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INSIGHT: SETLcoin – Hype vs Reality

July 19, 2018, 11:00 AM

The frenzy over blockchain has swept the market and popular culture. Most (in)famously, in December 2017 a small iced tea brewer rebranded itself as Long Island Blockchain and saw its NASDAQ-listed stock price surge by 200%, according to CNN Money. Comparisons to the dotcom bubble of the late 1990s quickly followed. But unlike other new technology booms where startups have amassed patents as a way to receive venture capital funding, the wave of blockchain patent filings has not yet arrived. So where are all the blockchain patents? One clue may surface as we approach the first anniversary of the issuance of one of the most hyped blockchain patents.

On July 11, 2017, Goldman Sachs was granted U.S. Patent No. 9,704,143 (’143 patent), entitled “Cryptographic currency for securities settlement,” which has been dubbed “SETLcoin.” SETLcoin is intended to be a virtual currency that can be exchanged for financial securities over a peer-to-peer network, allowing trades to settle instantly. On news of the patent’s issuance, the popular cryptocurrency website Coindesk proclaimed that Goldman Sachs “made headlines” with the revelation of the patent application. One investment website opined that the ’143 patent meant that “Goldman Sachs has clinched an important victory in its race to transition from a stodgy investment bank into a fintech powerhouse.” And a contributor to called the ’143 patent a “big leap forward” that placed Goldman Sachs “ahead of many others in the race to harness the power of blockchain.” Did this hype match reality?

The jury is still out as to whether the ’143 patent will commercially benefit Goldman Sachs. Looking at the issuance of the ’143 patent we make two observations—first, how did financial markets respond to Goldman Sachs being granted the ’143 patent, and second, what are the potential pathways for future patents in this area?

Measured through an event study, market reaction to the issuance of the ’143 patent was on balance muted, despite the exuberant headlines. Some media, however, expressed lingering skepticism about the value of traditional patents in this untraditional space. But the issuance of the ’143 patent may have cracked the code for securing patent protection for blockchain inventions. Of the relatively few patent filings in this space, many applications have been rejected for failing to claim patentable subject matter—reflecting the hostile post-Alice climate for fintech inventions. The ’143 patent may prove notable for the roadmap it provides to getting around the patentability issues that have plagued other blockchain patent applicants.

Cryptocurrency Primer

Perhaps the most publicized use of blockchain technology—though far from blockchain’s only application—is cryptocurrencies. Cryptocurrencies are peer-to-peer, decentralized, digital currencies capable of serving in highly secure transactions. The most well-known is Bitcoin, which was introduced in January 2009 by pseudonymous developer(s) Satoshi Nakamoto. Cryptocurrencies have faced significant challenges, including how to maintain scarcity of the currency, and how to avoid reliance on a trusted centralized entity. Scarcity is important because a currency has no value if it is not scarce. Times of hyperinflation bear witness to a currency’s loss in value if it’s abundantly available. Regarding the second challenge, the clear majority of currencies has relied on some trusted central authority to vouchsafe their values.

The issue of scarcity was resolved by early digital currencies which granted new “coins” to computers that solved cryptographic problems for which solutions are difficult to find but easy to verify. Once the proof of work—which details the solution to the mathematical problem—had been verified by other computers, the computer that solved the problem was rewarded with digital currency. In the same way that the mining of rare metals is costly, “minting” a new digital coin is expensive due to its massive consumption of computing power. Since new coins cannot be created without cost they cannot be debased by wanton issuance of new coins.

The second challenge—how to remove the need for a trusted centralized authority—was resolved by Nakamoto with the introduction of the blockchain, which is a ledger of all transactions. A copy of the full blockchain is stored on every computer running the software and is freely available to the public for inspection. In the event of a discrepancy between copies, the version stored on the majority of computers prevails: the larger the network, the more difficult it becomes to tamper with the ledger.

Nakamoto ensured that no one tampered with the ledger—for instance by spending the same Bitcoin twice—by turning the addition of new transactions to the ledger into a competition whereby the first computer to solve a given cryptographic puzzle gets to add a new block of data to the ledger (hence the term blockchain). That block is a record of the new transactions and includes the “proof of work”—the solution to the cryptographic problem. The cryptographic problem is based on previous blocks, which enables verification of the integrity of the blockchain.

Using Cryptocurrency as a Settlement System for Securities Trade

Investment banks are deploying blockchain technologies to increase the speed and security of daily transactions. The settlement of securities involves a process where securities are delivered typically against a monetary payment. If the product is applicable for clearing, a clearing house matches the trade instructions as received from both the trading parties. In the U.S., clearing houses provide clearing, settlement, risk management, and a guarantee of completion for certain transactions (e.g., depositary receipts and ETFs). They serve as the central counterparty (CCP) for trades in applicable products (e.g., exchange-listed and Dodd-Frank-mandated products) in the U.S. securities markets.

