Fintech 2020

Fintech 2020 covers 34 jurisdictions. This edition includes business-critical coverage of the fintech market, business models, regulatory regimes, legacy players, regulatory sandboxes, enforcement actions, blockchain and marketplaces, exchanges and trading platforms.

Last Updated: March 02, 2020

Author is one of the world’s largest blockchain developers, author of the EOSIO software and creator of Voice.

Understanding the Wrappers for the Next Fintech Revolution

There has been a quiet revolution happening in fintech over the past two to three years. Its adherents and proponents call it “DeFi”, which is short for “decentralised finance”. The movement’s antecedents began well before the rise of global decentralised networks, but the advent and wider adoption of decentralised, permissionless blockchains with smart contract capabilities brought significant advances to the business models and permitted a true peer-to-peer financial transaction experience. DeFi’s basic tenet is to eliminate intermediaries between market participants through the use of globally available platforms programmed to execute instructions from users. No central authority runs the platform or the applications (smart contracts) built on it, so there is no intermediary, at least in DeFi's purest theoretical form. DeFi can be applied to any aspect of financial services but popular applications include lending and trading cryptoassets.

The assets involved in DeFi, now and in the future, exist only in digital form. That is, they are information on a computer and do not exist in any other format. This idea is not a revolution. Many, perhaps most, financial assets already exist only in digital form, and we should remember that nearly all financial assets are some form of intangible asset or property, which is to say that they are a human idea that comes into being through some general agreement, based on laws and contracts, about their terms and features. Put another way, all intangible goods can easily exist digitally, and only digitally, because they are no more than human conceptions. Where in the past a share of stock was deemed to exist because it was recorded in physical form on a paper share certificate, we now have shares of stock that exist only in digital form on the computers of a central counterparty or depositary.

What exactly sits in digital form on those computers? That is to say, what is the technology wrapper? At the core, the technology is database software that stores digital information in a manner designed to create digital existence with various features and make each item digitally unique. This information in turn must be given a legal wrapper so that everyone knows it is, for example, a share of stock in a particular company, with a set of rights and obligations in law and through contract.

Which brings us to the question of what happens when the string of 1s and 0s does not have an established legal wrapper. Blockchain assets such as bitcoin, ether and EOS do not yet have a clearly assigned legal wrapper in many countries. Yet the platforms on which they were created are giving them existence and markets are giving them value. How the law of a jurisdiction will develop around these digitally native assets remains a source of speculation and may have implications for the development and growth of DeFi. Equally important is what regulatory wrapper applies to the activities relating to those digital items, once the legal wrapper is established.

This article first provides some background for DeFi. It then discusses broader implications if DeFi is successful. We then delve into the technology, legal and regulatory wrappers that will ultimately influence the success or failure to DeFi’s vision. Finally, we offer some concluding thoughts.

DeFi in Context

Current definitions of DeFi focus on the use of global permissionless blockchains and smart contracts, both for the creation of the assets transacted in and for effecting the transactions themselves. A core component that those technologies permit is peer-to-peer interactions. Blockchains, smart contracts and cryptoassets facilitate peer-to-peer transactions by creating the technological underpinning for both the existence of the asset and its transfer, pledging and monitoring. Examples include so-called decentralised exchanges (DEx’s), which are typically a smart contract on a particular blockchain that allows holders of the blockchain’s tokens to buy and sell those tokens with other holders. These DEx’s are particularly useful for popular blockchains that have been used by community participants to create a variety of applications, each with its own token and often in addition to the blockchain’s native token. The DEx extends the peer-to-peer nature of interactions on the blockchain to include the trading of those tokens.

Another type of DeFi that has seen increasing popularity allows for the lending and borrowing of blockchain tokens. These DeFi lending platforms take the promise of online marketplace lenders, who started this disruption ten or more years ago, and push it completely into the virtual world where even the currencies loaned and used to pay interest exist only digitally. Here, we see an original fintech disruption translated into the digital realm and then extended to a true peer-to-peer lending/borrowing experience, accomplished entirely without human intermediaries. The software does it all and is open sourced for everyone to see.

Just as DeFi lending platforms have their antecedents in fintech, the DEx’s do as well. The mid-1990's saw the rise of computerised trading in equity markets as the day trading movement took hold by allowing individuals an unprecedented level of control over their trading experience, from the research and selection process to the stock borrowing and trade execution side. Retail investors now have the ability to do it all and the computerised tools continue to increase in sophistication to meet the demands of these power users. The results improved the online trading experience even for the more episodic retail investors. You do not trade directly with other investors or traders because you still have an account with a broker-dealer, who executes, clears and settles your trade through centralised means. Nevertheless, the era of the floor broker shouting in a crowd to trade on your behalf is nearing an end.

