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austrian economics, Bitcoin & Blockchain, cryptoeconomics, global financial crisis, regulation, Strategic Viewpoint

Crumbling Behemoths: why banking size is a liability not an asset in the Blockchain Economy.

Crumbling Behemoths.jpg

In January 2008 I started writing a book called Crumbling Behemoths. I should have finished it. In October of that year, after the Lehman collapse, it could have been a bestseller. My experience in the Fintech engine room of core banking helped me see the fragility in what looked like an invulnerable system of giant global banks.  Here is the TLDR version that book, just after the 10 year anniversary of the Lehman collapse and just before the 10 year anniversary of Satoshi Nakamoto’s White Paper (January 3rd).

Banks are vertically integrated, tightly coupled, politically dependent entities. Most have been in business for hundreds of years. Their decline is inconceivable; like the decline of car manufacturing in Detroit, Blockbuster, bookshops, Kodak, etc, etc. Size gives some Banks great power today and size looks like an obvious asset on their balance sheet. However in the network age, their size is actually a liability.  This post explains why, with a focus on:

  • Legacy IT meltdowns and the liability of “technical debt”

 

  • Wells Fargo and the Creative Destruction 7 Act Play

 

  • Why Blockchain is the realisation of Coase’s post-Corporate vision

 

  • Satoshi’s vision of 7 billion banks is the long term threat

 

  • The networked small bank is the imminent threat

 

  • Regulators typically arrive about the time that technology is doing the job for them

 

  • Why Bailouts will not be possible next time

 

  • How Analog  Scale is fundamentally different from Network Scale

 

  • Trading Takeaway – how to profit from this insight

 

Legacy IT meltdowns and the liability of “technical debt”

Hello, my name is Bernard and I am a core banking system salesman. Yes that sounds like the intro to an AA meeting. i should say “was”, but in honour to AA I use the present tense.  My days in the engine room of Fintech, selling core banking systems to the biggest global banks for companies such as Misys, meant I was not surprised to witness the Legacy IT meltdowns and the gradual crumbling of the Bank Behemoths.. Those of us selling replacements for paper-based systems decades ago never imagined that those systems would still be operational in the 21st century. They are and now they have moved from the asset to the liability side of the Bank’s ledger.

Bankers often talk about the millions invested into IT as an asset. Anybody who writes code knows that software degrades over time and at a certain point that “technical debt” becomes a liability and not an asset. It is now cheaper to build the IT infrastructure for a startup bank, using open source and APIs, than it is to adapt Legacy IT for a modern world. The $ millions invested in IT now have a negative ROI.

I use terms such as assets, liabilities, technical debt and negative ROI is to make this accessible to non-technical bankers and investors. There is one technical concept that is critical but also easy for non-technical bankers and investors to understand, which is tight vs loose coupling.

Any programmer will tell you that a loosely coupled architecture via APIs accessible via networks is better than tightly coupled systems (aka “spaghetti code”).

The programming cost is not the issue. The big issue for the Behemoths, the reason they are crumbling is:

  • The banks cannot change their business model fast enough. Bank CXO teams are perfectly away of the threat of disruptive technology and that they must change their business model at a fundamental level. They know what they should do. The problem is that they send instructions to the engine room of their ship to go faster and to change direction to due West and the person in charge of the engine room tells them that if they shovel in a lot more coal they can increase speed by 10% and will take two hours to change direction to due West, but warn them that this means they will run out of coal before they arrive at the next port. Meanwhile the Bank CXO team in the captain’s tower sees a flotilla of small boats going due West at 10x their speed.
  • Loss of consumer trust. Consumers might be enraged by bailouts, but they still assume that banks are at least reliable and the only game in town. Some consumers read about Cyprus where the government unilaterally took money from their bank; this is “bailout in your face” (strangely described as a “bail-in”), but at least one can think “that is in some tiny far away island”.  Closer to home, a series of IT Meltdowns, such as at TSB and RBS, mean that consumers have days when they cannot get cash from an ATM or use their credit cards; banks are no longer “reliable”. Finally they hear from a friend who is raving about one these startup banks; the big old banks are no longer the only game in town.
  • Aggressive action that only makes it worse. This is what we saw in the Wells Fargo scandal.

Wells Fargo and the Creative Destruction 7 Act Play

The Wells Fargo fake accounts scandal was a more subtle version of the Cyprus bail-in. Money was taken out of your account, not by the government, but by your bank via a fee that you never actually authorised. This is Act 3 in the Creative Destruction 7 Act Play (described in Part 2, Chapter 1 of The Blockchain Economy book):

“Act 3. Denial. The changes are now real and the old guard management can see it, but they don’t know how to react so they reach for high pressure management to make the numbers work. In some cases, management also reach for creative accounting tricks to smooth out earnings and make it look as if nothing has changed (known as fraud in most circles). This Act can go on a long time as most investors work on surface numbers. A famous example of the Denial Act 3 was subprime mortgages that blew up in the Global Financial Crisis in 2008. For a long time the surface numbers looked good until a few nonconformists looked below the surface (watch The Big Short movie for an entertaining take on that story). A more recent example in Finance was the Wells Fargo fake accounts scandal (which was going on for a long time before it was uncovered). “

To understand why big Banks like Wells Fargo are under such pressure, one has to dig back to an obscure academic paper written in 1937.

