Contributed By TozziniFreire Advogados
The financial sector has benefited greatly from technology throughout history. Moore’s Law predicted that the computational potential would double every 18 months – and, so far, this has mostly been the case. Thus, computers performed more complex calculations that humans ever could, communication advances allowed faster, higher trades within the same hour and fundraising was forever changed after an international range became possible. Technology essentially presented easier outcomes to everyday tasks and brought more possibilities to the table, and that meant some of the most traditional institutions had to make way for the new structures that come alongside new solutions – and that includes the global financial institutions. This is where, and when, financial technology companies – FinTechs – enter the game, taking these tools to the next level, and implementing them into their services.
In a nutshell, FinTechs can be defined as groundbreaking and independent start-ups, which aim to improve financial services by implementing new technology. At their core, FinTechs strive to help consumers and businesses find better solutions to their financial needs and procedures through advanced algorithms. Once defined as technology implemented into systems of already established financial institutions (eg, the Brazilian bank Itaú's tech solutions allowed customers a 24/7 access to their accounts), FinTechs have acquired a whole new meaning since then, with a much more consumer-oriented scope.
FinTechs are also responsible for the development and trading of crypto-currency (eg, bitcoin). Crypto-currencies are known for their potential to change the nature of transactions, promoting cash-free and simpler trading through the blockchain technology. At a global level, this precise aspect of FinTech may face the most challenges and regulation obstacles.
However, questions still arise as to why and how the platform of blockchain would be relevant to a FinTech? The answer lies in the fact that FinTechs and blockchain share the same drive: to disrupt obsolete ways of conducting business. This should be possible through blockchain’s potential to reshape the market, enabling fast access to data, strong data protection (and thus credibility) and, as an overall consequence of these possibilities, the substantial reducing of operating costs.
Blockchain Beyond The Coin
To put it in a few words, the technology of blockchain consists of nothing more than a distributed ledger technology. Think of a registry book – if it is stored in a sole place it could be easily destroyed, robbed, or altered. However, if such a book had copies that were stored in different places, it would be almost impossible to take or hack its information fraudulently all at once. What blockchain does is to put that registry under a cryptographic protocol, by distributing the database to multiple computers in the network.
The information is stored in 'blocks', as suggested by the name itself, and each block is verified against the existing information in the chain, which is then cryptographed to protect data and avoid security threats. It replicates to multiple and simultaneous servers, making data highly resilient and almost impossible to lose, even if a copy of it is corrupted or a node on a network fails. Essentially, it is more secure in a world where nearly everything happens online.
As blockchain makes data traceable, it allows the involved parties to track and audit every transaction, change, and identity related to that information. It also confers data a 'trust protocol', as no unilateral changes are possible, due to its 'peer-to-peer' nature: all parties involved shall consent to any alterations made, and no third-party interference is needed (nor is it possible). If there were fraud, the chain would promptly identify it.
The reliability made possible by blockchain was originally related to financial operations, essentially crypto-currency – which is comprehensible, since it was at first developed to register bitcoin transactions (one of the main crypto-currencies of the market). However, a technology that revolutionises data security and storage cannot be oversimplified. There are many other known uses for blockchain the market should be aware and be taking advantage of – the so-called non-currency applications.
Initially, blockchain’s attribution was to 'mine' money from ones and zeros. This fundamentally meant the registry of any transaction in coin wallets – exchanging information from the spender to the recipient and contrariwise.
However, in just a few years, the extent of blockchain has quickly expanded beyond payments and currency, as blockchain may be used to improve any application that could benefit from transparency – and that means it is possible to list uncountable non-currency operations arising from this technology. By means of example, the cryptography and data protection also allow its use in stealth and strategic operations within a company, such as M&A transactions, international trade operations, business documents registry, among many other ramifications. Such technology is also likely to affect governance itself, by making feasible the set-up of new organisational structures that could promote more democratic and participatory decision-making through the provision of secret and safe voting. To name a few more of the industries that the technology has the potential to disrupt: agriculture, trade operations, logistics, government procurement, insurance, registry, financial institutions, among others. That is why it has been appealing to a wide variety of segments, from the medical field to the music industry and the financial market.
