Emerging Regtech Solutions Show Promise For Uncertain Financial Markets
In the first quarter of 2018 alone, the number of funds raised through token offerings was 118% of those raised in the entirety of 2017. This growth, while quite obviously disrupting traditional finance, has perhaps even more consequently exposed the holes in traditional compliance and its ability to support digital financial services with integrity.
In the crypto finance industry, nations such as Singapore have created a specific classification, guidelines, and definitions that outline various token use cases. Across the world, each country has its own definition of compliance creating a massively complex web and huge barriers to entry for innovation in finance. Regulatory bodies are beginning to hold the token issuers accountable for neglecting to take these measures seriously with hundreds, if not thousands, of additional regulatory actions expected in the near future. The commentary from the U.S. Securities and Exchange Commission to date has been that most tokens should be considered securities unless they have a clear exception or no-action letter.
While many token offerings have proven to be Ponzi schemes or scams, in other cases, well-intentioned issuers are still finding themselves in regulatory hot water. Most of my conversations with token issuers facing rescission orders or other regulatory actions have involved trying to find a path that enables the issuer to both be compliant and still do right by their investors.
Among the traditional financial institutions today, the status quo of their paper-based or even digitized mid-office and back-office systems are no longer viable. For many firms, it is threatening their very existence. Estimates by Bain & Company state that for major banks, 15-20% of their “run-the-bank” costs go toward governance, risk, and compliance.
Meanwhile, tools masquerading as compliance software have given many issuers a false sense of security, making these projects haven for money laundering and bypassing terrorist sanctions. For example, the facial recognition software in use by cryptocurrency exchanges today compares a selfie to your legal identity documents. Recently, it was discovered that these systems are incredibly easy to defraud with failure rates around 40%. In order to survive, entrepreneurs in digital finance simply cannot manage money for retail or institutional investors with the same digital identity verification tools used by unregulated ride-hailing and home-sharing services.
The Importance Of Comprehensive Know-Your-Customer And Anti-Money-Laundering Practices
To register for a regular bank account, credit card or investment account, a user must provide a significant amount of personal data and documents for verification. These policies are not new and have been used by financial institutions to govern operations for decades. However, in crypto-assets, the reality is that most issuers and exchanges are still ignoring legislated requirements. While this has enabled these firms to grow exponentially, these lax policies that rely on tools such as “snap a selfie” facial recognition enable any bad actor to create an unlimited number of duplicate, fake or fraudulent accounts with little to no oversight or consequences.
The use of designed-for-fiat and manual compliance techniques employed to govern this space is seen as one of the primary causes for these massive gaps in compliance. A report by CipherTrace found that nearly $1 out of every $20 on cryptocurrency exchanges in countries with weak anti-money-laundering regulations is engaged in some type of illicit activity. The good news is that the technology now exists to close these gaps.
The Emergence Of New Technologies
My company's head of product strategy says that no one goes to school planning to get into compliance — they fall back into it instead. My experience was no different. I started my career as a broker and financial adviser, so while compliance was not the nature of my business, it was also not optional. Before founding my company, which provides programmatic compliance for financial institutions using cryptocurrencies, I managed large-scale technology innovation projects across multiple finance and government applications.
I have seen first hand how important the governance of technology and data are to accomplish a safe migration of back-end infrastructure in finance, and the migration to decentralized finance is no different. It is clear that regulations and best practices designed for traditional finance cannot adequately serve their purpose in cryptocurrency markets; however, many new solutions have emerged to support the enterprise financial technology standards of today’s finance industry.
New technologies, such as liveness detection, blockchain forensics, zero-knowledge proofs, vocal fingerprint, and machine learning are emerging as high-fidelity solutions. This innovation is providing early adopters in finance with a new and significantly more powerful competitive advantage.
Another option for operating in a compliant manner in the decentralized financial market is programming compliance rules into the technology itself. Regulatory laws can be embedded into the code of, for example, Ethereum smart contracts. Once a law or rule has been set, it can be effectively carried out by an algorithm, reducing both human error and subjectivity and maintaining compliance throughout the life of a digital asset.
Ironically, one of the biggest advantages that blockchain technology has over traditional financial infrastructure is an opportunity for programmatic compliance. Simple private security sold by a broker-dealer today typically costs tens to hundreds of dollars in mid- and back-office processing, not to mention days or weeks to close. Alternatively, by tokenizing the same asset, the issuer benefits from automated screening for governance, risk, and compliance and programmatic reporting in accordance with relevant tax, securities, and compliance requirements. By reducing processing times and costs, it seems inevitable that as these technologies mature they will continue to infiltrate nearly every aspect of today’s private equity, real estate, and emerging capital markets.