Let’s face it: global financial regulation is in a pretty bad state. We‘ve not met anyone in the finance industry, whether it be banks, fintech companies, investors or even regulators themselves, that don’t agree with this.
While loaded with good intentions to ultimately protect the consumer, the regulations we’ve created over the past few decades is slowly turning the gun onto ourselves, creating a nightmarish bureaucracy that is placing a massive social and financial tax on society.
We need to regulate, yes, but the benefit should outweigh the cost, and many people fear that we’ve now gone past the point of no return.
Things are (hopefully) about to change.
The concept of the “50-year storm” was popularised by the movie Point Break, broadly referring to a storm that would create a mammoth freak wave that someone would only see once in their lifetime. They could surf this wave for the ultimate exhilaration, or to their own demise.
We believe financial regulation has reached a similar inflection point. Public blockchains, and Bitcoin in particular, is the 50-year storm so many people have been waiting for: a once-in-a-lifetime opportunity for financial regulators and law enforcement to start afresh and create a superior risk-mitigation system that will help them achieve all their objectives whilst minimising the overall costs to society. Or ignore this opportunity, and end up with a system that chokes everything around it.
How will public blockchains change things? Let’s first understand how we got here in the first place.
Why do we regulate ?
When it comes to new and very hyped-up topics like Bitcoin, it’s sometimes healthy to zoom out a bit and consider things at a more fundamental level. At the risk of over-simplifying a pretty complex topic, at its bare essence we regulate things to (attempt to) protect people from harm. So when we are dealing with things that we all agree are harmless, like oxygen, we ignore it. And when it is something that is definitely harmful, like heroin, we outright ban it.
The challenge comes with things that are both harmful and harmless, depending on who uses it. In these cases we can either aim to regulate it, as with guns or radio spectrum, or police it, as we do with the streets or the internet.
That decision will largely come down to balancing the practicalities, costs and the risks of the particular category, and it’s important to realise and accept that there will almost always be some trade offs.
Let’s look at the internet as an example. There is a lot of bad stuff that happens on the internet. Terrorists, money launderers and drug smugglers use Facebook, Twitter and Whatsapp to communicate and co-ordinate. To many people it’s already a problem that we’re dealing with at least 5%-30% of visible internet traffic from pornography. This is not even including the deep and dark web, where we’re where there are all kinds of bad things that I’m not going to even mention here. But despite all these issues, does society make a concerted effort to try and ban the internet? No.
And it’s not so much because it’s hard to do, it’s more because the positives to society grossly outweigh the negatives. For that same reason we should all be very careful how we think about new technologies like Bitcoin, because we believe that most evidence suggests Bitcoin to have the same net positive effect, if not more, than the internet.
Yes, there will always be risks, but just like with all other financial and communication systems, we should put our energy into trying to mitigate the risks, not eliminate them.
We explore this and many of the misconceptions around Bitcoin in more detail in an earlier post called Breaking Bitcoin’s Bad.
So how will public blockchains like Bitcoin actually make things better?
Balancing transparency and privacy.
One of the biggest misconceptions about Bitcoin is that it is completely anonymous. In fact, nothing could be further from the truth. Yes, as with everything in life there is always a way to circumvent the system, but the significant majority of users will never have the incentive or ability to do so.
Transparency of financial transactions is one of the key drivers of financial regulation — the only problem is that with the financial system we have in place today, it’s incredibly difficult and expensive to monitor effectively: Different institutions have different systems and everyone reports in different ways to different regulators. Reporting is often done manually and with long delays. Individuals use many different financial products that sit atop all these different processing and reporting systems, with no-one having single view of the overall state of play. At worst there is no visibility on certain types of transactions that move beyond certain borders or into certain financial products, at best it takes weeks or months to trace, and at a great cost.
At the same time, transparency and using that to protect society at large should be balanced with people’s right to privacy, not only because it is a basic human right, but also because it offers protection from things like identity theft and credit card fraud, which is sharply on the rise.
So how does one solve this conundrum? Enter Bitcoin’s public blockchain.
While Bitcoin is still relatively immature compared to other financial systems, we already have tools that are potentially more useful than any other that exist today, or certainly will be in the near future. This includes products built by companies like Elliptic and Chainalysis that allow us to monitor Bitcoin transaction in real-time as they move across the global ecosystem: between exchanges, wallets, market-places, people and so on.
For example, we can, with a reasonable level of accuracy, detect if someone, anywhere in the world, is buying drugs online — in real-time (we’ve written about this before, and how banks seemed to be more comfortable pretending this doesn’t exist). It even gives us visibility on companies that tend be higher risk in dealing with these kinds of individuals, as well as the respective financial exposure that companies like wallets and exchanges have to one another. The beauty of the public blockchain system is that it is not constrained by country borders or application (e-commerce, remittance, trading etc) — it’s an immutable, single global view. Which means it’s significantly easier, faster and cost-effective to work with.
