Modern financial regulation needs to encourage disruptive innovation without allowing unacceptable risks. Implemented correctly, it can result in transformational advancements without sacrificing consumer confidence or trust.
In the old world of gradual change to the banking system, changes in regulation only used to be triggered when legislators identified a problem that adversely affected constituents or the market. A recent example of that is the US’ move to put in place the so-called Durbin Amendment, passed as part of the Dodd-Frank financial reform in 2010 post the global financial crisis.
In the European Union, amendments to the Payment Services Directive (PSD) mean that consumers will soon be able to do cross border payments in real-time, consistent with what we see in more advanced economies like Kenya (sic), and that fintech startups will have access to the same payments rails that the big banks have. Another US example is the Consumer Financial Protection Bureau (CFPB) move to create a rule on payday lending that prevents abuse of consumers with predatory lending practices.
These are classic regulatory responses. Identify a systemic problem or risk that either is damaging the market, impacting consumers negatively, or where technology is moving the needle, and respond. But what happens when technology changes represent a risk to the status quo?
Let’s use a fictitious scenario. Imagine that some enterprising startup founder or engineer comes up with a new method of creating a bank account and transferring money that no longer requires a bank account at all. Imagine that same entrepreneur or engineer designs the system to be encrypted so that governments can’t track the movement of money as they do with the existing banking systems.
How would regulators respond? Would they embrace the new technology opening up banking to the masses, or would they shut it down because it circumvents the existing banking system and Anti-Money Laundering (AML) regulations?
We don’t have to wonder … because we’ve seen exactly that situation when Bitcoin took the world by storm.
The Anarchy of Bitcoin
In March of 2015, Charlie Shrem was interviewed on the Breaking Banks radio show, just a few days before he went to Lewisburg Federal Prison Camp in Pennsylvania for violating anti-money laundering regulations. For those of you unfamiliar with Charlie, he was CEO and founder of the US’ very first Bitcoin exchange called BitInstant, allowing its customers to purchase bitcoins via more than 700,000 stores, including Walmart, Walgreens, and Duane Reade.
Even back in 2010, Shrem was deeply into the Bitcoin architecture as an engineer, and saw the potential of the blockchain long before most had even heard of it. But how did Charlie end up in Federal Prison?
When Charlie ran BitInstant, he had dealings with a gentleman by the name of Robert Faiella, who supplied $1m in digital currency to people buying drugs on the now-defunct online marketplace Silk Road. At the time, BitInstant was operating in somewhat of a regulatory grey zone. Bitcoin exchanges weren’t technically money transmitters as they were transmitting only Bitcoin in the form of bits and bytes on the blockchain.
Many months after the $1m in Bitcoin had been exchanged on BitInstant, regulators ruled that the exchange was subject to the same regulations of all currency exchanges and needed to obey AML rules around reporting of suspicious transactions, verifying the identity of their customers and so forth. After speaking at a conference offshore, Shrem was detained at JFK airport, and then placed under house arrest and subsequently sentenced to 24-months in federal prison.
For many in the Bitcoin community, this was a retrospective assessment or interpretation of BitInstant’s responsibility as a money transmitter and exchange. To others Shrem had failed to carry out his duties as a compliance officer.
Interestingly, the same week that Shrem was arrested by the Feds, HSBC had struck a deal with US authorities over AML breaches in Mexico. In the case of HSBC, they paid over $1.9Bn in penalties, without any HSBC executive going to jail.
Even more recently, we’re hearing about Deutsche Bank processing over $10Bn worth of “mirror trades” for Russian clients, in what amounts to an even more significant money laundering scandal. Again, it is highly unlikely that the CEO of Deutsche Bank will end up in prison. While Charlie Shrem is a free man today, we should ask if it is fair that someone went to jail on behalf of the Bitcoin movement in a slowly developing regulatory environment?
In 2014, the Library of Congress surveyed forty countries in respect to Bitcoin legislation. At that time, only China and Russia had specific laws prohibiting Bitcoin use, whereas countries like the United States required Bitcoin exchanges to be licensed under new licensing criteria.
