Chapter 12
Financial Technology
IN THIS CHAPTER
Discovering future global bank trends
Uncovering new investment vehicles
Exposing risk in the banking blockchain
Developing new financing strategies
The first to adopt blockchain technology were banks, governments, and other financial institutions — and they’re the fasting-growing blockchain users, too. The powerful tools that are being built to manage and move money will reshape our world in new and unexpected ways, so it makes sense that financial technology (fintech) would jump onboard.
This chapter gives you the inside scoop on what governments are currently doing with blockchain technology and how it will affect you. Fintech touches your life every day, whether you’re aware of it or not.
In this chapter, I introduce you to future banking trends, new regulations, and the new tools that can help you move money faster and cheaper. I also explain new types of investment vehicles and other blockchain innovations. Finally, I warn you about potential risks of investments involving virtual currency and new blockchain-technology-enabled financial products.
Hauling Out Your Crystal Ball: Future Banking Trends
Banking was the first industry to recognize the threat of Bitcoin and then the potential of blockchain to transform the industry. The banking sector is highly regulated, and the fees to organize and operate as a bank are expensive. These heavy regulations have been an insulating and protective shield for the whole industry, as well as a burden. The application of fast, efficient, digital money that doesn’t carry the cost of handling cash and that is traceable as it moves through the financial system was an intoxicating and threatening proposal. The idea that value can be held outside the control of central authorities also piqued the interest of financial institutions and governments that back currencies.
Initially, these financial institutions and governments tried to squelch blockchain with regulation. Today, they’re embracing blockchain through investment across the board.
In 2013 and 2014, the U.S. Securities and Exchange Commission (SEC) issued a warning to investors about the potential risks of investments involving virtual currency. The warning was that investors might be enticed with the promise of high returns and would not be skeptical enough of the new investment space that was so novel and cutting-edge. According to the SEC, digital currency was one of the top ten threats to investors. Today, the SEC stands ready to engage with companies and investors as cryptocurrency gains traction within all industries.
Not even two years later, countries around the world — including the UK, Canada, Australia, Japan, and China — began investigating how they could create their own digital currencies, seizing cryptocurrency for themselves and put money on the blockchain. In 2018, Venezuela launched a cryptocurrency called the Petro. The launch of the Petro is a significant turning point for cryptocurrency because Venezuela was the first sovereign nation to issue its own cryptocurrency. The Petro was unfortunately used to defraud Venezuelan citizens. However, the future may hold an oil backed digital currency for Venezuela.
Blockchain’s promise of an uncompromisable ledger has been an appealing system to try for governments that are seeking to reduce fraud and improve trust. Innovations in blockchain technology promised to be able to handle the billions of transactions need to support economies, making a cryptocurrency feasible at scale.
Blockchains are in themselves permanent and unalterable records of every transaction that is inputted into them. Putting a country’s money supply on a blockchain controlled by a central bank would be utterly transformative because there would be a permanent record of every financial transaction, existing at some level within their blockchain record, even if they weren’t viewable to the public. Blockchain technology and digital currencies would reduce risk and fraud and give them ultimate control in executing monetary policy and taxation. It would not be anonymous like Bitcoin was at first. In fact, quite the opposite: It would allow them a full and auditable trail of every digital transaction made by individuals and companies. It might even allow central banks to replace commercial banks’ role in circulating money.
The question of what the future for banking will look like can be scary and exciting. Consumers can now pay friends through their phones almost instantly in almost any type of currency or cryptocurrency. More and more retail stores have begun utilizing cryptocurrency as a way to pay for goods and accept payment from customers. In Kenya, using cryptocurrency is more normal than not. But this is still not the mainstream option for most of the world. Western markets are still in the early adoption phase.
Given that most individuals have their wealth locked into legal tender issued by governments or locked into assets that are within existing government systems, fintech innovations must merge with these existing systems before we see the mainstream utility of blockchain or digital currencies. If regulators find ways to tax and register accounts, mass adoption of customer-facing wallets with digitized tokens is two or three years down the road.
The business-to-business market will start utilizing blockchain much quicker. A production-hardened system with the associated policies and operations is being tested. Ripple and R3 among others have been hard at work making this possible. These systems will first focus on the institutional creation of digitized representations of deposits. These are IOUs between internal organizational departments and between trusted partners, like vendors. Regulators, central banks, and monetary authorities are all investing heavily in making this possible. Canada and Singapore have been moving very quickly.
