PAYMENTS: Visa plays deal or no deal with the Competition and Markets Authority (CMA) over Earthport

Earlier this year we touched on the $250 million acquisition of UK-based B2B cross border payment giant Earthport by Visa. To refresh your memory, click here. The acquisition came after a drawn out pricing battle between Mastercard and Visa who are desperately seeking to harness the expanded networks of Earthport to improve their 17% and 7% respective growth rates within the cross-border segment - based on those numbers we can see why Visa won the bidding war at a $320 million offer (28% higher than the original). But such developments have recently attracted the attention of the Competitions and Markets Authority (CMA) of the UK to investigate the potential monopolistic power Visa would hold if such an acquisition were to take place. And we don't blame them, as such a network effect could see Visa receive a hearty slice of the potential +$200 billion up for grabs to companies seeking to improve cross border B2B payments, remittances, and the unbanked, as detailed in our latest payments report. Furthermore, companies like Earthport were built to create an international interbank money movement platform more efficient than Swift and cheaper than the credit rails. Giving this network back to the “Networks” makes it hard to see how anyone can beat them at their own game. 


Source: Visa (Q1 2019 Earnings Call)

CRYPTO: BitMax and $1.5 Billion in Phantom Daily Volume from Transaction Mining

Once in a while we land on Coinmarketcap's crypto exchange ranking, and choose "Reported" volumes instead of "Adjusted" ones. In that world, everything is topsy turvy. Binance is no longer on the top, and BitMax, Bithumb and other unmentionables float around the meniscus. The answer as to why this happens is called "Transaction Mining", and was a big deal halfway through last year. This practice is not really mining, as much as it is churning. Normally, an exchange charges a fee to the buyer and seller for facilitating a trade on its platform. In this case, however, the exchange also pays the trader a rebate in the form of its own token. The more you trade, the more of the exchange's proprietary token you receive. And some tokens, like Binance's BNB, have become valuable to the tune of $2 billion.

The positive way to look at this practice is to say that it is "growth hacking" the exchange rankings, thereby creating more visibility for high ranking platforms. Imagine you are trying to maximize visitors to your website. Well, you might practice some search optimization techniques, get back links from blogs, and perhaps even pay for some fake ones. Or, you are growing a social media audience, and decide to cheat by buying fake followers to create the impression of engagement. These techniques -- while misleading -- are merely meant to get you noticed, and then real activity can begin. Traditional banks offer $250 rebates to sign up for a new account or credit card all the time! And in the case of crypto exchanges last year, a number of them used transaction mining to growth hack the rankings, spread around their token, and have now switched to more accepted pricing models.

But Bitmax, and its $1.4 billion of mined volume per day, seems an extreme. The negative way to look at this practice is to compare it to churning an account. If a financial advisor with a fiduciary duty directs trades in a client's account in order to generate fees and create the impression of activity, they are breaking the law. In such an example, the financial advisor has full control of the account. You may say that crypto exchanges are optional, and that the decision to churn trades in order to generate/mine exchange tokens is voluntary. Sure. But if bot-driven advertising can swing an American election, certainly misleading financial incentives can skew how people make investment decisions. The belief that the exchange token is worth something -- backed by little other than promises that it will be worth more once other people have it -- leads to destructive financial activity. To us, this looks a lot like a digital-first version of churning driven by a suspect financial promotion. 


Source: Coinmarketcap (Exchanges), CoingeckoBitmax, Crypto Currency Hub (Is transaction fee mining a ponzi scheme)

ONLINE BANKING: Metro Bank and Revolut in the Doghouse

Facebook used to say "Move Fast and Break Things". It sure did. There are many ways to win, and some are sharper elbowed than others. Is growth inevitably tied to bad behavior, or is there a version of sustainable entrepreneurship that doesn't require us to sacrifice Ethics at the altar of Monopoly? Prior marquee Fintech bad-actors include Zenefits (fastest growing insurer whose brokers were unlicensed) and Lending Club (what's a little self-dealing?), not to mention all of Wall Street and at one point or another. Now we are seeing the same sharp elbows from Revolut and Metro Bank.

Metro Bank may be a fast growing operation, but it doesn't seem to be very good at being a bank. Of its £14.5 billion loan book, the company mis-categorized 10% of its assets last month, grading that capital at 100% when it should have been at best a 50% (e.g., commercial property loans are more risky than cash). That means the balance sheet needs way more cash, and Metro Bank is out raising a cushion of £350 million -- a number that will mean chunky dilution given that the public market cap has been under pressure. There is a certain irony here as well. Consider the sins of a bigger offender -- RBS getting a £45 billion bail-out a decade ago and being forced to set aside £775 million to as penance. Of those funds, £120 million are now flowing to Metro Bank to promote banking competition. 