Why Blockchain is the realisation of Coase’s post Corporate vision

Part 1, Chapter 14 of The Blockchain Economy book describes why Blockchain is the realisation of Coase’s post Corporate vision. Coase’s 1937 essay The Nature Of The Firm asked why hire employees instead of contracting tasks? His answer – a company exists because it is cheaper to do transactions within a company than outside. Blockchain has resurfaced this theory by dramatically reducing transaction costs.

The Internet seemed to be the  realisation of Coase’s post Corporate vision. However, although Dot Com and Social Media changed our world, that change was limited to exchanging content online.  The Internet was the perfect free copy copy machine. Blockchain enables us to exchange value online – where copying is not allowed (if I send you that asset I no longer have it).

This enables literally everybody on the planet to be their own bank. Satoshi’s vision of  7 billion banks (one for each person on the planet) is outrageous but not impossible.

Satoshi’s vision of 7 billion banks is the long term threat

Anybody can be their own bank. All you need is a wallet that can hold cryptocurrencies.

The Central Bank is encoded in the math (whether Deflationary for Bitcoin or mildly inflationary for Ethereum). You no longer need to trust a Central Bank and whoever guides their actions. You trust the math and the code, both of which you can verify.

Although most people won’t choose to be their own bank, it is the fact that it is possible that is such a wake-up call for big banks. This is the Napster moment. Napster proved that digital audio/video was possible. It was free and illegal. After that came cheap and legal in services such as iTunes and Spotify. Those services were only possible because the alternative of free illegal services such Napster and Kazaa was possible.    

This is why a network of small banks is the imminent threat

The networked small bank is the imminent threat

SIBOS is the big annual gathering of bankers organized by SWFT. At SIBOS 2016 in Geneva I attended a session on Blockchain and correspondent banking – The way to go? This was standing room only. My observation at the time (recorded on Fintech Genome) was that:

“The problem of the current dialogue about a Blockchain replacement of today’s correspondent banking network is very simple – correspondent banks are being written out of the script. Look at the panelists and you see a) technologists and b) global banks. Both agree that the future is bright.

Elsewhere in the conference there was a lot of talk about reducing the number of Correspondent Banks in your network. The driver was Compliance. You cannot have a Correspondent Bank in your network who does not comply with the latest regulations from governments related to tax, money laundering, terrorist financing and all the other bad actors who use money alongside the good actors – and these regulations get more onerous every day.

It is fashionable to say that Correspondent Banking is dead. This conflates the current incarnation of Correspondent Banking which is batch based with the concept of Correspondent Banking itself. I am convinced that Correspondent Banking will survive the transition to real time and that SIBOS will always be key to Correspondent Banking.

The Correspondent Banking is dead meme suits the global banks. It is inconvenient for them to deal with regional banks and much simpler to have a global network that is totally under their control. The technologists will deliver that for them. Voila – a handful of global banks control global trade.

Technically this is simple – really simple. Blockchain will be like Internet – we will use it invisibly every day. TCP/IP is not rocket science (but might have been perceived that way in 1996).

If you step outside the innovation echo chamber and talk to the regional banks you can sense the discomfort. They are being forced to consider a future without themselves in that future. Yet in the real world, these regional banks are prized by their customers.

Correspondent Banking will go real time. The 9,000+ member banks of SWIFT will keep the human relationships and just switch over to a new system.

One thing preventing small banks from competing is lack of equity capital. It is much easier today to buy one mega global bank that grew by “rolling up” lots of smaller banks. That is really the only option today for investors.  The gamechanger is new equity, whether from Security Tokens or traditional Equity Exchanges. That is why an unknown Community Bank filing for an IPO – Silvergate Bank – is so exciting.

Silvergate is traditional regulated bank offering services to the Blockchain Economy. It presages the future and its S-1 is data treasure trove for those seeking to understand that future.

I wrote at the start that “Banks are vertically integrated, tightly coupled, politically dependent entities”

I now want to focus on that last part about “politically dependent entities”. Banks are licensed by sovereign governments and Blockchain is inherently a stateless global network. We shall soon witness the loud bang that happens when an irresistible force meets an immovable object. Which brings us to the R word – Regulation.

Regulators typically arrive about the time that technology is doing the job for them

When 2008 happened, the regulators in America threw a complex rule book called Dodd Frank at the banks. For 10 years, the lawyers and regulators have worked through the details and now some elements seem to be up for negotiation. It has become a political football, just when technology may be making it irrelevant.

This has happened before. Regulators typically arrive about the time that technology is doing the job for them. Look at what happened in two earlier waves of technological disruption:

  • IBM was being regulated just when the world was moving from mainframes to PCs.
  • Microsoft was being regulated just when the world was moving from PCs to Internet.
  • Today Google and Facebook are being regulated just when the world was moving against all our data being used as a tool to control us. Note: this is happening right now, which makes it a bit harder to see than the two previous waves.

The problem is that in 2008, the technological disruption was still in the mind(s) of Satoshi Nakamoto. So the regulators resorted to the only thing they knew – a complex legal document.

When the next financial crisis hits, the discussion around bailouts and regulation will be quite different.

Why Bailouts will not be possible next time.

  • Populism has a political voice. The rise of extremism of both right and left is all over the globe will make it harder to bail out banks again.
  • Governments are running out of firepower to pump in more liquidity. For every loan there has to be a lender and at some point lenders worry about inflation from money printing. Lack of funds will make it harder to bail out banks again.
  • The disruptive alternative (Bitcoin) is now more mature and tested. People now have the tools take control over their own financial resources, regardless of what politicians say.

How Analog Scale is fundamentally different from Network Scale

Analog Scale, what most Big Banks have, is all about vertical integration, management hierarchy, secrecy and control.  In short, hierarchy.

