FinTech: Decentralizing A Centralized System
Blockchain technology has the potential to solve some of the most challenging problems in the financial services industry. These include regulatory risk management, the time delay in payment of assets/securities and transfer of ownership, as well as compliance.
Today, you can use bitcoin as an asset to make a transaction i.e. by paying beneficiaries in Bitcoin, and expect the transaction to clear within 24 hours - which has driven transaction costs down and has proven to be hugely disruptive in terms of payments. Blockchain, upon which Bitcoin is built, reduces the transaction costs involved with settlement of transactions by settling the transaction instantaneously.
Looking back at some of the financial services largest federal indictments, for example, the failure of eGold, wherein they themselves were the administrators.
It is easy to see why technology like blockchain, wherein the system relies on, and is beneficial because of the extent of transparency that it allows, has the potential to disrupt financial services.
What this means for financial services is that our monetary system is controlled by no-one, but yet at the same time it is controlled by everyone; and in order to shut it down, it would require everyone to simultaneously shut the internet down, a feat that is wholly implausible.
When Bitcoin was invented in 2009 and gained traction as a tool, people thought it was nifty because of the reduced lag in transaction costs and settlement time. However, Bitcoin does not come without its flaws. As an alternative store value with a lot of potential, but it does come with regulatory responsibility. On the one hand, Bitcoin benefits startups by acting as an alternative method of securing finance because of the low overheads, which allows them to gain traction at a faster pace than traditional financing methods; but on the other hand, because of the lack of compliance, it also acts as a vessel through which money can be laundered, leaving plenty opportunity for shady investment.
We are now at a turning point, where regulation has caught up with Bitcoin, and at a faster rate than it was able to address. For example: in Russia, you face up to 7 years in prison or could be fined up to $38,000 if caught transacting with Bitcoin. The fact that Bitcoin is completely outlawed in Russia is interesting, particularly when you have countries like Singapore where the Monetary Authority of Singapore (MAS) has taken the position to waive regulation regarding Bitcoin specifically for startups to a large extent. The trade-off for the MAS in doing so is compromising compliance and control, but perhaps they feel that the monetary gains in making Singapore an attractive location for startups to incubate and incorporate will attract enough foreign direct investment to tip the risk-reward scale in favor of reward.
While on the surface it appears as though Russia are trying to insulate their economy from the regulatory risks that Bitcoin poses by favoring regulation over the ease of access to finance and increased FDI through startups; there is speculation that the real reason they’ve outlawed Bitcoin is because it threatens governments’ control on the economy. One of the Russian governments’ primary function is financial control, and many entrepreneurs and technologists alike feel that the government have done this because they aren’t quite ready for individuals to challenge the extent to which they are able to practice financial control.
Access to finance is one of the leading factors that determine where startups will incubate their companies. The USA, for example has heralded its place as an attractive location for startups to incubate, particularly Silicon Valley. However, it’s no longer easy to operate a FinTech company in the US because of the changes in regulation that have come about in recent years (never mind the cost of housing in the Bay). Startups financed through lumped Bitcoin payments are subject to registering at both a state and federal level, which can cost up to $2m and take up to two years, before they’ve even proved their market. It’s clear that the regulatory space in which FinTech companies operate is key to their success.
The lack of consensus in Bitcoin regulation worldwide and the fact that countries are fighting for foreign investment by deciding how loosely they want to tie the knot based on their own cost-benefit analyses, contributes to why Bitcoin as a currency has failed to reach fruition.
The reason why Bitcoin has failed to reach mass-market penetration is both due to the inability to enforce any sort of regulation due to the lack of compliance
inability for Bitcoin to reach mass-market penetration
as payment in an age where countries are fighting for foreign investment.
Stepping outside the box of bitcoin and looking deeper into the realm of blockchain, one can understand blockchain as a distributed database that operates in a linear fashion. It lends itself well into FinTech applications and can be used to record and transact assets, bonds, stocks, securities and other instruments on its ledger in a safe and secure manner. These ‘digital assets’ are also called ‘smart contracts’, ‘asset-backed tokens’ and tokenisations, but basically mean that a blockchain is used to create a digital representation of the asset. For example a share certificate can be transferred from one individual or institution to another by transferring it in a secure way using cryptography. It allows you to automatically do disbursements for example: paying dividends, by wrapping up a diverse range of technologies on the back-end. That being said, not all blockchains are the same, and no one blockchain is going to be really useful at everything. A simple way to understand this: at work you use Microsoft Office, which allows you to use Word, PowerPoint, Excel, etc. and has wrapped up all of the Microsoft products together in a unified way to allow users to frictionlessly work with each product. The minute you open Pages, you’re unfamiliar with the technology, and the uses aren’t quite what you’re used to; nor are the features the same or used for the same purposes.
What is exciting about this is that we are going to see a world with many different blockchains all with different assets. There may also be some dominant blockchains, for example issuance in securities.
With Bitcoin, you can program money, but you can’t extend the technology to the plethora of other applications that a coder would want to use it for. Ethereum for Bitcoin has potential, but it uses a programming language to stick it on the blockchain.
Now that we have the notion of a distributed application, the question is how to make it work for all
with the announcement of a smart contract of the CORDA ledger system which is inspired by blockchain. Corda was developed by R3 CEV, the leading FinTech blockchain innovation firm, for Barclays - one of a consortium of 42 institutional investors whom have poured money into this 30-person R&D team based between London and New York. The problem of ‘settlement’ that Corda aims to resolve is a problem inherent in financial services and a problem that will take time to resolve.
The promise of blockchain, that is: forcing transparency in financial services, has to deal with the underlying trade-off between efficiency and transparency. If everyone shares the same ledger, then that is to say that you don’t need a ledger that is different to mine, so one the one hand we’ve solved the problem of transparency, but we're still battling to work out compliance and accessibility.
The difficulty in finding an effective solution to the increased regulation faced by financial institutions and crack-down by governments across markets is undoubtedly going to come from a combination of blockchain products that interact together to not only solve the problem of settlement, but the issue of compliance. This brings me on to the second, equally as interesting use-case for blockchain, that is: identity.
- lack of transparency (regulatory risk management)
- settlement slow (payments, securities)
- limited financial access (identity, infrastructure)
A distributed ledger allows for instantaneous transactions that are securely recorded
What makes blockchain exciting is that the technology can be abstracted and applied in other contexts to disrupt other industries that would benefit from the transparency that it provides. Read the next blockchain post to hear about blockchain's best-use cases.