The milestone fund structure portends a reduced role for broker-dealers, who may be sidelined by innovators unwilling to wait for regulators.
By Stephen P. Wink and Deric Behar
On July 6, 2020, asset management firm Arca announced that the US Securities and Exchange Commission (SEC) granted it approval under the Investment Company Act of 1940 to issue shares of a closed-end US Treasury fund in the form of digital securities. The fund will comprise a managed portfolio invested primarily in interest-bearing and low-volatility short-term US government bills, bonds, and notes. Interests in the fund will be purchased directly from the fund and will be issued to approved Ethereum wallets as “ArCoin” ERC-1404 tokens, digital securities that are transferable using blockchain technology. ArCoins are decidedly not cryptocurrencies or stablecoins, but are securities tokens representing equity interests in the fund, with a net asset value that will fluctuate based on the value of the fund’s underlying Treasury assets in the same manner as other mutual fund shares.
Arca asserts that its offer of digital securities rather than traditional shares will allow investors to transfer shares peer-to-peer quickly, in small increments, and at lower cost. Additionally, peer-to-peer transactions using ArCoins will be trackable by the fund administrator and transfer agent on the Ethereum blockchain on a real-time basis.
Digital Asset Milestone
While the advent of ArCoins is not a watershed moment (such as when an exchange-traded fund finally obtains the SEC’s blessing to hold cryptocurrencies or stablecoins as underlying assets), the share delivery via ArCoins deserves distinction as a digital asset milestone. By offering shares as ArCoin tokens and the ability to transfer the digital securities peer-to-peer over the blockchain, Arca has effectively removed financial intermediaries from a long-standing equation in the investment universe. While the fund’s underlying assets will be held at a third-party custodian bank, shares will be directly tradable among individual or institutional investors. Arca also claims that investors and digital asset firms can theoretically benefit from the friction-free transferability of ArCoins in multiple use-cases, such as payments, lending, clearing, settlement, treasury management, and insurance.
Additionally, the ERC-1404 protocol that is being employed provides investors with an enhanced measure of security over the popular ERC-20 protocol, as ERC-1404 tokens can only be transferred to white-listed wallet addresses (in the case of the Arca US Treasury Fund, that this means anti-money laundering/know your customer (AML/KYC) and other documentary clearance).
The Arca US Treasury Fund and ArCoin innovation is the first in a series of blockchain-based financial products that Arca plans to offer, and others firms are sure to follow with similar products and competitive offerings.
Innovation and the Consequences of Regulator Inaction
The ArCoin innovation sheds light on an issue that has been apparent since the dawn of digital assets: regulators are much slower to act than innovators, and the consequences of foot-dragging may be contrary to the regulatory mandate to protect markets and investors. The promise of securities tokens has been severely limited by the failure of the SEC and the Financial Industry Regulatory Authority (FINRA) to permit registered broker-dealers to custody digital assets given their stated concerns about such assets. As a result, secondary markets for security tokens have been extremely limited.
By disintermediating broker-dealers, Arca will avoid this regulatory logjam by issuing security tokens directly to investors and permitting them to trade the tokens on a peer-to-peer basis. And while peer-to-peer trading may offer certain advantages to markets and investors, it is clear that by eliminating the regulated intermediary from secondary market trading, a good portion of the protections ordinarily afforded investors under the securities laws will no longer apply. It is ironic that the inability of the SEC and FINRA to find an appropriate way for broker-dealers to trade in these assets may actually lead to less protection of investors as innovators work around them.
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