Network Scale is all about networked partnerships through APIs, online networking, knowledge networks and verifiable transparency. In short, wirearchy.

The thesis of this post is that wirearchy beats hierarchy.

Cryptoeconomics takes this wirearchy to a new level.

In October 2014, I was privileged to be at an Ethereum MeetUp in London to hear Vitalik Buterin talk about:

“Cryptoeconomic Protocols In the Context of Wider Society”

That is right. This was about as interesting to 99.999% of the population as the discussions at the Homebrew Computer Club in the 1970s when the PC revolution was starting. At the time I was more conscious of witnessing history in the making (as I recorded here) than really understanding  cryptoeconomics. Today I see cryptoeconomics as an updated version of what one the greatest investor of the 20th century (Charles Munger) talked about, which is the power of aligning incentives. I knew this to be true from my years leading enterprise sales teams. What is different about cryptoeconomics is that it takes these incentives out of the closed world of the enterprise and makes them available to 7 billion people in a permissionless network.

We can already see Network Scale in the big winners in the Centralised Internet. What Vitalik Buterin was talking about in 2014 and is now making happen is Network Scale in the big winners in the decentralised Internet. As Trace Mayer puts it, this will be a once in a species level transfer of wealth.

Trading Takeaway – how to profit from this insight

Investors will start to sell/short banks & buy Bitcoin, Blockchain & Cryptocurrency. The banks will resist change and have a lot of clout, so shorting at first will only be for those banks who face traditional balance sheet problems (such as Deutsche Bank). Problems with consumer trust and regulators at banks such as Wells Fargo don’t seem to translate into stock price weakness.

That is because there is a difference between inevitable and imminent. The changes I am writing about maybe  inevitable but it is really tough to figure out timing. That is why the simpler strategy is to go long Bitcoin, Blockchain & Cryptocurrency; you can hold for as long as it takes for this to play out. The Bitcoin, Blockchain & Cryptocurrency tsunami is likely to follow the usual rule of disruptive change which is is that a) it takes longer than people think and b) the change when it happens is bigger than people think.

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Bernard Lunn is a Fintech deal-maker, investor, entrepreneur and advisor. He is the author of The Blockchain Economy and CEO of Daily Fintech.

Check out our advisory services (how we pay for this free original research).

To schedule an hour of Bernard’s time for CHF380 please click here to send an email.

Bitcoin & Blockchain, code is law, global governance, regulation, tezos

From Treaty of Westphalia (start of national sovereignty) to global Blockchain governance to a more practical outcome =  arbitration clauses

Peace_of_Westphalia,_Treaty_of_Osnabrück

People who geek out on code is law and law is code (I plead “guilty as charged your honour”), will love this. Busy entrepreneurs and executives may want to jump to the practical takeaway about international arbitration clauses.

The problem today is summed in the old schoolyard dialogue:

“I am right and you are wrong”

“Yea, who says?”

“I say”

“Yea, you and whose army?”

Law has to be backed up by credible force. Which is an issue when there are 195 countries, each claiming national sovereignty.

The Blockchain borderless alternative is not yet working, as we explore in the chapter of the Blockchain Economy book entitled why non state governance for bitcoin, ethereum and other cryptocurrencies is so hard. Irony aficionados enjoy the fact that about a year later after raising what at the time was record amount for an ICO to solve governance by code, Tezos collapsed into ye olde courtroom battles.

TL:DR. the legacy system is broken and the replacement system is not ready. Fortunately there is a practical hack which is international arbitration.

Treaty of Westphalia.

For historians and international jurisdiction lawyers, the Treaty of Westphalia in 1648 is the seminal event that led to the rise of the Nation State with the principle of Westphalian sovereignty. This is the principle in international law, enshrined in the United Nations Charter, that each nation state has exclusive sovereignty over its territory.

When I used to run an enterprise software company I recall the sometimes heated negotiation about which jurisdiction  was used in the contract. This was not an academic debate. In a dispute, you want to be on your home turf in a language and legal system that you are familiar with. That is a tough enough conversation  between two parties. What on earth do you do when the participants in a Blockchain contract maybe from hundreds of countries and the issuer maybe from an offshore jurisdiction (where there are simply not enough lawyers and judges to cope)?

Binding Arbitration

Our Advisory Services are known for their combination of big picture thinking with pragmatic execution. So, enough of the big picture thinking, lets move onto the pragmatic execution. If the legacy system is broken and the replacement system is not ready, what is the practical hack? The answer is a Binding Arbitration clause. 

Binding Arbitration is is a clause in a contract that requires the parties to resolve their disputes through an arbitration process, outside the courts.

It must be binding. All parties must accept the conclusion of the abitrators. If not, lawyers for one side will find a way to drive the dispute to the courts, making arbitration useless.

That means that the location for arbitration is critical.

Location for Arbitration

The location for Arbitration must meet these criteria:

  1. Big enough economy to have enough lawyers and expert witnesses. The disputes will be at the intersection of Blockchain technology and law and how many people understand enough of both to be part of a credible arbitration process?  Offshore jurisdictions usually fail on this score. The issuer jurisdiction does NOT need to be the same as the Arbitration Location.
  2. A rule of law that is globally respected.
  3. Good airports and plenty of flights (usually goes with 1).
  4. English language. It is the closest we have to a global language of business (much as we may not like the cultural erosion from less use of local languages).
  5. A time zone that works well globally.