At the same time, privacy is not necessarily compromised. When you make a payment or transfer with Bitcoin, you don’t provide any personal information ‘at the point of transaction’. If someone knows your real identity (and someone likely will, more below), they will know exactly what you did with all your transactions, but this is not something that is shared with all parties you transact with, typically only ones you trust. This means institutions and regulators can monitor the flows but won’t necessarily know who made the transactions until there is something that is clearly illegal activity, in which case it is then relatively easier to identify the person (or certainly a lot faster and cheaper than with existing methods). This also means that we will increasingly have the ability to not just analyse past events better, but also predict future ones with more accuracy and speed.
That said, the system is not perfect: in order to find the actual identity of the person they need to have been KYC’d at a legitimate exchange or transact with another party that can identify them. But with the increase of self-regulating exchanges, advances in monitoring technology, and the fact that transaction histories are immutable, it will become increasingly difficult (and pointless) for individuals to use public blockchains like Bitcoin for questionable or illegal use. This also means that Bitcoin itself is a form of self-regulating system, which we believe is the most effective means of financial ‘regulation’.
Transparency and privacy might appear mutually exclusive, but they’re not. Systems like Bitcoin can potentially provide both. But other than the practicalities involved, it will require an important change in mindset by existing financial institutions and regulators.
New (and huge) economies of scale
Public blockchains like Bitcoin has another major advantage: it will allow for huge economies of scale. Currently so many countries, companies, regulators and law enforcement officials use their own systems or methods to help them achieve their goals. This results in a huge amount of duplicate work and inefficient allocation of resources.
Given that Bitcoin is the same system used everywhere in the world, companies that create services to monitor and analyse transactions provide global technologies that can be used by anyone, anywhere, in the same way. It then also becomes much easier for these parties to share relevant learning that can be added back into these systems to optimise the outcomes even more. The result: infinitely cheaper, faster and better ways to manage risk.
Risk measurement redefined.
Because we can now monitor transactions globally at an individual transaction level at an extremely low cost, for the very first time it becomes economically feasible to perform risk-management on individuals rather than on large arbitrary groups or amounts. This means no more blanket definitions like ‘high risk countries’ or best-guess transaction size triggers. This will result in even more cost savings and faster transaction processing, never mind better customer experiences and equatable treatment.
Incidentally, we’re seeing the same trend across other industries like insurance; and given the much more accurate and relevant financial data on public blockchains, combined with better technology for data analysis including machine learning and artificial intelligence, we expect to see some step changes in risk management and mitigation on this front.
The relatively problem, and opportunity.
We also believe that Bitcoin is about to experience a watershed moment in terms of it’s actual and perceived use, certainly from a regulatory point of view.
With the launch of a whole range of new digital currencies like Monero, Dash and ZCash that aim to make transacting ‘truly anonymous’, we’ll likely see a shift in attention to these as higher risk categories versus current public blockchains like Bitcoin and Ethereum.
There are of course many very legitimate reasons why people might prefer to use these alternatives, and we’re certainly not pointing them out as inherently bad. But suffice to say, if you’re a criminal wanting to get away with something you’re much more likely to choose the option that can give you the most anonymity, and Bitcoin seems to be an increasingly bad option for that.
Smart regulators will figure this out very quickly, and we believe it will help drive more measured and practical regulation for some digital currencies like Bitcoin.
The evolution of identity verification.
Lastly, we see Bitcoin as an opportunity for regulators to test new regulatory methods that can be applied to the broader financial industry. For example, we all know that we can get much better information about a person’s identity from their social graph than from a snapshot of their identity document, but in many countries we’re still required to use these documents and/or proof of residence to give us what is essentially a worse outcome.
Regulators might not be able to change the rules for the entire financial services industry overnight, but coming up with new rules that allow small Bitcoin companies to start testing this with the appropriate regulatory oversight could result in much-needed practical learning that can then be applied to the broader financial services industry at a later stage.
The Bitcoin industry is still very new, and will likely take many decades to fully mature. That said, for a ‘financial system’ that is so new and small, it has made surprisingly big strides in terms of building tools to get the right data and to help the industry self-regulate.
Let’s also not get too stuck in the present, especially given the size of the Bitcoin market. Let’s look at the longer term trend and realise that we’re on a fast trajectory that is not only positive, but one that is likely to take us to a place where we’d be able to do things better than with any other financial system that has ever existed.
Public blockchains like Bitcoin provide the world with new ways to balance transparency and privacy, create huge economies of scale, and give us better ways to monitor and manage risk. This will have a dramatic positive impact on the cost and user experience of financial services. On top of that, it potentially alters the existing economics of finance to allow for large-scale banking of the so-called ‘unbanked’, connecting billions of people to the financial system for the first time.
Bitcoin is an opportunity, not a threat. It’s a once-in-lifetime chance for regulators, financial institutions and consumers, a true 50-year wave. Let’s capitalise on it by working together in a mature and rigorous yet open-minded manner, and by entering the storm with confidence. That is how we will surf our 50-year wave successfully.
This is Part 4 of our series on [Banks] of the Future, where we explore what the future of finance might look like, and what role Bitcoin and/or blockchain will play (if at all). Read the rest of our [Banks] of the Future series here:
This series was first published on the BitX Blog.