Even though mainstream currency applications to blockchain relate intrinsically with FinTechs, these non-currency applications are the ones that might really help them reach their goals. Through data security to faster transactions, the possibilities in its exploitation in FinTechs are expected to enhance any application within their scope of service.
The Synergy Between FinTech and the Blockchain Platform
The financial market should be the one to benefit the most from blockchain. Whether it is expediting payments, creating financial instruments, organising data and information exchange, foreign currency exchange, creating autonomous computer protocols known as 'smart contracts', online lending, and even facilitating interactions between humans and machines, FinTechs may see great outcomes in the near future, as blockchain’s peer-to-peer nature will allow transactions to be as easy as sending and receiving an information.
Accounting procedures and financial statements
Another aspect of blockchain’s corporate use is in the accounting records of a company, which would be upgradable in real time, enabling auditing and its supervision.
One of the most striking applications of FinTech is the revolution in bank secrecy and data-sharing, as the non-compliance to such standards holds severe consequences and the structure needed to comply currently represents one of the most expensive costs a company can bear.
Recently, the Central Bank of Brazil published Resolution No 4,658, of 26 April 2018, introducing some requirements of a Brazilian financial institution to structure its cybersecurity policies and to hire this service from a third party.
The Central Bank of Brazil does not restrict the usage of the blockchain platform, but, on the other hand, it imposes severe restrictions on data storage (especially abroad). Blockchain is not based in a country or subject to a special law – it is a strong tool that can be used anywhere, by many different people simultaneously. Hence, the control of cryptography will be a relevant challenge in terms of regulation, regardless of the size of the structure.
Wire-transferring and exchange
When the structure of sending and receiving information is simplified, opportunities to performing swift (and, therefore, extremely competitive) services are countless. FinTechs need to bring their 'A game' in order to compete with the all-mighty banking industry – and blockchain can be their most important ally in doing that.
Regulatory Framework in Brazil
In order to provide a better approach into the regulatory aspects of blockchain in Brazil, it is first important to clarify its classification into a broader scenario. It is essential to comprehend that any transaction comprised in blockchain may be defined as a token, and that tokens are essentially classified in two distinct types: the utility token and the security token. The first-mentioned, utility token, is defined by Merriam-Webster Dictionary as “a digital token of crypto-currency that is issued in order to fund development of the crypto-currency and that can be later used to purchase a good or service offered by the issuer of the crypto-currency” – in other words, a utility token represents a right, an asset.
The security token, on the other hand, is the one developed as a means to raise funds through initial coin offers (ICOs) and, therefore, may be comprehended as a security.
ICOs are much like IPOs: fundraisers which aim to finance new projects, the expansion or redesign of a structure. The difference lies in the destination of the funds: instead of a company, ICOs finance mostly coins, but also services or apps – which make them an interesting alternative to venture capitalists. By these means, any interested investor receives a new crypto-currency token specific to that individual ICO – and that is the remuneration for their effort and support undertaken to the applicable project. The issuer of the ICO should destine any funds raised to their endeavours, whether they are the launch of a digital currency or a new product. Investors, on the other hand, expect their token to perform well and provide them with a significant financial return.
Start-ups generally have been using ICOs to bypass the rigorously regulated fundraising process required by banks or venture capitalists that seek support in their projects. However, as any kind of investment that promises financial returns, and (as suggested by the name itself) security tokens may be deemed as securities and, therefore, subject to control. Such control lies on the understanding of authorities on a case-by-case basis.
With the purpose of verifying whether the token may or not be classified as a security, due to the vagueness of the legal concept, the United States Securities and Exchange Commission applies the Howey Test (an enquiry method based on the US Court case Securities and Exchange Commission v WJ Howey Co, 328 US 293), which has set standards to classify if a transaction shall be deemed as a controlled investment. Regulators in other countries, including Brazil, have replicated this procedure to determine which transactions shall be under their remit.
Having determined what shall be subject to control, regulators establish standards and obligations issuers shall abide by, as well as the investors’ behaviours.
Regarding the Brazilian regulatory framework, it is worth noting that the Brazilian financial system has an extremely high banking concentration. PWC recently conducted a study in which it demonstrates an 82% rate of participation of the five largest banks in the financial system (by percentage of total assets). This concerns not only authorities, but also consumers and smaller players who would very much benefit from a diverse market. This has sparked a series of discussions among regulators in quest of solutions.