Switzerland, where Tezos was adjudicated, met 1,2 & 3 bit not not 4 (although, as a Brit living in Switzerland, I can attest to the fact that English is widely used for global business done within Swiss borders). The Swiss brand around neutrality does help build confidence.

5 is where UK is better than USA, Canada or Australia, but it is a less critical criterium. I am seeing more arbitration clauses set in UK, which will be a boon for UK lawyers and expert witnesses (a smidgeon of good news among all the Brexit turmoil).

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Bernard Lunn is a Fintech deal-maker, investor, entrepreneur and advisor. He is the author of The Blockchain Economy and CEO of Daily Fintech.

Check out our advisory services (how we pay for this free original research). To schedule an hour of Bernard’s time please click here to send an email

Get fresh daily insights from an amazing team of Fintech thought leaders around the world. Ride the Fintech wave by reading us daily in your email.

allianz, axa, AXA Tianping, china, Foreign insurer, InsurTech, regulation

Insurtech Front Page Weekly CXO Briefing – China opening up

AXA

The Theme last week was Artificial Intelligence trends.

The Theme this week is China opening up its insurance market. This is actually a gradual process and now we are witnessing an upgrade from joint ventures to the approval of fully independent foreign insurers in China.

For more about the Front Page Weekly CXO Briefing, please click here.

Editors Note: Insurtech is normally Thursday. We changed to Wednesday this week because this news is big.

For this week we bring you three stories illustrating the theme of China opening up its insurance market.

Story 1: AXA to acquire the remaining 50% stake in AXA Tianping to accelerate its growth in China as the #1 foreign P&C insurer

Extract, read more on AXA press release:

“AXA announced today that it had entered into an agreement with the current domestic shareholders of AXA Tianping Property & Casualty Insurance Company Ltd (“AXA Tianping”) to acquire the remaining 50% stake* of the company.

Total consideration for the acquisition of the 50% stake would amount to RMB 4.6 billion (or Euro 584 million*), representing an implied 2.4x FY17 BV* multiple, of which, subject to regulatory approvals, RMB 1.5 billion (or Euro 190 million*) should be financed through a capital reduction of AXA Tianping to buy back shares from the current domestic shareholders.”

AXA Tianping was jointly founded in 2004 by AXA’s subsidiary in China and Tianping Auto Insurance. After 14 years, it has become the biggest foreign property insurance company in China. This purchase, if approved by Chinese regulators, will make AXA Tianping a fully-owned subsidiary of AXA group and help AXA move further in Chinese market.

Story 2: Allianz China unit given regulatory go-ahead

Extract, read more on Reinsurance News:

“Insurance giant Allianz has received approval from the China Banking and Insurance Regulatory Commission for the preparatory establishment of an insurance holding company in China.

Based in Shanghai, Allianz (China) Insurance Holding Company Limited will be the country’s first ever insurance company wholly owned by a foreign insurer.”

This happened a day before the AXA news. But Allianz’s plan was approved by the regulator already. The approach is different, since AXA is achieving it through equity acquisition while Allianz is starting from scratch. But the goal is same, to make presence in Chinese market.

Story 3: China moves closer to allowing foreigners to control insurance ventures

Extract, read more on Reuters:

“China will accept applications early next year from foreign insurers seeking to take control of their local joint ventures and is even weighing giving them full ownership earlier than flagged, people with direct knowledge of the matter said.

The regulator is expected to publish its final guidelines as soon as the first quarter of 2019 and would begin taking applications from interested foreign insurers soon after that, they said”

This article was released last Monday, and certainly it’s a signal. Our first two news proved that things are moving much faster in China.

China has already drawn its roadmap of opening up for the financial sector. Insurance industry is obviously executing the plans with efficiency and determination. I believe there are still huge potentials in Chinese insurance market and the future of insurance market in China will be shaped by Chinese and foreign insurers together.

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Zarc Gin is an analyst for Warp Speed Fintech, a Fintech, especially InsurTech-focused Venture Capital based in China.

Get fresh daily insights from an amazing team of Fintech thought leaders around the world. Ride the Fintech wave by reading us daily in your email.

Bitcoin & Blockchain, regulation, security token

Entrepreneurs try flying the Security Tokens plane while the plane is still being built

Boeing_747-8_Test_Planes_in_Assembly.jpg

This post, the 3rd in a series of 4, is written by Sheldon Freedman, a fintech and funds lawyer at Hassans in Gibraltar. Click here for last week’s post in this series

Editors note: the question of jurisdiction is in many entrepreneurs’ minds as we read headlines such as “SEC Charges EtherDelta Founder Over ‘Unregistered Securities Exchange”. Entrepreneurs (and the incumbents thinking about how to disrupt before being disrupted) know that timing matters and that Security Tokens are coming. They also know that flying the Security Tokens plane while the plane is still being built is scary and dangerous.

A security token is issued digitally on the blockchain, backed by tangible assets such as shares in a company, real estate or rights to cash flows. Security tokens are digital assets subject to securities regulation, with compliance required in the issuer jurisdictions as well as in investor jurisdictions – from initial offering by the issuer to all secondary trades among investors.  The path to issuing a security token is a long, uncertain, innovative process with advisors, lawyers, exchanges, platforms and regulators, as issuers are breaking into new regulatory territory, applying conventional securities laws to revolutionary security tokens. The regulatory situation currently is confusing because the incipient security token ecosystem is evolving. Regulators who are trying to find their way lack experience, with no model example to look to.

Editors note: in law, precedence is everything. It is very tough to be guided by precedence when everything is changing as something totally new and disruptive such as Blockchain appears.

