FinTech #2: Fad or Future?
Avoiding FinTech in corporate practice is becoming more and more difficult. FinTech start-ups litter the market, gladiators battling in high-stakes, high-risk environments where only a few will survive to become fully-fledged unicorns. Developed unicorns have begun to launch IPOs, we see ICOs popping up, FinTech firms invest in huge acquisitions and investments, IP and data queries are increasingly orientated around FinTech, smart contracts are being progressively adopted and there’s a near-constant buzz around the subject of cryptocurrencies.
We’ve already looked at how to define ‘FinTech’ and grappled with the basics of how it works, in a previous blog. But is it here to stay? Is it a lasting facet of finance and legal practice, or a bubble waiting to burst? A long-term prospect, or a frivolous fling?
The FinTech space is a FinTech race. A hurdle race. A series of obstacles exist between FinTech and its widespread adoption. These are different depending on the kind of FinTech we’re talking about and the application of FinTech in different circumstances. Competitors may be start-ups, banks, law firms, developed unicorns, states or just about anyone else, hurtling through the course in order to be the first to develop safe, sustainable, accepted, regulated FinTech.
We’re going to move from any consideration of AI into an almost-exclusive assessment of blockchain technology. AI can still be applied to some of these examples, but for now, let’s put it to one side, and just think about blockchain. Does it have what it takes to complete the race? Is the underlying nature of blockchain sufficiently positive, innovative and resilient to conquer the hurdles in its path?
Let’s start by identifying the hurdles, so we’re familiar with the course, then we’ll see whether we think blockchain has what it takes to cross the finishing line.
What are the hurdles in the path of blockchain development?
This is a development of a blog post I wrote in the Justis 2019 writing competition. The below is a more detailed analysis, but covers some of the same ground.
This is one of the biggest hurdles to blockchain development. Since authorities haven’t decided quite how best to deal with much of the new tech we see, there’s very little guidance available, and businesses and individuals are dissuaded from gambling large sums by using this technology. The Bitcoin website reads: ‘To the best of our knowledge, Bitcoin has not been made illegal by legislation in most jurisdictions.’ This is a pretty pathetic opening statement. ‘We don’t think your investment is illegal yet, but it might be tomorrow.’ That’s the reality, however, in many jurisdictions.
Many states are playing a wait-and-see game with blockchain. Sandboxes have become a regulatory playground for the development of appropriate technology and complementary regulation. A sandbox does what it says on the tin: it’s a safe space for market participants to play with new technology, overseen by a regulatory authority like the FCA, for a limited time before the technology can move into mainstream use, possibly with complementary regulation being developed in tune with the tech. Outcomes can be greater engagement with FinTech, safer development of tech, the education of regulators concerning the tech and tech developers concerning the law and more appropriate regulation of new technologies.
Regulation is increasingly emerging and is in a near-constant state of flux as authorities toss up the best way of approaching Fintech. Can FinTech fit within current regulatory regimes, or does it require novel, independent regulation? How do we reconcile FinTech with current regulation, like the GDPR?
Much as I would love to, I won’t delve into all the different regulatory approaches here, aside from scratching the surface of sandboxes. Further sources and topics to go away and look at if you’re interested include:
FCA Sandbox (plus the global sandbox the FCA is proposing)
FCA stance on cryptoassetsand when these fit within the FCA rules
The SEC approved a regulated token offering for the first time in July 2019
Italian Law No 12/2019 provided key definitions and affirmed the legality of DLT and Smart Contracts
This is one of the biggest hurdles for cryptoassets to jump to gain credibility, and is likely only to be conquered when we see the emergence of fiat cryptocurrencies. As of today, one Bitcoin is worth £8,349.03. The reality is that uncertainty, in terms of the legality and valuation of cryptoassets, means that this can fluctuate hugely. Bitcoin has ranged between £2,000 to over £16,000 in value. Charlie Munger, Warren Buffet’s BFF and one of the planet’s best investors has branded Bitcoin ‘worthless, artificial gold.’ Whether states will step in and affirm the legality and back the future of cryptoassets will, in my opinion, be the defining step in establishing more consistent valuation of cryptocurrencies.
The GDPR has thrown a big spanner in the works and no-one seems 100% sure whether current tech does comply with these requirements. Challenges in the realm of blockchain are especially pertinent. An irrevocable permanent ledger which automatically publishes party information sails very close to the wind of what is allowed under the GDPR and new attempts to protect privacy. Can data be published in an immutable ledger? Can a transparent record book which is potentially public retain sufficient levels of privacy? How do we reconcile digital identity and legal identity? Does blockchain refute a right to be forgotten? These are all interesting and important questions regulators and developers will be looking closely at to provide answers to the market.
Fraud and AML
This goes hand-in-hand with privacy. A blockchain platform aims to establish trust where there is not naturally trust as parties rely on the technology rather than one another. To meet requirements under the GDPR, it may be necessary to establish a kind of digital identity which meets the threshold of ensuring accountability and transparency, but which does not expose who is really on the other side of a transaction. This situation feels uncomfortable in terms of security and potentially fraudulent transactions.