Know Your Customer (KYC) and Anti-Money-Laundering (AML) regulations require banks to know who they’re doing business with and ensure that they’re not participating in money laundering or terrorism. Banks issuing cryptocurrencies still have significant challenges to overcome first. In order to stay compliant with KYC and AML regulations, they need to know the identity of all the individuals utilizing their currency. In many cases, people’s bank accounts are already debit and credit service of transactions, like distributed ledgers in blockchains, except for centralized. The first candidates in this area are going to be regions where regulators, banks, and central banks work together. Singapore and Dubai are good candidates that already have blockchain initiatives.
Moving money faster: Across borders and more
Assessing the transaction volume needed to be met by a blockchain handling the currency of an economy like the UK or U.S. is difficult. The U.S. alone is processing billions of transactions a day and over $17 trillion in value a year. That’s a lot of responsibility for a new technology! The nation would be crippled if its monetary supply were compromised.
The International Monetary Fund, the World Bank, the Bank for International Settlements, and central bankers from all over the world have met to discuss blockchain technology. The first step toward faster and cheaper money would be adopting a blockchain as the protocol to facilitate bank transfers and interbank settlement. Official digital currencies that ordinary citizens use on a daily basis would come much later.
Individual consumers wouldn’t directly feel the cost reduction from utilizing a blockchain for interbank settlement. The savings would be seen in the bank’s bottom line as cost reductions for fees charged by intermediaries.
Consumers will still want retail locations and commercial banks for the foreseeable future. But millennials have already adopted app-activated payments through PayPal, Venmo, Cash, and more. A new way of paying through their phones won’t faze them.
The great challenge is that if all money is digital, compromising it could be catastrophic. It’s possible that the architecture of blockchain systems could be strong enough. The issue might be instead that the code within the system is executed in an unexpected manner, as happened in the decentralized autonomous organization (DAO) hack on Ethereum (see Chapter 5). If the cryptocurrency were operating on a traditional public blockchain, then 51 percent of the nodes in the network would have to agree to fix the issue. Getting an agreement in place might take a lot of time, and it wouldn’t be practical for businesses and people who need stable and secure money at all times.
Many blockchains operate as democracies. A majority (51 percent) of a blockchain’s nodes network are needed to make a change.
Creating permanent history
Data sovereignty and digital privacy are going to be huge topics in the future. Fraud prevention will be easier because if the whole economy is utilizing a cryptocurrency, there will always be an auditable trail inside the blockchain that secures it. This is enticing for law enforcement, but a nightmare for consumer privacy.
From a customer perspective, there’s already an audit trail for everything you purchase with a credit or debit card. From an institution perspective, it’s beneficial to have audit trails because it increases transparency of documentation and life cycles of the movements of these assets between different regions. It adds legitimacy to the trading of assets and allows them to bake compliance into their day-to-day transactions.
The “right to be forgotten” rules in Europe, which allow citizens the right to not have their data forever propagated on the Internet, are a difficult challenge for blockchains, because blockchains can never forget. Governments and corporations would have permanent historical records of every transaction, which could be devastating to national security if they were exposed to the public. Or in a company’s case, it may allow their competitors to have an inside scoop on how their competitors are investing.
The biggest challenge to using a permissionless blockchain such as Ethereum or Bitcoin would be guaranteeing that you haven’t sent money to an OFAC country to support terrorism. The answer is that you can’t because they are somewhat anonymous and anyone can open a wallet. It is possible to create algorithms to trace transaction movement — the U.S. government has been doing this for years — but anyone can move value in a permissionless world.
The Office of Foreign Asset Control maintains sanctions on specific organizations or individuals in what are considered high-threat countries. The government is unable to track the history of transactions when using permissionless platforms anonymously.
The need for KYC and AML makes a case for the permissioned blockchain in the shared ledger space. The software company R3 developed Corda, a private and permissioned blockchain-like platform to meet many of these challenges directly. They specifically do not globally broadcast the data from their participants. This keeps the data within the Corda blockchain private and was the primary nonfunctional requirement requested by the more than 75 banks that worked with R3 to adopt blockchain technology. They need to maintain their privacy and meet strong regulatory demands.
Going International: Global Financial Products
Blockchains will usher in many new types of securities and investment products. New markets will be opening with more efficient ways of calculating risk because collateral will be a lot more transparent and fungible across institutions when accounted for within a blockchain-backed system.
Blockchain technology also has applications in helping reduce scams within the global warehouse market for fraudulent double-sold goods. Blockchain entries enable manufacturers and regulators to document the provenance of products and, in turn, allows buyers to check the authenticity of what they’re buying. There are several solutions in the market, including Everledger and Provenance.
Hernando de Soto, the famous Peruvian economist, estimates that providing the world’s poor with titles for their land, homes and unregistered businesses would unlock $9.3 trillion in assets. This is what is meant by the term dead capital.