Following a successful match of the trade details, the clearing house initiates the settlement process that involves the securities transfer from the seller’s account to the buyer’s account (and payment in the opposite direction). The clearing and settlement process can take from one (T+1) to two (T+2) business days. In the U.S., the settlement date for marketable stocks can be two business days after the trade is executed and for listed options and some government securities it is usually one day after the execution. This lag from the time of trade to final settlement, in the absence of a CCP, can involve risks, such as counterparty risk (i.e., defaults). The clearing house serves as the counterparty for both sides and offers protection against counterparty risk, which makes it essential in this process.

SETLcoin seeks to replace the existing system of clearance and payments resulting in instant, accurate, and secure settlement of a security as well as cash. SETLcoin achieves that goal by offering instant trade settlements and a self-regulatory mechanism based on blockchain technology, making the functions of clearing houses redundant, according to Investopedia.

The ’143 patent describes a settlement system for securities market based on cryptographic currency protocol. This concept would enable the settling of securities trades through a built-in cryptocurrency, SETLcoin, instead of cash or other cash equivalents. The patent describes exchanging SETLcoins for digitized stocks of firms such as Google and Microsoft, as well as cryptocurrencies, including Bitcoin. A trader’s virtual wallet would hold multiple assets that would generate, manipulate, and store SETLcoins. According to the ’143 patent, a stock buyer can enter her trade details in her virtual wallet, and a stock seller will enter his sell side trade details in his wallet. The generated SETLcoin transactions then go onto the blockchain-based network, where the transactions (presuming the buyers has sufficient funds and seller has sufficient stock) are authenticated and matched in a clearing process, causing instant transfer of the stock and money.

Market Impact of the ’143 Patent Grant

The news media reacted enthusiastically to the ‘SETLcoin patent application. The SETLcoin patent application was first announced on November 19, 2015. Positive news coverage of the patent application began to appear in early December 2015. As an example, the patent application was discussed in The Financial Times on December 3, 2015. discussed the patent application on December 8, 2015 and suggested that the ’143 patent placed Goldman Sachs “ahead of many others in the race to harness the power of blockchain.” Investopedia, on February 17, 2016, noted that “this path-breaking technology is expected to become the future backbone of financial system.”

With the hype surrounding the potential for SETLcoin, it is worth examining how the financial markets reacted to the granting of the ’143 patent. At first blush, a positive reaction would have been expected. Yet the financial market’s reaction to this “important victory” was far more muted.

An event study is a common way to examine whether an event, such as the granting of an “important” patent, is viewed by investors as material. It is a standard statistical technique used by financial economists to determine whether a security’s price reaction to a news announcement (or some other event) was material (i.e., statistically significant), and is the standard analytical technique used to assess the stock market’s responsiveness to new information when testing for market efficiency. New information is the “event,” and generally the one-day change in the company’s common stock price the day the information is released into the market (or the next trading day if the information is released publicly while the market is closed) indicates the stock market’s assessment of the information’s significance. The stock market’s reaction is consistent with market efficiency when the actual reaction to the new information conforms to the reaction one would expect based on economic theory.

We conducted a standard event study (see detail below) to test for the market reaction to the announcement of the ’143 patent grant. On the day of the patent grant, July 11, 2017, the abnormal return on Goldman Sachs’ common stock was 1.3%, but it was not statistically significant under the common criterion of 95% confidence. One interpretation from the event study is that investors did not view the patent grant as material despite the media fanfare. Another interpretation could be that the value of the patent grant was not substantial relative to Goldman Sachs’s overall market capitalization. Similarly, we did not find evidence of market impact, as there was no statistically significant abnormal return associated with the announcement of the SETLcoin patent application on November 19, 2015.

We also reviewed research analyst reports to gauge whether the patent grant was material to investors. We looked for discussion about the ‘143 patent or SETLcoin. We did not, however, find such discussions of SETLcoin in analyst reports nor through a search of Bloomberg News around the time of the patent grant date.

The absence of a material market impact on Goldman Sachs’s share price can be interpreted as an indication of the general uncertainty regarding either the economic benefits of the ’143 patent and the SETLcoin trading system specifically, or about the value of patents in this space more generally. Another possible explanation for the muted market response is that the market may have anticipated the patent grant, and by the time the patent was issued, it was “old” news that had already been internalized in the stock price. However, the general lack of analyst research coverage does not support this premise. It also was far from certain that a patent would have been granted in light of the Supreme Court’s June 2014 decision in Alice Corp. Pty. Ltd. v. CLS Bank Int’l that deemed most fintech patents unpatentable by prohibiting patents that claim abstract ideas (e.g., methods of settling securities transactions) unless the patent presents a technological solution to a technological problem.

Despite the muted market reaction, the ’143 patent may prove significant for another reason—proving that cryptocurrencies can be patented despite current trends against financial inventions.

Is the ’143 Patent a Roadmap for Blockchain Patents?