Identity aside, blockchain opens the door on hackers to access funds fraudulently. Blockchain is difficult to hack in the sense that each block which is added to a chain references the chain which predeceases it, so to hack the system, you’d have to unwind the chain back a reasonable number of blocks in order to take the funds. Exploiting defective code, however, is much more manageable. It’s estimatedthat there are up to 100 coding errors in 1000 lines of code! This leads to scandals like the 2016 DAO attack,in which $60m was taken by a hacker who legally and legitimately exploited the coding error. The uncertain safety of blockchain remains a considerable hurdle for developers, who will need to iron out faults and, alongside regulation, develop greater certainty and security around transfers which occur using blockchain technology.
Our world seems increasingly switched on to the negative impact we have on our planet, and whilst decentralised ledgers do cut out some of the natural externalities brick-and-mortar institutions accrue, the energy required to fuel these ledgers is astounding. One expert has compared bitcoin mining to the daily energy consumption of Ireland. The sustainability of ledgers is a question which often gets pushed into the background, but must be seriously addressed before we get too invested in the innovation and excitement behind FinTech.
Has blockchain got the strength to run the race?
We’ve looked at the hurdles in the path of blockchain development, but what are the positives about blockchain which give the technology the energy to run the race towards sustainable application? Which features mean that jumping hurdles is worth the time, money and energy blockchain development requires to compete with traditional decision-making mechanisms.
Efficient. Transparent. Innovation.
Blockchain offers something novel, a new kind of competitor in a new kind of race.
Any kind of digitalisation procedure will claim to improve efficiency in the sense that work can be done more quickly, without wasting paper resources or human time. A more sophisticated, blockchain-specific argument is that by enabling parties to independently execute their own agreements, the need for financial intermediaries may be reduced in future. Let’s take an example of a classic transfer of value, which could happen using a cryptocurrency, or be executed by a smart contract on a blockchain platform.
When most of us make a transfer, it usually goes something like this:
A agrees to pay B £100 - A sends B £100 on his bank account - B receives £100
Whilst this is the only aspect that we see, much more is actually going on way above us to enact this transfer. If A banks with Bank ABC, and B banks with Bank XYZ, the reality is that, at the end of a business day, it’s really ABC and XYZ which make any transfer. It looks more like this:
A agrees to pay B £100 - A sends B £100 on his bank account
ABC and XYZ are both financial institutions with bank accounts held at the Central Bank. By the end of the day when A transferred B £100, ABC owes XYZ £1,000,000, because lots of transfers have occurred. On the same day, XYZ owes ABC £750,000 of transfers. So, these amounts are netted and ABC transfers XYZ £250,000 at the end of the day.
Whilst the figures in this example would realistically be much higher, you get the gist. Even for a simple bank transfer, there’s an awful lot of financial intermediation going on. This can be both a good thing and a bad thing. Bitcoin was developed as one of the leading cryptocurrencies in a post-2008 attempt to migrate away from the centralised authority of banks, Satoshi Nakamoto (pseudonym) developing a mechanism by which parties can operate independently, without the need to rely on this elaborate infrastructure in simple exchanges.
The reality of blockchain is not always so simple, or desirable. For example, the volatility of cryptoassets largely derives from the fact that they have no centralised authority through which to validate and anchor their value. This is not always the case, but even for Bitcoin, a household name and one of the most famous cryptoassets in the market, it remains unclear quite how the valuation of assets is ascertained and justified.
The reason that blockchain can reduce intermediation in investment chains is that it relies on a consensus mechanism which effectuates decisions where humans, or other machines, would have previously made those decisions. This function has been singled out as one of the most important facets of blockchain, and noted by several commentators as trust-inducing. These writers note that parties no longer need to trust one another, the technology simply has to be sufficiently good that they can trust that trades will be executed in a reliable manner. This is one of the central arguments of Don and Alex Tapscott in their book Blockchain Revolution, a book I’ve admittedly only recently started but would recommend for anyone looking to develop a base knowledge of blockchain further. Note that anything in print will be outdated in some ways by the time you read it, I think the authors handle this well and offer an array of potential applications, flaws and concerns associated with blockchain technology which remain relevant today.
In order to achieve trust, there has to be sufficient transparency, and reliable performance of the technology. We have seen above that this may be problematic, and is a hurdle to overcome, but the principle of an immutable digital ledger which is very difficult to modify does show signs of potential. Perhaps trust in the technology will be sufficient in many ways presently where there is alreadytrust between parties, it remains to be seen how completely we can rely on the technology so much so that we no longer need to know who is on the other side of an exchange.
Can blockchain get across the line?
In many areas of law and finance, blockchain has already permeated into practice, and it is now far more commonplace to use this technology to resolve issues in an innovative and efficient manner. Blockchain does seem here to stay. Probably not all applications of blockchain will be able to overcome the hurdles in their paths, certainly without state intervention. Some will surely flourish and remain increasingly utilised in the corporate world, well beyond the evolving models of blockchain we currently see in markets, into fully-fledged, reliable, widely-adopted tools and products.