The task of securities regulators is well known to facilitate the orderly, productive functioning of securities markets and to protect investors with fairness practices, disclosure and qualification thresholds. However, with the advent of electronic financial systems, global finance has become comprehensively regulated by laws and procedures pertaining to anti-money laundering, sanctions and anti-terrorist funding.

Editors note: some might see regulation as designed to protect consumers/retail investors. That is what it says on the tin. Some might cynically say regulators have been captured by incumbents who seek protection from disruptive new entrants (i.e. that regulation is designed to prevent innovation). Sheldon points to the concern of regulators – anti-money laundering, sanctions and anti-terrorist funding.

To appreciate the sheer comprehensiveness of this regulation, one need only remember one example – the experience of banking organization HBSC, which this writer represented as counsel. Originally known in 1865 as “The Hongkong and Shanghai Bank”, HSBC Holdings plc is today the largest bank in Europe, a global roll-up of banks headquartered in London.  Operating out of 3,900 offices in 67 countries, HBSC is the world’s 17th-largest public company, with the Americas, Asia Pacific and Europe each representing approximately one-third of its business. HSBC is the largest bank in Hong Kong and prints most of Hong Kong’s local currency in its own name. HSBC has frequently been named the world’s most valuable banking brand by industry rankers.

In the early 2000’s, as HBSC and other major institutions embarked on sprees of acquisitions of valuable global banking businesses, compliance with the relatively new anti-money laundering laws was not primarily on the minds of acquirers, who were in fact acquiring regulatory liabilities with businesses they were acquiring.  In 2012 HSBC was the subject of anti-money laundering enforcement hearings in the United States Senate Permanent Subcommittee on Investigations. HBSC was investigated for deficiencies in its anti-money laundering practices, which gave HBSC a permanent hangover from years of acquisition partying. The Senate subcommittee found HSBC had transferred $7 billion in drug crime-related funds from its Mexican to its US subsidiary, was disregarding terrorist financing links and was circumventing U.S. safeguards to block transactions involving terrorists, drug lords and rogue regimes. In one instance, “two HSBC affiliates sent nearly 25,000 transactions involving $19.4 billion through HBSC’s U.S. affiliate accounts without disclosing the transactions’ links to Iran. The Justice Department charged, “HBSC officials repeatedly ignored internal warnings that its monitoring systems were inadequate”, exposing the U.S. financial system to “a wide array of money laundering, drug trafficking, and terrorist financing.” 

The Senate subcommittee also found HBSC provided financing and services to banks in Saudi Arabia and Bangladesh that were tied to terrorist organizations, while also clearing $290 million in “obviously suspicious travelers cheques” that benefitted Russians “who claimed to be in the used car business.”

Furthermore, the investigation showed how the bank’s regulator, the Office of the Comptroller of the Currency (OCC) failed to take a single enforcement action against HSBC despite numerous violations by the international bank.  Among them, failing to monitor $60 trillion in wire transfer and account activity, a backlog of 17,000 unreviewed account alerts regarding potentially suspicious activity, and a failure to conduct anti-money laundering due diligence before opening accounts for HSBC affiliates.

Editor’s note: incumbents, thinking about how to disrupt before being disrupted, are even more nervous than entrepreneurs about falling foul of regulators. Banks are licensed by governments. Having that license taken away is an existential threat.

Dozens of countries now adhere to their own anti-money laundering directives, and are additionally obligated by muscular international instruments and standards deploying sophisticated IT systems for anti-money laundering data collection and analysis, such as United Nations conventions against narcotic drug trafficking, organized crime and corruption, and FATF (the Financial Action Task Force on Money Laundering) formed by the G7 countries.

Editors note: in an era of increasing protectionism and nationalism, expect these regulators to get tougher. I will carbon date myself by saying I have an old passport, pre-Thatcher era, which has a stamp in it saying that I was approved by the Bank of England to take GBP50 out of the country. That story won’t sound so strange to our subscribers in China or India or other countries with exchange controls.

Security tokens and blockchain technology, with their opaque digital representations, high speed of transacting and decentralized record-keeping, present fierce challenges to anti-money laundering, anti-terrorist financing and economic sanctions efforts, demanding even higher standards of regulation than conventional securities. 

Due to the stigma that has attached to a stampede of low quality ICOs to date (most ICOs have been cryptocurrencies), there is an apparent emerging convention to term the issuance of security tokens “STOs” to distinguish issuances of security tokens from issuances of cryptocurrencies and utility tokens. 

Jurisdictions regulate STOs under their existing securities regimes, which are not sufficiently comprehensive or evolved to provide clarity to issuers, investors and regulators.  Innovation and improvisation are now the domain of intrepid issuers aiming to fashion a regulatory path with regulators, or to stealthily rely on existing exemptions.  Prof. Bhaskar Krishnamachari of the University of Southern California observes: “We are flying an airplane while we are still building it”. 

Editors note: entrepreneurs seeking to seize the day with early-mover advantage want to know whether the plane lacks seat-back entertainment (boring but safe) or lacks hydraulics (will crash unless pilot is really good and a bit lucky). The short answer is a) all startups have risk b) get good navigators to minimise that risk.