It is imaginable that countries that can free their dead capital, the unfinanceable real property they own, will be able to bundle and sell these interests in these assets across a global marketplace. This would be things like transparent mortgage-backed securities for new real estate developments in Colombia or Peru.
In the future, countries will be able to free up their dead capital. Owners of properties, undeveloped land, and un-financeable properties will now have the opportunity to sell the interests in these assets across a global marketplace.
These assets will be appealing because asset managers will be able to actively parse underperforming assets given the transparency and capability of one being substituted in place of another through blockchain-based technology. The use of blockchains to manage these assets will give managers the power always to own top-performing securities, removing the rotten apples, reclassifying them, and selling them as new securities.
For non-institutional customers, micro-investments will be an attractive outlet enabled globally and locally through blockchain trading platforms. Using blockchain technology will also give them the means of investing in companies and their specific activities without having minimums or going through intermediaries that take a percentage of the investment.
Decentralized autonomous organizations (DAOs) are already out there and making DAO investment pools happen for a few risk-tolerant and more technically savvy investors. It may be some time before an institutional investor utilizes one or a portfolio manager recommends putting money into a DAO-based vehicle for her clients.
DAOs remove a lot of the necessary paperwork and bureaucracy involved in investing by creating a blockchain-based voting system and giving shares to those who invest in their product. To any blockchain, the “code as law” concept makes it unforgiving. The risks are many, particularly when there is poorly written code that executes in unintended ways. The consequences are that hacks to this system can be severe. The transparent nature of the original system, the poor code, gives hackers a wider attack vector and allows them to attack multiple times as they gain more and more information each time.
In the following section, I discuss the effects and benefits of blockchain technology on the world economy.
Border-free payroll
Our world is global, and companies don’t have borders. Instant and nearly free payroll is enticing and would save a lot of headaches for organizations. But there are drawbacks, too.
The largest risks will be with the loss of funds through hacking. If you’re compensated in cryptocurrency, and you were hacked, it would be impossible to retrieve your funds. There’s no dispute resolution center. There’s no customer service to complain to for the loss of these funds. Thieves of digital currency have global access while being somewhat anonymous. The hacker could be anywhere.
With the current structure of blockchains, the consumer is responsible for his own security. Currently, customers don’t have the main burden of protecting and insuring themselves from a loss. Larger companies and governments offer protection and insurance, and they have for as long as anyone can remember. Regular individuals haven’t had to protect themselves in this manner since they stopped holding their own gold during medieval times (more or less).
These challenges haven’t stopped companies from processing payroll using cryptocurrency. Bitwage and BitPay are both competing in the market for payroll processing via Bitcoin. Bitwage allows employees and independent contractors to receive part of their paychecks in cryptocurrency, even if their employers don’t offer the option. BitPay, on the other hand, has payroll service providers Zuman and Incoin integrated into its payment and payroll APIs. Again, early adoption is happening in areas that had nonexistent or inadequate solutions before.
Faster and better trade
Blockchains will facilitate faster and possibly more inclusive trade. Global trade finance has been restricted in recent years. Some banks like Barclays have even pulled out of growing African markets. They leave behind a vacuum for financing trade. Companies still need capital to ship their goods.
DAOs and micro investments could meet that need and give investors more profitable returns than are currently available on the market. Transparency of all the goods being sold, secure identity, and seamless global tracking that is all connected to a blockchain would open up this opportunity for small investors.
The interoperability between currencies, which companies like Ripple facilitate, will also allow for more trade because they offer flexible ways of calculating foreign exchange rates than through the transfer mechanisms. The introduction of more popular digital currencies into foreign currency exchanges will add to the adaptability and integration of underserved markets.
Aza Finance, formally called BitPesa, is a company that converts M-pesa phone minutes from Kenya into Bitcoin. With this technology, it offers businesses a faster and cheaper way to send or receive payments between Africa and China. The trade between Africa and China is a market of over $170 billion. It takes days to settle payments across borders, and the fees are high. When you use Aza Finance’s digital platform, payments are instantaneous and cheap.
Guaranteed payments
Guaranteed payments that are permitted through blockchain-backed transactions will increase trade in places where trust is low. Poorer countries can compete on the same playing field as wealthier nations within these types of systems. As this happens over the next ten years, the global economies will shift. The cost of commodities and labor may increase.
Global companies pay their employees based on competitive pricing, as well as on employees’ previous salaries. If blockchains allow for equality across economic divides, it won’t happen overnight. Developers and other knowledge workers would be the exception because it’ll be easier for them to support themselves based on anonymous work.