DEx’s represent the natural progression beyond online brokerage. They are computer programs with sophisticated trading tools for blockchain tokens that exist independent of an intermediary and allow any user to trade directly with other users. Some of them can integrate seamlessly with DeFi lending platforms and have user interfaces that allow traders to pull in information from a variety of sources to determine when and what to trade. Key to the experience is the peer-to-peer nature of trading. No broker-dealer or other counterparty touches any aspect of the trade, including the settlement, because the application is programmed to handle everything directly on a decentralised blockchain.

Thinking Even Bigger: Platforms Where Everything Is Available

The promise of DeFi might be best summed up as creating a global platform that allows for the purchase and sale of all manner of goods and services through the internet. In other words, DeFi creates a worldwide marketplace in the virtual world where anyone can participate, buying/selling or lending/borrowing any digital item, not just financial assets. Although DeFi’s current adherents are focused on the financial, nothing stops the trading of any digital item, financial or otherwise, including digital representations of physical items.

This vision has immense power and potentially world-changing implications. If anything can be digitised and traded on a virtual platform hosted by the decentralised internet, then people around the world can trade everything at the speed of light (or as close to it as current technology allows). Blockchain partisans expect that their database technology will facilitate this activity because it solves the double-spend problem (allows for digital uniqueness). DeFi proponents build their platforms on this underlying assumption, among others. Of course, if the internet is interrupted, unreliable or censored, these marketplaces will not function. But with available internet, the globe is drawn even closer through virtual barter and trade. That is an exciting prospect.

A key step in realising this vision relies on a mechanism for the creation of the digital items that get bought and sold on the platform. This mechanism involves a technology wrapper, a legal wrapper and a regulatory wrapper. The technology allows for digital existence and uniqueness. The legal categorises the item as a bundle of legal rights and obligations. The regulatory extends the legal wrapper into the trading realm by creating a more specific regime around the actions and actors. The next sections will delve into this idea of different wrappers in more detail.

The Technology Wrapper

The underlying technology must create the digital item and ensure its uniqueness in order for people to value it. This solving of the double-spend problem is at the core of blockchain technology, which at root is really a database (or, in its simplest incarnations, a ledger) with an architecture that seeks to guarantee digital uniqueness through several technologies.

There is no reason that blockchain has to be the only technology that can accomplish digital uniqueness. Blockchain’s current popularity makes it the dominant technology for these purposes but there are other ways to achieve the same goal.

More importantly, while the technology might help define the functions and features of the digital item, it does not alter the bundle of rights and obligations associated with those functions and features. A digital stock or bond or currency is a financial instrument, not because of the technology used but as a result of the features and functions of the instrument created by the technology. For this reason, a digital software licence is not a financial instrument, nor is a digital song, book or work of art. Digital identity also is not a financial instrument, but it also is not software, song, book or work of art. Digital health records are not a financial instrument, nor are they software, song, book, work of art or identity (though they may form part of digital identity). Use of the word “digital” in each of those examples simply recognises a technology wrapper used to create and sustain its existence, just as the physical world technologies that used to embody those items did not define them at law.

In order to determine the classification of a digital item at law, we need to consider the rights and obligations of the item through its functions and features. Lawyers and policy makers undertake this task all the time. That is, they define the legal wrapper of an item, either in a law, a contract or a combination of the two.

The Legal Wrapper

When thinking about legal wrappers, it is helpful to divide digital assets into three (overly) broad categories. First, there are digital representations of physical world (tangible) items. An ounce of gold, a pair of shoes or a shipping container can be represented digitally on a blockchain or other database (leaving aside the tracking and other technologies that would also be involved). The digitised version of these items should be recognised at law as the same as the physical version. When one shops for shoes online, one is still shopping for shoes even though it involves digital representations of shoes on a database somewhere in contrast to physical shoes in a real-world shoe store. The law might impose some additional requirements around the delivery of the shoes from the online retailer to the buyer but the legal wrapper for a contract of sale with future delivery should be well-trod under the law.

Second, there are intangible items from well-recognised asset classes that are digitised. Intangible items are really just human ideas or conceptions that do not exist in the physical world, so they are easily susceptible to digitisation and therefore to existing entirely on a blockchain or other uniqueness database. They are really pure information because prior to the advent of computers (indeed, still today) their existence was memorialised in written form, such as a contract or a law, which created all of the features, functions, rights and obligations of the intangible item. A share of stock, frequent flier miles and the terms of an employment arrangement are examples.

