Speakers: Blockchain Will Change Everything, Auditors Must Be Nimble

By:
Chris Gaetano
Published Date:
May 11, 2018

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Blockchain technology will disrupt the financial world just as surely as the Internet disrupted the media world decades ago, and while this may seem threatening to some, it also represents an opportunity for forward-thinking firms to find a niche in this new world and thrive when others go extinct. This was the message put forth by a pair of speakers at the Foundation for Accounting Education's Broker Dealer Conference on May 9; they exhorted their audience to get out of 20th-century thinking and embrace all the possibilities this new technology brings. 

“Not all publishers went out of business, and the ones who took advantage of [the Internet] did quite well.  … Some of you will take and embrace this, and you’ll have a cool opportunity. Those who want to put their heads in the sand, just retire,” said panelist Paul Johnson, the founder of Nicusa Investment Advisors. 

The other panelist, attorney James Jalil, the chair of the cryptocurrency practice at Thompson Hine, asked his audience to consider how fast and how profoundly the Internet changed society. He said that if he were addressing an audience 20 years ago much like the one he was addressing now, few people would have said they regularly used the Internet or even had an email address. Today such a thing would be unthinkable. He gave a personal example to illustrate. 

“I got my wife for Christmas [one of the] first computers, a Dell. It was tall and had .02 megabytes and she said, ‘What am I gonna do with this? What use does it possibly have?’ ... Well, fast-forward 20 years, and she can’t imagine living 10 minutes of her life not plugged into her phone or laptop or notebook, her Internet, because she now has become part of the digital world,” he said, adding that it will be the same with blockchain. “This will be the future of digital assets.” 

Blockchain is essentially a distributed database that is nearly impossible to tamper with retroactively through conventional means. Johnson asked the audience to imagine a paper ledger with a list of transactions, the type most accountants would know. He then asked them to mentally put the ledger in a bucket, then seal the bucket with a top and a combination lock. The bucket is “your first block," he said. Then, he said to imagine a new transaction. Instead of adding the new transaction to the list in the first bucket and changing the information, a participant would take a copy of the first ledger, note the change, put it in a second bucket, seal it with a lock, and then write the time and date on the outside of the bucket . The new bucket is “your second block," he said. Participants then repeat this process for every subsequent transaction, creating new buckets as the records change, with time stamps written on the outside of each new bucket. Since all blocks are based on the information in the prior blocks, changing the overall ledger would mean having to change what’s in every single block (bucket) along this chain, and doing so before any new blocks are added to the chain. That would make the system essentially tamper-proof. 

While digital currencies like bitcoin are the most visible application of this technology, Johnson told his audience to ignore them—while they are “interesting and fun and get the headlines” it’s the blockchain technology undergirding them that really matters. Many companies are already experimenting with the different applications, and Johnson said that auditors will be vital to them all, though in a slightly different role. The focus will be less on the past than the present: If all the blocks on a blockchain can be verified by the previous block, auditors will be focusing more on what he called the “gateway problem.” Basically, who is entering information into the blockchain in the first place, and is that information accurate? A recent research paper from the Bank of Canada posed the hypothetical of using a blockchain to record and transfer land ownership titles. To initiate this process, though, people will need to attest that a specific plot of land exists and to assign it to an initial owner. Who does this? Johnson suggested it would be auditors. 

“How do we get that information on [the blockchain]? We might want an auditor to come in and audit that. … If we put something on the blockchain, and it’s accepted once it’s on there, there is still a gateway problem, so auditors can still have a vital role. It’s not a case of keeping track of the chain, but the gateway,” Johnson said. 

He added that auditors could also come in when there is a dispute between what’s on a paper record and what’s recorded on a blockchain, such as with a paper contract and a parallel “smart contract” (a blockchain-based self-executing and self-enforcing contract). With this in mind, Johnson envisioned blockchain, rather than threatening the livelihood of auditors, as a massive jobs program for the profession. He noted that the billionaire Winklevoss twins, who have invested heavily in cryptocurrencies, recently took their passwords, broke them into four pieces, and hand stamped each on a metal plate that they then placed in safety deposit boxes around the country. 