The US Securities and Exchange Commission (SEC), recognized global leader in securities regulation, has not offered anything regarding security tokens.  Security token issuers are attempting to effect conventional registrations with the SEC or to rely on Reg D exemptions and new crowdfunding provisions. It is not surprising the SEC has been slow to act.  A large organization with six independent divisions and 25 offices, sharing financial regulation with several other US agencies (CFTC, FINCEN, IRS, state regulators, etc), the SEC simply has not yet addressed security token offering regulation.  However, the SEC recently announced on October 18 the establishment of The FinHub, the SEC’s Strategic Hub for Innovation and Financial Technology tasked to address new distributed ledger-enabled securities. The FinHub replaces and builds on the work of several internal SEC working groups and is intended to serve as a resource for public engagement on the SEC’s FinTech-related issues and initiatives, including STOs. 

The FinHub will be staffed by top industry experts, led by Valerie A. Szczepanik, Senior Advisor for Digital Assets and Innovation and Associate Director in the SEC’s Division of Corporation Finance.

The current situation is confusing and the ecosystem itself is evolving. Jurisdictions are trying to find their way, while there is no example to look to.

A small number of STOs are taking place in USA, such as:

  • Indiegogo – shares in Colorado resort (Aspen Coin)
  • Spin – electric scooter offering 125 million for investors to share in revenue
  • Blackmoon Financial Group -security token which tracks its lending fund

In the EU, similar to USA, STO issuers are seeking registrations and relying on conventional exemptions.  In the EU, exemption may be available for offerings of less than 1mm Euro per year, offerings to less than 150 people per member state, and to qualified sophisticated investors.

A UK example of a current STO is The Elephant (tokenized private equity platform).

A small number of STO’s are taking place in light-touch regulatory jurisdictions, such as Switzerland and Singapore, but these are smaller markets and their rules are not widely accepted by major countries.  Examples of STOs being carried out in Switzerland:

  • SwissRealCoin – Switzerland’s first real estate coin
  • Nexo – fiat loans
  • Lykke – offering security tokens representing equity in Lykke (which is building a financial asset marketplace)

An STO example in Germany is Brille 24 (eyewear).

An STO example in Lithuania is security tokens representing equity in Desico (which is building a financial asset marketplace)

Surprisingly absent in security tokens is South Korea. Despite being innovators in so many areas of blockchain, South Korean regulators currently seem more focused cracking down on bad ICOs than enabling compliant STOs.

Editor’s note: the Etherum ICO in 2014 was the Napster moment for the Securities business. Napster was free and illegal. Then in 2017, entrepreneurs went for the ICO gold rush, using the Ethereum platform. Like with Napster, the regulators cracked down. But market demand finds a way to leverage disruptive technology. The STO market awaits something like iTunes or Spotify – cheap (not free) and legal. It hears the music and wants to buy it.

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Bernard Lunn is a Fintech deal-maker, investor, entrepreneur and advisor. He is the author of The Blockchain Economy and CEO of Daily Fintech.

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Bitcoin & Blockchain, Blockchain, EU, regulation, Strategic Viewpoint

In the EU Blockchain Resolution we Trust

Bictoin EU

It was my name day on September 20th – a significant day for a Greek Orthodox – but I was by no means going to miss the “Blockchain: Building Trust in Society” event with Dimitrios Psarrakis, a Greek leading specialist in European regulatory policy. This was the first event in PwC Switzerland’s joint thought leadership series with the blockchain hub Trust Square. I was not disappointed; on the contrary, both the speech, the panel discussion with Daniel Gasteiger, Founder, Trust Square & Founder, Procivis, Doris Fiala, Chairwoman, Swiss Control/Parliamentary Oversight Committee & President, Swiss FDP Liberals Women, Guenther Dobrauz, Dimitrios Psarrakis; and the party; were unique.

Greeks built the principles of Democracy. Eva Kaili, is the Greek EU parliamentarian that is leading a team with a mission to raise awareness in the European Parliament on the revolutionary potential of Blockchain and how to grab the opportunity to lead in the 4th industrial revolution with relevant and powerful policies.

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At the opening of his speech, Dimitrios Psarrakis, spoke about their team work in the EU parliament to educate, raise awareness and understanding about blockchain. They slowly but surely managed to obtain nearly 750 votes in the parliament for the Blockchain Resolution, a long and detailed policy for the EU which is based on the principle that Blockchain holds the potential to build Trust in our society in a different and better way, at many levels.

Driven by the fact that the internet has been a technological development that has undoubtedly created more convenience and connectivity, but has fallen short in creating more fairness and trust; Blockchain presents an opportunity to build trust and fairness in a very different way.

Driven by the belief that Blockchain will restructure several sectors: energy, healthcare, capital markets, Intellectual property etc.; the EU wants to mobilize capital to fund this revolution – the 4th industrial revolution.

The Blockchain Resolution includes several articles and aims to be fully in place in 2019. It has no intention to regulate any instruments – like coins, tokens etc-. It will only regulate the use of them on the newly created platforms. The Blockchain Resolution sees these new digital assets as legitimate instruments and does not attempt to categorize them as securities or commodities. The Blockchain Resolution sees them as alternative investments or contractual arrangements. Therefore, applying the Regulation in the EU for alternative investments, which is fairly flexible, is appropriate. The due diligence process on the platforms should be similar to the due diligence process in crowdfunding.

In Europe there is no consensus on the definition of a Security. Europe has MIFID, without a standard definition of a Security.

The Blockchain Resolution sees digital assets as alternative investments and the regulatory framework that applies is fairly flexible. Europe, through the Blockchain Resolution, wants to create policies that will mobilize capital to fund the next wave of restructuring the way several markets / sectors function.

The view of the EU is to present regulatory principles that are Technology neutral, Business-model neutral, and pro-Innovation.