The fact is, it took the US almost 5 years after the legendary Satoshi Nakamoto released his famous paper on Bitcoin to enact the simplest of new licensing requirements restricting the trade of the cryptocurrency and requiring exchanges to track customer identity, movement and their sources of funds. That’s woefully slow in today’s real-time economy, where innovations are occurring at the speed of the Internet.
For the next series of innovations we see emerging today, regulators may not be able to reign them in as effectively as they did with Bitcoin.
Ethereum, the DAO, AI and Risk
Blockchain is not only the foundation of Bitcoin, but also is being used for everything from trading ownership of property to file storage and identity management to name just a few (unique uses include tracking individual diamonds, deploying solar cells in Africa). But innovation occurring on the blockchain is only just getting started, and the Decentralized Autonomous Organization (DAO) is further proof of the fact that the genie is out of the bottle.
The DAO was the world’s first Artificial Intelligence-based company, or more technically, the world’s first AI-based investment fund. It holds the record for being the second largest crowdfunding project ever.
The ‘company’ has/had no legal structure that you’d be familiar with today, but it has by-laws written into its code. It has investors, who all invested their cryptocurrency in the venture, but they don’t have share certificates, and their investments in the DAO aren’t handled by a private bank or investment advisor.
These invested Ether alt-coins give the rights holders Tokens that can be deployed based on a consensus for investment in new blockchain startups, but the investors don’t have to sign term sheets on behalf of their investments or notify the SEC of their investments. At least not as of now.
The problem is that everything about how the DAO operates is technically … illegal. Why? You can’t operate a company that takes investment without registering the company in the local jurisdiction where the company operates.
Technically, however, the DAO doesn’t operate in any physical location, nor does it have a registered office, nor is it even a company in the classical sense – it just sits on the cloud somewhere. The law says you can’t recommend or enable an investment in a fund or investment vehicle without making sure that the fund is both registered, licensed and that investors are fully informed of the risk they take in investing in that structure.
But if you’re investing Ether alt-coins, does this investment carry the same risk? Would the SEC consider that this loophole absolves the operators of the DAO from their responsibility to ensure that the risk associated with the DAO fund is made clear? Not likely. The organization doesn’t have a management committee or any executives that could be jailed for breach of regulations, because the whole entity is just essentially program code.
So, should the regulators simply shut down anything resembling the DAO and all future attempts at AI-based companies that can invest cryptocurrencies? Should all AI-based companies by banned from being connected to the financial services ecosystem? Should investors be restricted from investing alt-coins and cryptocurrency holdings unless it goes through traditional brokers or investment advisors?
The Conflict Between Regulation and Innovation
If an economy wants to stay competitive in the Augmented Age, it needs to allow for experimental innovations to play out. In the case of markets like Singapore and the UK, local regulators have chosen to embrace these new financial models and are creating sandboxes where innovators can experiment without fear of penalty or prosecution.
In the event that a project emerges that enables an innovation like the DAO that doesn’t fit any existing regulatory paradigm, the regulators can watch it unfold in real-time and determine if there is any risk to the market and if regulations need to be adapted or modified.
The Ying is that new structures, initiatives, creations like Ethereum and the DAO could conceivably result in some unanticipated risk to the market or investors. The Yang is that if regulators prohibit such innovations and experimentation, or overreact to something like Bitcoin in the future, it could be the equivalent of shutting down the Internet in its earliest days. It would represent an economic tragedy and a serious barrier to innovation for generations to come.
Regulators have a difficult transition to make. They need to become platforms for creation of new structures, new thinking, and new economic opportunities in finance … not just serve as the managers of systemic risk. They need to ensure that they aren’t hampering innovation in favor of laws, rules and policies that have evolved around incumbent business models, and that are already out of date. They need to embrace the fact that more net new investment is moving into financial technology than is moving into the creation of traditional financial institutions.
The future is uncertain, but one thing is for sure. In 250 years, no economy ever thrived by stopping their best and brightest from innovating. And most certainly, the regulators haven’t seen anything yet!
To find out more about the Blockchain, Ethereum, the DAO and other Blockchain innovations, listen to the Blockchain series of podcasts on Breaking Banks at iTunes, Voice America or at BreakingBanks.com