“Auditors will love that. [A hypothetical auditor would say,] ‘Who has the keys? Where are they? We’ve got to solve this problem before we move on,’” he said. 

If there’s anyone who should be worried about blockchain threatening their jobs, according to Johnson, it’s transfer agents. If someone can instantly transfer ownership of property, which is one potential application of blockchain, it makes little sense to involve transfer agents in the transaction. 

Confusion Plagues Both Ends 

Because the technology is so new, however, regulators have been acting without fully understanding just what it is they are regulating, according to Jalil. He said that the government is trying to apply 20th-century thinking to a 21st-century phenomenon. He noted that, in defining bitcoin, the SEC referenced a 1952 Supreme Court case, SEC v. Howey Co., which defined a security as anything involving an investment of money into a common enterprise taking profit from the efforts of others, which in turn birthed the Howey Test for determining whether or not something is a security. The SEC last year sent out a notice saying that it believes digital currencies like bitcoin pass the Howey Test. 

“You can call it a token, an alt-coin, a digital asset, a bitcoin; you can call it a ham sandwich, [but] if you’re raising capital, that is a security,” he said.

Digital assets that are not used to raise capital (such as an in-game currency) are considered “utility tokens” instead of securities and thus are not SEC-regulated. 

While this distinction might seem straightforward, the conception doesn’t really mesh well with the more ambiguous applications. Jalil brought up the example of an initial coin offering (ICO) for a company called Munchee. The idea was that people would use their coin to write reviews for restaurants, and every minute someone held the coin “you could do cool stuff with it.” But the problem, according to the SEC, was that the company issued millions of dollars of these coins before Munchee had begun any operations or even had any money. It instead used the money from these tokens to build the platform. The SEC said Munchee could not do that, and it shut the ICO down last year. 

“It issued millions of dollars of these coins that could be used in the future, and they took that cash to build the platform and this became a real legal problem," he said. "Can a given token buy a security one minute and a utility in another? Like light being both a wave and a particle? And what the SEC said was, ‘I understand ultimately these tokens will be used in this food [service], but because you issued it now, it’s a security. And they came after them with enforcement.”

Jalil likened the agency’s reaction to the days when companies were required to mail their prospectus to investors, even when email started becoming increasingly popular. He critiqued the SEC for approaching the sector with its enforcement division, versus its corporate finance or investment management divisions. 

At the same time, however, many innovators in this sector are ignorant of the relevant rules and regulations and tend to get in trouble because they don’t think these rules apply to what they’re doing. Jalil said it’s not so much that these people are unsophisticated but just that they haven’t learned the rules and tend to just move ahead with their plans. For instance, he said that many small cryptocurrency exchanges operating out of a garage were caught unawares by the Financial Crimes Enforcement Network’s decision that all exchanges are money-transmitting services and must therefore follow the same regulations as companies like Western Union.  

“I’ve had some 19-year-old-kid saying, ‘It’s interesting, I’ve been doing this for six months, and I have $20 million,’ and I say ‘You’ve been committing a felony for six months,” he said.

Johnson reported similar experiences in the blockchain world. He said he was at a conference recently where someone said that he had a problem with no bank letting him deposit his cryptocurrency reserves. 

“I’m laughing so hard because they didn’t do any [know your customer] or [anti-money laundering due diligence,] and the bank said, ‘You’ve got to be kidding; you may as well have come in here with $10 million in satchels,’” he said. 

This sort of thinking, said Jalil, can lead some blockchain enterprises to accidentally become public companies without knowing it. If digital tokens are securities, and if they sell to more than 2,000 purchasers or investors, “congratulations, you’re a public company and now you have to file a 10-K, and this 19-year-old in his mom’s basement says, ‘What are you talking about? I’m running a game here!” 

With the landscape shifting so rapidly, particularly with regard to regulators trying to get their arms around the whole concept of blockchain, Johnson said that it’s very difficult for advisers to advise thoughtfully, observing, “You almost can’t give them good advice yet.” While this might make getting involved in this world seem risky, he said those risks can pay off. 

“Where there is risk, there is also reward,” he said.

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