The main principle is to allow for Disintermediation Economics that build Trust. Such economics promise to (a) reduce transaction costs and create new efficiencies, (b) reduce operational frictions by increasing liquidity, (c) automate monitoring processes with limited informational asymmetries (e.g. agency frictions, moral hazard, adverse selection).

The Blockchain Resolution is brave enough to look into the promise of Blockchain for Public infrastructure. The view is to restructure (a) traditional public services like land registries, licenses, certificates etc. (b) ways to reduce tax evasion and fraud, (c) cross-border transactions, regulatory reporting, data transactions between European citizens via smart contracts.

The Blockchain Resolution just got support from the Strasbourg Plenary.

“Blockchain has united this House, as all the parties in the Committee on Industry, Research and Energy (ITRE) voted in favor of the resolution under the principle of being technology neutral and innovation-friendly in Europe.” “One of the core messages of our text was to signify that the European Union aspires to become the global leader in the fourth industrial revolution,” said Eva Kaili.

The European Commission will be next in November at the European Parliament Blockchain event. This will be followed by the Blockchain and international Trade Report. In December, the Crowdfunding Regulation will be updated.

Some of the recommendations that the resolution makes are[1]:

  1. For member States to establish non-profit “innovation hubs” to promote research, education and training among their citizens
  2. For the Commission and ECB to identify dangers for the public and incorporate cryptocurrencies into the European payment system.
  3. To develop technical standards for Distributed Ledger Technologies
  4. Conduct a clear analysis of legal enforceability of smart contracts among EU member States
  5. Decentralize the storage of EU citizens’ data in preventing the misuse of data
  6. Decentralize infrastructure to ensure no monopolies are held, for instance the storage of nodes and servers
  7. Use blockchain for tracking EU funding to achieve greater accountability
  8. Evaluate blockchain-based e-voting systems as a use case for the EU
  9. The creation of funding opportunities from the EIB, EIF and EFSI 2.0
  10. The creation of an Observatory for the Monitoring of ICOs and clarification of utility tokens and security tokens as unique asset classes
  11. For any regulations on blockchain to remove barriers and founded on principles of technology neutral and business model-neutral

In Q1 2019, the Blockchain Resolution will be seen and hopefully adopted by ESMA. Europe is leading the way.

We live a world in which Trust is lacking, Trust is being re-defined, Trust has to be re-built.

[1] Excerpts from EU Parliament Passes Blockchain Resolution

Efi Pylarinou is an independent trusted Fintech and Blockchain advisor. 

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AI, CFTC, Consumer Banking, FCA, IBM Watson, MAS, microfinance, p2p lending, Regtech, regulation

The £50 Billion opportunity and how the global stage is set for Regtech

Regtech is a £50 Billion per year opportunity, and that is just in the UK. That is due to the hundreds of millions of pages in regulatory texts that firms have to deal with, to be compliant. It is critical that firms equip themselves with technology solutions that will help them navigate through the complex world of regulation.

Please note that while Regtech covers regulations across industries, I am taking the liberty of using this term loosely to refer to FS based Regtech use cases.

During my time at PwC, I was involved in evaluating AI products for their Legal and Regulatory offerings. We were looking into IBM Watson, and had some interesting conversations on sending Watson to school to learn Legal and Regulatory language (in English). The AI engine (deep learning, NLP) would then be able to provide guidelines to firms in plain English on what was needed for regulatory compliance.

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It has been almost five years since then and we have seen various developments across the globe. Regtech has never been more relevant. US and Europe have more than 200 Regtech firms, as these two regions are clearly seen as the pioneers of financial services regulation.

‘The FCA is the most innovative regulator in the world in terms of using new technologies and the other regulators look up to them”

– Philip Treleaven

In my opinion, Europe and in particularly the UK’s FCA are world leaders in working with innovative ways of achieving regulatory compliance. Be it payments, open banking or crypto currencies, they have taken a collaborative approach in nurturing the right firms. 37% of Regtech investments across the globe happen in the UK.

But its the happenings in Asia that I find more interesting from a Regtech stand point.

Fintech India has seen massive growth with digital payments being well backed by policies and technology infrastructure. The rise of PayTM, UPI and more recently Google Tez have all helped in bringing the total transaction volume of digital payments to $50 Billion. But with growth comes greed, and regulations have to kick in. There were tens of P2P lending firms in India until the Reserve Bank of India (RBI) launched their regulatory framework for P2P lending in Q4 2017. There are now only a handful of well capitalised P2P lending platforms.

There is a lot of work to be done around automation of transaction reporting. For example, the Microfinance market in India is still largely cash based and reporting is manual. There are startups trying to disrupt this space with cloud enabled smart phone apps, that allow for real time reporting of transactions, when an agent is on the ground collecting money from a farmer. This allows for massive gains in operational efficiency, curbs corruption, but more importantly helps transaction reporting so much easier.

I see India as a market, where Regtechs can help the RBI develop a regulatory framework across Financial Services.

China’s P2P lending market is worth about $200 Billion. Recent frauds like Ezubao, where about a million investors lost $9 Billion, indicate that the market needs to have strong regulatory controls. The scam led to a collapse of the P2P lending market in China. A regulatory framework that helps bring credible players to this space, well supported by a bunch of top Regtechs will help the status quo.

Singapore is the destination for Regtechs in Asia – without a doubt. After the US and the UK, Singapore attracts the most investments into Regtech firms. The support that Monetary Authority of Singapore (MAS) provides to budding startups is the real differentiation that Singapore has over Hongkong as a Fintech hub.

