draws on the firm’s global platform and market-leading corporate finance, financial regulation and enforcement, intellectual property and technology, privacy and cybersecurity and M&A capabilities, making it uniquely qualified to offer clients exceptional depth of experience and full-service capabilities. Skadden would like to thank complex litigation and trials partner Alex Drylewski; M&A and financial institutions partner Jon Hlafter; financial institutions regulation and enforcement counsel Collin Janus; derivatives of counsel Jonathan Marcus; investment management associate Prem Amarnani; financial institutions associate Patrick Lewis; financial institutions associate Tim Gaffney; financial institutions associate Han Lee; and M&A associate Marcel Rosner for their invaluable contribution to this chapter.