Can we use smart contracts to prevent employee insider trading?

At Modular, we are very excited to see the growth and maturity of blockchain-based assets (cryptoassets). More and more stakeholders are entering the space and seeing it as an asset class worth considering, both at the retail and institutional level. With this transition comes increased attention from government and regulatory bodies seeking to ensure fairness and rule of law in these emerging markets. How can companies possibly avoid the pitfalls that other noble players have fallen victim to?

This question has been central to our thought process and development of our upcoming cryptoasset custody technology. It pains whenever we see another company or user fall victim to the complicated regulatory environment we live in.

As cryptoassets continue to gain adoption and attention, companies seeking to interact with this new asset class will need to understand and embrace the underlying technologies in order to stay safe and compliant with local and federal laws.

Reuters recently wrote that compliance officers are worried about how to remain compliant with local and national laws when their companies get involved with cryptoassets. These organizations have identified some of the large opportunities that exist with cryptoassets, but don’t want to engage in any activity that will put them at odds with governments and regulators.

Reuters notes:

There is also an absence of clear rules from global regulators, making it harder for financial companies to set their own. The U.S. Commodity Futures Trading Commission considers bitcoin a commodity, while the U.S. Securities and Exchange Commission says some cryptocurrencies may be securities without specifying which ones.

This lack of clear regulatory guidance puts companies interested in cryptoassets in a difficult situation. Some potential violations, such as needing a securities license, may be relatively easy to spot. But other legal or regulatory pitfalls may be harder to track and avoid.

An Example: Token A

Take for example a situation where cryptoasset ‘Token A’ has ambiguous status somewhere between a ‘utility token’ (not subject to securities regulation) and a ‘security’ (subject to many different rules and laws).

Hypothetical ‘Finance Company’ has been interacting with Token A as part of its business, including exchanging the asset on behalf of clients. If a regulatory body within the same legal jurisdiction of Finance Company declares Token A to be a security, Finance Company could be in violation of multiple securities laws, including those around licensing requirements, insider trading and others.

For traditional asset classes like equities, we have clear and established regulations that make it easier for companies to track and prevent things like insider trading or improper transfer. But in cryptoassets, where legal guidelines are still evolving, it is much more difficult to stay compliant.

Enforce Rules with Smart Contracts

Thankfully, the underlying technology of cryptoassets has provided us a solution to this problem: smart contracts.

Smart contracts, snippets of programmable logic that can be hard-wired into blockchains that support them (e.g. Ethereum), can be written so that rules and regulations are enforced at the token (asset) and protocol (technology) level.

This is a huge benefit to both the companies wanting to interact with cryptoassets and the regulators seeking compliance. Smart contracts can not only remove the need for continuous compliance checking, but are able to eliminate the need for compliance checks in the first place.

Imagine that you own a company who wants to raise funds using a cryptoasset token, ‘CompanyCoin’. Your legal and regulatory counsel has advised that you utilize Rule 504 of Regulation D, which provides an exemption to the normal registration requirements assuming certain conditions are met. One of those conditions is that CompanyCoin is a restricted security, meaning it can’t be sold for at least six months to a year without going through securities registration.

In the current state of the cryptoasset market, preventing all of the participants of the CompanyCoin offering from violating this 6–12 month restricted lockup rule is a difficult and labor-intensive process.

Yet, with smart contracts this is a relatively easy problem to solve.

Instead of issuing CompanyCoin directly to users’ personal cryptoasset wallets, which gives way to track or prevent assets from being transferred or sold unlawfully, CompanyCoin can be distributed directly into a smart contract that locks the asset’s movement for a specified time period, ensuring that your company and employees are compliant with Rule 504 of Regulation D.

The path forward

As opportunities in blockchain and cryptoassets have grown significantly, regulation and compliance tools have not kept pace. There is a real threat of legal or regulatory liability when businesses interact with assets that may be considered securities. With our technology, Modular is working diligently to give banks and users the management tools to solve these challenges and many others.

Stay tuned for more updates and product announcements from Modular. We’ll be detailing more features of our technology in upcoming posts in the modular publication, so make sure to follow in order to receive updates!

If you are a bank or team interested in a versatile custody solution that solves many of the challenges related to custody and management of cryptoassets. please reach out to contact@modulartech.io

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Thanks to C. Brown and Alex Treece for help on this post!