FinTech & Financial Services Business Innovation and Digital Asset Regulation

Updated: Nov 26, 2021

Companies Look to Gain an “Unfair” Competitive Advantage via Innovation

The main purpose of business is to gain competitive advantage and leverage innovative business models and creative use of technology to deliver compelling value to customers. Incumbents traditionally achieve this through business transformation, acquisitions and outcomes of specialized R&D initiatives. Those operating in regulated industries, such as financial services, healthcare, and insurance, are traditionally slower to innovate. This is partly due to time consuming and costly regulatory compliance requirements. It is also important to note, though, that the barrier to entry regulations cause, also significantly reduces the threat of competition. This is why highly regulated industries, have traditionally, insulated those operating in them from highly disruptive threats. When threats emerge, incumbents expect regulations and regulators to dampen the impact of such threats by setting a high-bar to enter the sector.

This has been the traditional model for most disruptive technologies. The internet, mobile, cloud, etc. we can all think of incumbents that were disrupted, some out of business. However, regulated sectors such as financial institutions, healthcare providers, insurance firms, etc. took decades to adapt and still survived, This is why, the Canadian healthcare system still uses faxes as a predominant means of communications; we are still working on payments modernization to settle payments in seconds instead of days, support rich data, and the most basic of banking APIs to enable a handful of open-banking applications. Incumbents were able to get away with this approach, as regulations helped hinder any serious competition.

Enter a new era of decentralization with Web3 and blockchain technologies that enable intrinsic means to transfer value, make payments, invest and trade instantly in almost any manner you would in traditional finance, and do so in digital assets globally, and from pretty much anywhere in the world.

Businesses, especially start-ups like FinTechs can leverage the trifecta advantage of decentralized blockchain technology; ability to exchange value in form of digital assets without threat of double-spend; and create new business models to differentiate themselves.

As such, businesses have many options, as illustrated below, from investing treasuries in cryptocurrencies to fund raising via a token offering, to launching new products and services. Public sector organizations from state/central banks to municipalities are exploring the technology alongside the business model innovation blockchain provides. However, unlike most technology plays, when it comes to the use of digital assets and blockchain, regulations and compliance are an integral part of the equation.

Regulators want to Protect Consumers while Encouraging Innovation and Economic Development, However, ...

Regulators insist that their view to regulation is to balance protecting consumers while encouraging innovation, however, the current situation makes innovating very difficult, costly and the notion of compliance highly unpredictable. As illustrated below, companies must go through a series of considerations including legal, regulatory and compliance to determine their corporate strategy.

Startup businesses as well as incumbents must consider regulations, in some cases, similar to those that large financial institutions, such as banks, payment networks and securities exchanges have to. This can make compliance in these cases to be highly costly and time consuming.

The myriad of regulations a business may need to comply with in the blockchain and digital assets space is also large. The table below only covers a subset of all possible regulations businesses may have to meet.

The cost of which for a start-up can range from tens-of-thousands of dollars at the low end to several hundreds-of-thousands of dollars and even more, specially if there is any possibility that the use of digital asset can be termed a security or if prudential requirements to protect consumers apply.

Regulators must rethink how this makes innovation accessible to everyone in every corner of the world. It simply doesn't.

And this leads to regulatory arbitrage and a tendency to focus on de-risking exposure rather than compliance, as even the term compliance is questionable in such circumstances.

The types of regulatory requirements and costs depends on many factors, including:

  • How the regulator(s) interpret the digital asset's use, its function, design, transmission;

  • The dynamic nature of digital assets. The fact that digital assets are programmable in code, and their characteristics are not always static. That is, gold is gold, a dollar is a dollar, but a token can take on different forms from being used as a simple utility to perform an essential function within the platform, like video game credit, to a store of value, collateral for yield farming, security to raise investments, a derivative, etc.;

  • The jurisdiction. For some regulations like taxation, the location of the business determines its tax regulations, for securities it depends on the location of the investors and also the business. All it may take is one unintended investor to allow that jurisdiction's security regulator to consider the business within their nexus of regulation;

  • Licensing requirements. Its not just about the digital asset and its use, but what the business is enabling to be done with the asset. For instance, while a cryptocurrency trading platform may only be trading native cryptocurrencies - which some regulators (such as, in the US) consider a commodity and tax authorities treat as either an intangible asset or property depending on where you are and who the regulator is - the platform itself may well be treated as a securities exchange, and hence securities laws would apply to the platform;

  • In addition to this, many countries and regions are looking to employ banking laws and regulations such as prudential rights of asset holders, especially for stablecoins, to ensure that the assets are protected - much like the FDIC/CDIC insurance against holder default, liquidity of assets specially for stablecoins, and transparency of governance

Challenges in Digital