New York Regulator Approves Internal Use of “Permissioned” Blockchain by Commercial Bank—Other Institutions Should Follow

Guest Commentary

thompson_max_web_10262018_7561796858267778162By Maxwell T.S. Thompson, an Associate with Murphy & McGonigle, P.C. in the firm’s New York, NY office. Prior to joining the firm, Mr. Thompson was Assistant General Counsel and Assistant Corporate Secretary with Bank Leumi USA and served in the General Counsel’s office of the New York State Department of Financial Services.

On December 4, 2018 the New York State Department of Financial Services (“NYDFS”) announced that it had approved an application by Signature Bank to offer a new blockchain-supported digital payment platform named “Signet.” Housed entirely within Signature, the Signet platform “will leverage blockchain technology in its architecture, allowing commercial and asset management clients to make payments in U.S. dollars 24-hours-a-day, 7-days-a-week, 365 days a year.”1

Clients that interact with one another on the platform will see their transactions settle in real time, safely and securely, and with no transaction fees. Better yet, “[d]eposits held within the Signet platform are eligible for FDIC insurance up to the legal insurable amounts defined by the FDIC.” Blockchain proponents have long lauded the technology’s potential for added efficiency and cost reduction. With the implementation of Signet, Signature has positioned itself to actualize these benefits, and the decision should motivate other institutions to consider where their business and clients may also benefit from similar platforms.

Signature partnered with New York-based fintech company trueDigital Holdings to develop the platform. As a permissioned version of the ethereum blockchain, “Signature Bank’s digitized dollars, or signets, are designed to only work on the bank’s proprietary Signet platform, and are not expected to interoperate with other exchanges and services built to accommodate the [ethereum ERC-20] standard.”2 The idea is simple: traditional payments utilize the SWIFT interbank platform or the Automated Clearing House network that can take several days to settle, and even longer if executed prior to or during a weekend when these platforms are generally unavailable. With the introduction of Signet, “funds are transferred in real-time between commercial clients of Signature Bank.”3

The announcement by NYDFS approving Signature’s use of the permissioned blockchain makes Signature the first bank to receive regulatory approval to use blockchain technology in this capacity. The financial services industry has seen a litany of consortiums seeking to cooperate on implementing blockchain technology, but what makes Signet unique—and what other institutions need to consider for their own operations—is the permissioned nature of the Signet platform coupled with the single-organization approach. While Signature may seek to open Signet to a broader audience in the future, the current iteration serves only Signature and its commercial customers.

Sunil Hirani, the Founder and Chief Executive Officer of trueDigital, stated that “[t]he launch of Signet will address an obvious need that diverse ecosystems have for exchanging funds repeatedly with the same counterparty.” With this in mind, other institutions should look at Signature’s implementation of Signet as a model and consider where these types of permissioned, single-organization blockchains might be beneficial in their organization.

For example, those institutions subject to Section 23A of the Federal Reserve Act are generally required to ensure that extensions of credit to affiliates are properly collateralized. Managing the collateral to ensure 23A compliance requires a careful ongoing review of exposure levels, which may be in constant flux, and an adjustment of the required collateral depending on the level of exposure. Like those commercial parties targeted by the Signet platform, the entities within an affiliated group subject to 23A certainly qualify as those that are “exchanging funds repeatedly with the same counterparty” and could utilize a signet-type permissioned blockchain to transfer collateral to one another more efficiently, safely, and in a timely manner.

With the complexity of services offered by today’s financial institutions, the potential applications of an internal, permissioned blockchain are voluminous. In addition to the previous collateral example, some institutions may consider implementing permissioned blockchains for other internal or intergroup products and services, such as cash management or interest rate swaps.

As part of its approval, NYDFS stated that Signature will be “subject to significant regulatory conditions all of which will be subject to examination and inspection by DFS examiners as well as independent consultants to ensure that important protections for New York markets and consumers are being met.” Those requirements include implementing, monitoring, and updating effective risk-based controls to prevent money laundering and wrongful use of virtual currency; complying with NYDFS’ transaction monitoring rules (23 NYCRR Part 504) and cybersecurity regulations (23 NYCRR Part 500); and maintaining policies and procedures for consumer protection and for promptly addressing and resolving consumer complaints.

By explicitly imposing these responsibilities on Signature as part of its implementation of the Signet blockchain, NYDFS has arguably placed Signature in the position of a pseudo-regulator over the service. Those entities that seek to follow Signature’s decision should consider the implication of this position and carefully determine the types of covenants they might need to include in their contractual agreements with any vendor, like trueDigital, that they may partner with to build these developments. Contractual provisions focused on BSA/AML, cybersecurity, maintenance and service level requirements, audit rights, and indemnification are just a few convenants that institutions should consider when entering into a vendor arrangement for a permissioned blockchain product or service.

For those institutions that may still remain skeptical of the advantages that come with this technology, Signature Co-Founder and Chief Executive Officer Joseph DePaolo had this to say: “[W]e have to do this, otherwise we’re not going to exist …. If you’re not involved in blockchain, in five years, you won’t be around as a bank.”

Notes:

  1. https://www.truedgtl.com/truedigital-launches-signet.
  2. https://www.forbes.com/sites/michaeldelcastillo/2018/12/04/signature-launches-institutional-payments-using-permissioned-ethereum-blockchain/#503ad8cd3eff.
  3. https://www.signatureny.com/business/signet.

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