Brazil still lacks specific legal provisions on the regulation of blockchain. Brazilian regulators do not yet officially recognise it as a data registry technology, even though its application is being publicly discussed and studied.
The first practical uses of blockchain within financial structures in Brazil are emerging, so any observances or restrictions (if any) imposed by authorities should be made soon. Until no specific statement is given, some firms are grasping the opportunity to develop blockchain-based solutions to their customers. As an example, Santander Brasil has recently announced their launch of a blockchain-based foreign exchange platform, which is supposed to be the first service using the technology for individual clients in Brazil, promising faster exchange and safer transactions.
In Brazil, the main regulators overseeing FinTech set-ups are the Central Bank of Brazil and, when applicable, the Brazilian Securities and Exchange Commission (CVM).
CVM has been applying the Howey Test in many of its decisions to determine whether an endeavour is a security. Although there was not an official ruling on ICOs up to this day, the Brazilian Securities and Exchange Commission released an official statement in which it warned investors on possible risks arising from this kind of operation.
This regulator, however, has recognised its responsibility over crowdfunding FinTechs and rules them through CVM Ruling No 588, of 13 July 2017. According to Leonardo Pereira, CVM’s former president, “Crowdfunding investing is an innovative alternative for financing entrepreneurs. The CVM believes that the legal security brought by the new standard can leverage the creation of new successful businesses in the country, allowing the acquisition of resources in an agile, simplified and wide reach to investors through the use of the internet.” This is the extent of their responsibility over FinTechs until now.
On the other hand, the Central Bank of Brazil has officially pronounced on crypto-currencies, stating that they do not deem them as official currency and, therefore, they should not be under their scope of responsibility. However, this authority has been studying blockchain implementations, and recently released a 34-page study on the technology, exploring potential applications of it, mostly in data security.
This essentially means further innovation might be on its way. Up to this moment, it is possible to say that the Brazilian financial field has been through three waves of innovation on the regulatory sphere since 2013, which all bear a relation to its FinTech market.
The first wave
The first wave, with the advent of Law No 12.865, of 9 October 2013, defined means of payment and their use, and outlined rules and standards for their implementation. This was estimated as an important step towards innovation in the financial market, as it legally defined new kinds of platforms used for expediting payments.
Currently, companies pertaining to this particular innovation wave are not considered FinTechs, as their market is more mature and they do not need to develop new products or tech solutions to disrupt the market.
Moreover, there is at this time a strong demand for payment services, which has led market players to issue IPOs (eg, Pagseguro and Stone Pagamentos launched public offerings at the US Stock Exchange raising, respectively, USD2.3 billion and USD1.1 billion) and become global companies, receiving the so-called 'smart money' (eg, Nubank has sold 5% to Tencent, a huge Chinese payment company).
The second wave
Following the 2013 advances, the second wave arrived in 2015, with the dawn of the first online lenders, societies that connect borrowers with investors through an online marketplace, allowing more inclusion in credit operations. The advent of these societies is due to new legal possibilities that made possible the set-up of partnerships between banks and FinTechs by means of a banking correspondent contract.
The main consequence of this second wave was the emergence of two new types of financial institutions by the Central Bank of Brazil in April 2018: P2P lending (Sociedade de Empréstimo entre Pessoas – SEP) and balance sheet lending (Sociedade de Crédito Direto – SCD). In the same publication, the Central Bank of Brazil has also recognised and outlined online lender operations, provoking an operational evolution in this market.
The third wave
The third and most recent wave is still coming; at the end of 2018, the Central Bank of Brazil published a communication to the financial market which aims to organise and regulate the instant payments market.
As mentioned above, the Central Bank of Brazil has introduced two financial institutions to improve the country's FinTech market.
The Central Bank of Brazil defines SCDs as financial institutions whose purpose is the lending, financing and acquisition of credit rights exclusively through an electronic platform, with the particularity that it may only use financial resources originating from its own capital. It faces some limitations imposed by the Central Bank of Brazil, such as public fundraising (with the exception of stock offerings) and holding any participation in a financial institution’s capital.