Under Alice, it is not enough to claim an improved way of conducting business. It isn’t sufficient to develop a financial system that requires massive computing power. The patent invention must improve the functioning of the computer. The patent landscape for cryptocurrencies thus differs from the thousands of business method patents that proliferated during the bubble of the late 1990s—before courts restricted what could be patented.

These restrictions have hamstrung many promising cryptocurrency patent applications. For example, in August 2013, JP Morgan filed Patent Application No. 13/958,881. The publication of this patent application a few months later was greeted with fanfare, with CNN Money touting the patent application’s inclusion of “digital wallets, the ability to transfer money to anyone and anonymity too” as a groundbreaking Bitcoin-alternative.

The Patent Office initially agreed, indicating in early June 2014 that it would grant JP Morgan a patent, but when Alice was handed down a few days later, the Patent Office withdrew the patent acceptance, finding that the application was “directed to providing an anonymous payment from a payer to a payee which is a fundamental economic practice and an abstract idea … implement[ed] … on a computer, and/or electronic network.” (134 S. Ct. 2347). Despite at least eight separate attempts since 2014 by JP Morgan to persuade the patent examiner, the Patent Office has stood firm in its position that this Bitcoin-alternative payment system does not claim patentable subject matter. The JP Morgan application remains pending. The bank is expected to try for a ninth time later this summer. Many other cryptocurrency-related patent applications have met similar fates.

The ’143 Patent appeared headed to the same fate as the JP Morgan application with the Patent Office initially finding that “[t]he claims are directed towards trading cryptographic currency on a peer-to-peer network which is considered to be an abstract idea … [and] both a fundamental economic practice and a method of organizing human activity by providing an opportunity for parties to enter into a specified agreement.” (Appl. No. 14/528,289 Feb. 13, 2015 Non-Final Rejection at 6). Goldman Sachs, however, responded by emphasizing that its patent “is not directed to organizing information but involves an interaction between computing nodes and verification of the interaction.” (Appl. No. 14/528,289 Nov. 12, 2015 Applicant Remarks at 13). Goldman Sachs also emphasized the importance of SETLcoin’s verification steps, which require the system to “verify a digital signature of the electronic transaction message, verify the ownership of an element in the electronic transaction message, receive external electronic verification of the ownership, and transmit electronic messages to computing nodes indicating a change in ownership.” (Appl. No. 14/528,289 Nov. 12, 2015 Applicant Remarks at 17). By focusing on how a transaction is electronically verified and providing a purportedly new combination of steps, Goldman Sachs was able to secure patent protection.

Other cryptocurrency patent applications that issued after the ’143 patent have followed a similar roadmap by emphasizing specific computing operations. For example, U.S. Patent No. 9.836,790, issued to Bank of America in December 2017, overcame multiple Alice rejections by emphasizing its purportedly unique way of using public/private key pairs and hash functions to store a cryptocurrency private key. CPN Gold B.V.’s U.S. Patent No. 9,747,586 was issued in August 2017 by arguing that its patent improved the mining of new bitcoins by generating currency from a single block rather than traditional mining operations that work on the entire blockchain.

So what lessons can we learn from these patents? The wave of cryptocurrency patents may never arrive as there is significant post-Alice skepticism of patents covering financial transactions. Where patents are likely to flourish are in improvements to the underlying blockchain technology, whether that be new tools for verifying transactions or new ways of making computers more efficiently mine blocks. The ’143 patent may thus prove noteworthy by being one of the first granted patents in technology that has applications beyond settling securities transactions.

Event Study detail

The event study conducted for this article examined the expected return of Goldman Sachs’ common stock by applying the Capital Asset Pricing Model (“CAPM”) with a one-year estimation period prior to the grant date for the ‘143 patent. The CAPM was modified to include the returns on an industry index of common stocks that are comparable to Goldman Sachs. The industry index represents the return on the capitalization-weighted custom index comprised of members of the S&P 500 Investment Banking & Brokerage Index (“S5INBK Index”), excluding Goldman Sachs. The four members include Morgan Stanley, E-Trade Financial Corp., Charles Schwab Corp. and Raymond James Financial Inc. The abnormal return was significant at a criterion of 90% confidence.

Brian Pandya is a partner at Wiley Rein LLP in Washington, D.C. He represents technology and pharmaceutical companies in patent litigation and other complex legal matters. Brian has first-chair jury trial experience, has argued multiple appeals at the Federal Circuit, and has authored numerous petitions and briefs filed at the U.S. Supreme Court and Courts of Appeals. He also maintains counseling, opinion, and post-grant proceedings practices, represents clients in trademark, trade secret, and other commercial disputes, and advises trade associations on IP public policy matters.

William Choi, Ph.D., is a managing director at AlixPartners LLC. He is an experienced economist who assists organizations and governments in solving complex and challenging issues in the marketplace and the courtroom. He has testified before federal and state courts as well as in arbitration. He also has provided consulting services across a range of industries and technologies that include artificial intelligence, financial products, ecommerce, virtual reality, big data, retail, insurance, and consumer products.