MAS have recently tied up with CFTC (Commodity Futures Trading Commission) in the US to share the findings of their Sandbox initiative. Such relationships between regulators help keep regulatory frameworks aligned across jurisdictions . So, when a Fintech is looking to expand beyond borders, they don’t have to rethink operational, strategic or technology aspects for the new jurisdiction and they can focus on what matters – the consumers.

As Fintech evolves over the next few years, there are several ways in which Banks, Insurance providers, asset managers and regulators can work in partnership with Regtech firms. In some areas, these firms will piggyback off what the incumbents have or haven’t done.

There is often a rule of thumb in the top consulting firms – build propositions in an area where there is fire. In other words, if a client has a major issue that could cost them money and/or reputation, come up with a solution for that. This is particularly true with Regtech firms, where they focus on an area that has a serious lack of control and governance.

However, in many parts of the world, there is a genuine opportunity for Regtechs to go a step further and define the controls in collaboration with the regulators, and perhaps ahead of the regulators.

Arunkumar Krishnakumar is a VC investor focusing on Inclusion, a writer and a speaker.

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alternative finance, Fintech, Fintech Global Tour, regulation, revolut, Strategic Viewpoint

A Thinktank Fintech initiative out of Greece

“Necessity is the mother of invention” is an English proverb that is not at all outdated. Small countries are developing regulatory frameworks to embrace and take advantage of the so-called “future technologies” because it will enable them to play vital roles in the 4th and 5th industrial revolution. As tech accelerates, it is expected that one generation may actually live through two major revolutions.

Smaller countries, policy-making organizations and think tanks are actively building the next layer to welcome the socio-economic changes that are inevitable.

A Greek think tank, To Diktio, was founded in 2013 with a European focus. To Diktio (the network in the Greek) is a member of the Foundation of Progressive Studies based in Brussels and focused on proposing reforms in Greece and Europe. I would like to thank the President of To Diktio, Anna Diamantopoulou[1] for reaching out to me. We can only grow through collaboration – see partnerships of ToDiktio, here.

To Diktio hosted yesterday a Fintech focused event for its members during which a very thorough Fintech report was presented by Dr. Kourouthanassis, of the Ionian University and Dr. Doukidis, of the University of Athens; and several policy reforms were suggested. I had the honor and pleasure to review the report (in Greek) and also participate virtually in the event to share some of my insights on Fintech global trends and the first necessary steps for Greece to dive into the Fintech opportunity which is much broader than simply reforming banking services (see video here – in Greek only).

The 40-page report offered a thorough overview of Fintech subsectors and also of the policies that have enabled countries to become Fintech hubs.

Naturally, mentioning first the FCA as an early pioneer in the Fintech. Highlighting that the first European Union country that developed a regulatory framework for “specialized banks”, was Lithuania.

The UK and Japan, are the leaders in establishing frameworks to facilitate the Open Banking movement.

Regulatory sandboxes exist in the UK since 2016 and only this summer the Central Bank of Spain announced a Fintech sandbox to be launched.

In Europe, only the UK launched Project Innovate last year to facilitate the dialog between Fintechs and regulators to innovate in the interest of consumers. Only in Australia, there is a comparable setup of the Capital markets authorities who setup as early as 2015, an Innovation Hub program to encourage the cooperation of regulators and innovators.

Fintech pulse

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Based on the Greek Fintech report, already in 2018, the median size of M&A fintech deals in Europe has nearly tripled from last year.

 

 

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Challenger banks, a European specialty, are the ones that have absorbed large Fintech investments; Revolut, Atom Bank, and N26.

 

 

Revolut has already opened offices in Greece, this past Spring. The penetration in the Greek market is remarkable. By the end of 2017, Revolut had acquired 55,000 customers in Greece, making Greece the 4th largest country/client for Revolut after the UK, France, and Lithuania. Revolut is planning to triple the customer base in Greece.

The first homegrown Greek challenger bank is PraxiaBank. The two also homegrown e-money companies are Viva Wallet and Tora Wallet. Viva is already well established with 60k retails clients and 280k business clients and 30mil euros of transactions only for 2018.

As expected several payment Fintechs have presence and business in Greece. Payments are the most mature but thin margin Fintech subsector. From the 375+ payment businesses with EU passporting, ten have reps in Greece and 9 have licenses to operate in Greece. From the 170+ e-payment Fintechs with EU passporting, 3 have a presence in Greece.

The largest Greek telco, OTE, has a new subsidiary Cosmote payments with a plain vanilla topup card. But what is more interesting is to watch what OTE does with their dormant insurance license and their newly acquired full banking license.

Opportunity via Fintech

The low hanging Fintech opportunity in Greece lies in alternative funding for SMEs. Greece is one of the few EU countries that lacks a crowdfunding and P2P lending framework.

The Greek government needs to launch a Digital ID platform borrowing design elements and tech from Estonia and India. Combining this with a basic regulatory reform for alternative lending, would be a short and long-term strategic move. In a traumatized economy that is recovering from foreign investments in real estate, Digital identities and access to alternative funding would make magic.

[1] Anna Diamantopoulou, has served in the Greek parliament for 11yrs and as European Commissioner for Employment, Social Affairs and Equal Opportunities (1999-2004). She has served as Minister of Education, Lifelong Learning and Religious Affairs and as the Minister of Development, Competitiveness and Shipping. She active in several European think tanks.

Efi Pylarinou is a Fintech thought-leader, consultant and investor. 

Get fresh daily insights from an amazing team of Fintech thought leaders around the world. Ride the Fintech wave by reading us daily in your email.