Financial inclusion and equal global trade are very important topics for governments. Adoption of digital currencies will more likely be done nationwide in small and developing countries. Most large countries have decentralized power structures that prevent quick changes to vital systems like money.
The central power structures of small countries will allow them to leapfrog over legacy infrastructure and bureaucracy. For example, most African and South American countries don’t have landlines or addresses, but they all have smartphones and ability to create cryptocurrency wallets. The missing piece is overall trade liquidity and capacity to pay for basic needs such as utilities, rent, and food through a cryptocurrency.
Micropayments: The new nature of transactions
Micropayments are the new form of transactions. Credit card companies may use blockchain technology to settle the transaction, reduce fraud, and lower their own costs.
Global institutions like Visa and MasterCard, which provide the benefit of delayed payment, will always be needed by consumers in capitalistic societies. Even if the backend changes, you still have the same access points for customers. But physical cards will go away. In fact, that’s happening now, even without blockchain technology. With blockchain technology, the customer identities behind payments will be more hardened against theft.
People still need credit to operate a business and get by personally. Credit card companies will keep making money through transaction fees. Credits run the world, and capital markets will always exist in our current social structure. The cost of sending money between groups will decrease, but that’s a good thing for financial institutions. They want to focus on the service of providing their customers with the best choices in their investment or banking markets.
Squeezing Out Fraud
Bitcoin was created as an answer to the financial crisis, where fraud and other unethical actions caused the world economy to collapse. It shifts from a “trust or doesn’t trust” view of the world to a trustless system. This subtle difference is lost to most. A trustless system is one in which you equally trust and mistrust every person within the network. More important, the blockchain provides a framework that allows transactions to occur without trust.
These same types of frameworks can be used for more than just exchanging value over the network. Let me share an example that will help illustrate the potential.
I go to a bar and the man at the door stops me and asks to see my ID. I reach into my wallet and hand him my driver’s license. My license has a lot of information on it that the bouncer doesn’t need, nor should he have access to (like my address). All he needs from the ID is that I’m over the age of 21. He doesn’t even need to know how old I am — just that I meet the regulation requirements.
In the future, blockchain ID systems will let you choose what information you expose to what person and at what level. The more anonymous data it has, the safer it will be. Blockchain systems will help curb the theft of identity and data by not sharing information with those who don’t need it or have permission to see it.
Another aspect of blockchain technology is that it will shift fraud from where it happened (past tense) to where it is currently happening in real time. Within our current system, audits are fractional post-mortems of what has happened. A group of outside auditors comes, pulls a few random files, and sees if everything is in place. Doing anything beyond this is too costly and time-consuming.
Record systems that have blockchain technology integrated within them will be able to audit a file as it’s created, flagging incomplete or unusual files as they’re created. This will give managers the tools they need to proactively correct files before they become a problem.
Another feature of blockchain systems will be the ability to share the data with third parties transparently. In the future, sharing data will be as easy as emailing a zip file, except the receiver will then have access to the original copy, not a copy if the file sent across email. When someone sends a file, he has a version on his computer and the receiver has a version. With blockchain technology, the two people will only be sharing one version.
Blockchains act as a third party that witnesses the age and creation of files. They can tell at a granular level each person who interacted with a file across systems, internally and externally. They can show what is missing from a file, not just the data that is contained in it now. Blockchain files can also be shared in a redacted fashion that does not compromise the validity of documents.
What this means is that you’ll be able to see the age of a file, the complete history of a file, and what it looked like over time as it evolved. More interestingly, you’ll also be able to see if anything is missing from a file. This concept is called proving the negative. Most file systems at this point can only tell you what they have within them. But you’ll be able to tell what a file doesn’t have.
Auditing will be less expensive and more complete. Updating audit rules could be done in a more centralized way. When regulatory nodes within a blockchain network have a shared and transparent view into asset transactions, the reporting of these transactions can be done through the regulator’s location, without mandating 100 or more other institutions to adhere to the same rule set.
Blockchain-based systems that are fully integrated across an organization will be able to know where every penny was spent. The last mile of how money is spent is the most difficult to account for across organizations and governments. Because it’s so difficult to account for, those wishing to steal funds have the opening they need.
The last mile could become a company’s greatest opportunity to save wasted resources and identify corrupt individuals. Nonprofits that have strict guidelines on accounting for how they spend their money could benefit from this type of system the most. They could meet their needs for auditing and accountability to their donors without impeding them in their greater missions for good.
One system that has been explored would integrate directly into the workflow of aid workers. This system was originally designed to track medical records but could also track back all the supplies that are used with each medical patient. The benefits of this system would be monumental, given that so much fraud and theft occurs within the NGO world.