The third category is natively digital items existing on a decentralised platform that do not have a traditional basis in law. Bitcoin and other cryptocurrencies are at the vanguard of this grouping, although there are good arguments as to why this category is really a subset of the second category. Just because the law has not yet blessed them does not mean that people have not agreed on their terms and usage, as is evidenced by their usage and trading outside of traditional marketplaces.

Nevertheless, let us for the moment treat the second and third categories as distinct. These are the potentially troublesome categories because they lack physical-world equivalents that will be delivered in due course or housed at a custodian. In the paper world, one could simply look at the contract terms and determine the functions and features of the intangible item, which were the legal wrapper. Their representation, whether digitally or on paper, is merely the stringing together of information that the parties agree, or the government provides, has legal significance. You can own a share of stock or a bitcoin, which effectively means that you own a bundle of rights and obligations, even though there is no physical representation of either.

At the present time, the law seems to be grappling with the legal wrapper for the natively digital category of items because the rights and obligations do not exist with a central authority or in traditional written form. Rather, the rights and obligations are created by computer code, exist entirely in the virtual world and without a central authority to which one can appeal for redress. The database or ledger is still a central source of truth, but it is distributed across the internet in a way that does not allow for centralised redress. This state of affairs differs from stocks and bonds that exist only digitally because those are the subject of written documentation and redress through a central authority (the issuer, the market on which the instrument trades or the intermediary who traded it for you).

It is as yet unclear whether practitioners and policy makers will treat this distinction as relevant to the legal wrapper of natively digital items. If a different legal regime is applied, it will have far-reaching consequences for both category two and category three items as category two items become natively digital on decentralised platforms, which would seem a natural progression. Careful and diligent thinking must occur to understand fully the practical results of a decision to apply a new legal wrapper simply because the technology does not allow for appeal to a central authority for redress, particularly when redress can be had from one’s trading counterparty.

There is a fourth category that straddles the tangible and intangible worlds: arts, theatre, literature and music. All of these spring from human ideas but it is their physical world representation through painting, sculpture, books, performance and recordings that makes them come alive. A discussion of the further interesting issues posed by this category is beyond the scope of this article due to the added complexity from intellectual property law and concepts of moral rights.

The Regulatory Wrapper

When a marketplace trades everything, how do you regulate it? DeFi does not force us to answer this question but if its broader promise is realised we will one day have to determine how truly multi-asset/multi-item marketplaces should be regulated. For now, with DeFi’s focus on financial instruments, most DeFi platforms can fit within existing financial regulation schemes. That fit might be uncomfortable in true peer-to-peer trading that relies on "decentrally-operated" computer programs because most financial regulation relies on the presence of an intermediary. A DeFi platform that is just a computer program maintained by people who do not themselves receive any payments in connection with the transactions represents a structure not usually contemplated by financial regulation. Nevertheless, regulators and other stakeholders should recall that peer-to-peer trading has long been permissible and usually regulated through anti-fraud rules.

Financial regulators will become increasingly sophisticated about how different DeFi platforms operate and the different roles undertaken by different participants on the platform. “One size fits all” is not how regulation of traditional financial services works and it will not be how the regulation of DeFi works either. The biggest challenge for regulators and policy makers will be whether they impose regulation on creators of software used in DeFi, something that heretofore has been outside the regulatory purview. Software, as a form of information, can be owned and can be used for financial activities, including the creation of financial assets. But whether the creation of that software is itself a financial activity has for the most part been answered in the negative. To change that answer simply for decentralised platforms would seem a seismic shift.

Closing Thoughts

The move towards a more digital global economy proceeds apace and there seems to be little standing in its way. Various technologies continue to facilitate this march, including digital uniqueness technologies like blockchain. As interconnected platforms continue to dominate the markets for different goods and services, economies and communities that exist solely in the virtual world play an increasing role in everyday life, including financial services and fintech. The virtual world thrives on digital items and the law will need to develop legal wrappers that recognise property rights in these items as being just as valid as property rights in real estate and chattels.

The law has always found ways to recognise rights in ideas and information, so the flexibility to do so is not in question. But how the functions and features of a natively digital asset on a decentralised platform will have recognition under law will raise interesting questions as policy makers and market participants sort out the legal status.

Author is one of the world’s largest blockchain developers, author of the EOSIO software and creator of Voice.