The emergence of legal scalability in technology-regulated asset structures
With the rise of technology-regulated asset structures the regulatory needs of those financial entities will shift from an entity-based perspective to a component-based approach which centers around technologically integrated compliance and investor protection. This paradigm shift gives rise to the legal scalability of regulatory compliance and ultimately enables a new generation of financial products with low entry barriers for creation and participation. What is therefore needed is a highly scalable, fast and enforceable framework based on the classification of critical components for compliance, asset and investor protection, and methods for their measurement against an (ISO) standard. Such a framework can only be created through a tight cooperation between industry associations, self-regulating organizations (SROs) and financial authorities like the Swiss FINMA, while it can minimize time requirements for regulatory action.
Write it, cut it, paste it, save it, load it, check it, regulate it — Technologic
The advance of blockchain technology is presenting financial regulatory bodies like the FINMA with new challenges to regulate functionalities which may resemble known models but often strongly deviate from those models on a technological level. In case of FINMA, regulators so far have demonstrated a patient and thorough approach towards regulating these new technologies with the “banking light” license and sandbox environments.
While the regulators’ openness is the main condition to enable innovation in the fintech sector, technology experts have to give authorities a deeper understanding of underlying technologies and actively shape regulations by proposing ways to regulate them in a reasonable way. Therefore we see three main points as crucial to consider in discussions with regulators for the development of a regulatory framework for asset management on distributed technologies.
1. Technology regulation standards
Smart contracts and similar technologies allow for the creation of automated business logic, built-in compliance, strong investor protection and asset security. Those features can be technologically verified with formal verification proofs and code reviews among other methods. It then becomes viable to regulate the technology instead of users and providers of financial products. Basis for such technology regulation is the classification of components and creation of categories and metrics for their assessment. Security benchmarks can be organized in a set of modules that have to emerge from a cooperation between technology providers and relevant regulatory authorities. The following elements are central to this approach:
- Compliance — Providing a formalized way of documentation that is compatible with the standards of the regulative authorities.
- KYC/AML — Blockchain-based solutions of identity verification and automated AML- threshold systems.
- Investor Protection — Transparently structured prospectus and risk overview of financial products. Maximization of the users control over their investments. Example: redeeming investments from a fund on the Melon protocol is at the discretion of investors at all times.
- Asset Protection — Formal verification proofs and code review to ensure industry best practices concerning the product design and applied security measures.
Regulators and industry associations can leverage these verifiable components as starting points of navigation to work together towards universal (ISO) standards which ensure the easy reproduction of quality and produce trust with investors by providing a system that assesses the technological and structural quality of a product.
2. Legal Scalability
Applying this set of assessment schemes to technologies enables a fast and reliable evaluation of asset structures. As soon as (ISO) standards are established it is easy to use them as benchmarks for technology providers, while regulators can use them as a lens to assess financial product integrity. Once a technology component is tested and regulated, it can be reproduced and re-used. This increase in scalability and effectiveness enables new business models and provides financial entrepreneurs with a toolbox of ready-to-use components at their disposal. As financial products diversify with this modular approach, they will become ever more specialized with lower entry barriers, attracting new investor segments and transforming traditionally excluded capital into investment capital. With regards to Switzerland such an approach will contribute significantly to the ambitions to become a leading force in blockchain technology. In the light of rapidly growing usersbase sizes in decentralized fintech services this argument grows even stronger.
3. Self Regulating Organizations
As time and resources of regulators are scarce a balanced mode of cooperation between regulators and technology and service providers has to emerge. Providers in the best case gather in Self Regulating Organizations to combine their expertise and provide regulators with an extensive assessment of the underlying technology and enforce industry standards among themselves. The key tasks of SROs are:
- Technology analysis
- Quality standards
- Compliance and enforcement
Conclusion
Financial economies are at the inception of a new era characterized by transparency, security and inclusiveness. It is now of greatest importance to establish best practices that center around standardized technologies in order to provide investors with great products which produce trust by elimination of possible malpractice. The byproduct of this process is the legal scalability of regulatory compliance which holds the promise of opening the door to young, talented creators, providing new revenue streams and expanding the universe of financial products into unknown territory.
Philipp is Head of Strategy at Midas Technologies AG, the company building the investment app Midas.
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