SEPs are financial institutions whose purpose is loaning and financing between people exclusively through an electronic platform.
Another revolutionary development of blockchain is the expedition of payments, wire transfers and currency exchange; these are expected to harness much freedom from old standards – no more business times or need for a third-party intervention.
This particular aspect of payments has seen many innovations in recent years, such as the introduction of instant payment, which allowed immediate transactions through simply pointing mobile cameras at QR codes (matrix bar codes).
In this regard, the Central Bank of Brazil recently published Communiqué No 32,927, dated 21 December 2018, which addressed the fundamental requirements for the Brazilian instant payment environment.
This provision is very much welcomed, especially since the Central Bank of Brazil has finally established the main aspects of the structure of this new form of payment in which governance rules, forms of participation, operational and centralised settlement infrastructure, connectivity services and settlement provision stand out.
It is clear that the autarchy is concerned with the application of a flexible and open system of participation that grants financial inclusion as well as the advent of different structures, which may fit in the following ways as service providers.
It is also worth mentioning the participation of the Central Bank of Brazil in this new means of payment, intended to centralise the settlement infrastructure, operating these transactions one by one, 24/7 every day of the year.
Most importantly, the Central Bank of Brazil did not mention whether it allows the use of a blockchain platform. The Communiqué was not specific in regard to the type of technology to execute instant payments. As there is not an express restriction, this opens up the possibility of developing an innovative wire-transferring structure in Brazil.
Initiatives of the Brazilian Securities and Exchange Commission (CVM)
At the beginning of 2018, the Brazilian Securities and Exchange Commission (CVM) published the Legal Mandate No 1, which was clear to prohibit a Brazilian investment fund to investment directly in crypto-currencies.
However, the CVM recognised, by the Legal Mandate No 11, an indirect investment in crypto-currencies. In other words, it is possible for a Brazilian investment fund to invest in an overseas investment fund which has crypto-currencies in its portfolio.
This position reflects a previous CVM decision about investments of Brazilian funds in foreign funds, which leaves a uniform positioning of this autarchy. On the other hand, it allows, even indirectly, investments in a market that still has not decided whether the CVM is or is not competent, or whether or not crypto-currencies are securities.
Initiatives of the Central Bank of Brazil
The Central Bank of Brazil does not recognise tokens as a currency, regardless of their classification as utility or security and, consequently, has not assumed the responsibility of overseeing the crypto market.
However, it is safe to say that there is some indirect impact of the Central Bank of Brazil's rules on the crypto-currency market.
Recently, one of the biggest banks in Brazil has achieved success in a litigation against a famous broker company. The main argument of the financial institution involved 'know-your-customer' procedures, because there is little or no data control of each crypto-currency client.
Thereby, the last Brazilian judicial instance has recognised the possibility of Brazilian banks closing bank accounts, especially when not comfortable with the source of the money/crypto-currency and personal data from the brokers companies’ clients.
The Brazilian financial system is solid and highly concentrated, with almost all market capitalisation held by a handful of banks. In recent years, there has been a movement towards more inclusion in the financial market, striving for solutions that reach those that were previously cast-offs to banks. This has sparked a series of improvements and advances in the Brazilian financial system, such as studies by the regulators, recognition of new means of payment, among others.
The technologies to promote this sought-after financial inclusion exist, one of which is the blockchain platform, enabling such solutions and the furthering of important advances on the Brazilian financial system, by allowing accessibility, data protection and, therefore, a significant cost reduction.
All these positive remarks would be even more substantial if the Brazilian legal system and regulators followed the same pace of technological evolution, as their actions to the moment are a little more conservative than expected, especially when compared to regulators abroad, such as in Canada and Australia.
Regulators in Brazil, at least for the time being, seem to be close to developing a 'sandbox', that is, an environment in which they will observe and test empirically the engagement of technologies in firms before taking further action, in the same way that the UK is with its Global Financial Innovation Network (GFIN). This lack of express definition could be considered positive, as it does not limit the employment of blockchain in start-ups and firms, opening up a range of opportunities.
Nevertheless, Brazilian regulators are taking their first steps, albeit rather slowly, into technology innovation applied to the financial market, and their actions so far have set a positive expectation of what the future may hold for FinTechs in Brazil.