One of our favorites, Revolut, has also been in the news with a spat of ugly news. There are reports of over-clocked, destructive culture. Some Fintech aspirants are asked to sign up 200 funded accounts for Revolut as part of the interview process, without a job guarantee. Once they do land a job, workers are expected to drive 100 mph through weekends and holidays, leading to burnout and churn. Sounds like SoFi two years ago. Money Laundering concerns abound, with information coming out that KYC/AML control lapsed in the middle of last year. For a company that launched Bitcoin trading, this type of news is both embarassing and systematically destructive. And lastly, the main adult in the room (CFO Peter O'Higgins, former JP Morgan) has just quit as well. 

It's easy to say to look at people doing hard things and judge them on style. But sometimes the ambition isn't worth the damage. 


Source: Guardian (Metro Bank), SharesMagazine (Metro Bank), AltFi (RBS Settlement), Wired (Revolut Culture), Finextra (Revolut CFO), Banking Tech (Revolut AML)

BIG TECH: The macro-scams of Fyre and Theranos & the micro-scams of Google and Facebook

Spoiler alert: Fyre Festival ended up being a securities fraud that cost investors $27 million dollars, left hundreds of workers unpaid and emotionally ravaged, and negligently put attendees in dangerous conditions. Even Blink-182 cancelled their performance! Another spoiler: Theranos ended up being a securities fraud costing investors (including Betsy DeVos!) $700 million, leaving hundreds of workers unpaid and pushing at least one to suicide, negligently putting users of the product in dangerous medical circumstances. In both cases, the founders were young and narcissistic, optimizing the story-telling about their company over delivering on the promised expectations. Billy McFarland used Instagram supermodels to sell a false vision. Elizabeth Holmes leveraged the Steve Jobs black turtleneck and VC group think to do the same.

This stuff is so easy in retrospect -- to point fingers and throw the stone. Having spent a lot of time in the early stage ecosystem, we can tell you that all founders have these devils inside them. These are the devils that let you take the risk, tell the story and defend your tribe (e.g., see Elon Musk). The issue is that these particular people could not and did not execute -- and any reasonable person in their situation would know enough to stop marketing and selling lies. We can look at crypto ICOs to date and say the same thing. Surely the people who raised over $30 billion globally, and burned nearly all of it, sold us a falsehood. Some -- like John McAfee or Brock Pierce -- had to know what was up. Or did they, perhaps believing in a zeitgeist change tilting the axis of human industry? 

The issue is asymmetric information and intent to profit from that asymmetry. When someone sells us a broken car claiming it works great, they are selling a "lemon" -- something the US protects against with "lemon laws" that remedy damages from relying on false claims. Let's shift from these obvious macro lemons, to the invisible micro lemons sold by Facebook and Google. It was revealed that Facebook was -- in the worst case -- paying 13+ year olds $20 per month to install a research app that scraped all their activity (from messages to emails to  web) and provided root permissions to the phone, misusing Apple-issued enterprise certificates. Facebook should not have been able to create these apps for anyone other than its employees on internal apps (e.g., bug testing new versions). But it did, and got its access revoked by Apple immediately.

Google did a version of this too, exchanging gift cards for spying on web traffic. As yet another example, Google's employees refused to help the company build a war-drone AI for the US Department of Defense. So instead, Google outsourced the work to Figure Eight (a human-in-the-machine company), hiring gig economy workers for as little as $1 per hour for micro-tasks like identifying images (teaching drones to see). These workers had no clue what they were doing -- and we imagine that some would exhibit the same ethical concerns that Google employees did in refusing the work. In all these tech company examples, the lemon is the un-revealed total cost. Compared to Fyre and Theranos, where we pay billions, and get nothing in return, here we are given $1 an hour or $20 per month (i.e., nothing), but we lose our privacy, agency and humanity (i.e., everything). 


Source: Wired (Project Maven), The Intercept (Google project maven), Gizmodo (Google micro-tasks), TechCrunch (Facebook, Google, Apple), Wikipedia (FyreTheranosLemon Law)

BLOCKCHAIN: Public Crypto searches for meaning, inventing new narratives for bear market

We have seen an unusual amount of soul searching in the Crypto community in the beginning of 2019. Crypto assets, which the more detail-oriented thinkers in the space see as fundamentally improving, continue to bleed out. Nearly 90% of decentralized applications have less than 1000 users. In response, the priesthood of the movement must find new language to motivate global open source development and continued investment. Given the type of person that has a following in the crypto space (Millennial, male, developer, international, math/econ overindexed), their stories and investment theses are rooted in Bayesian thinking, macro economics, and formal logic. The stories create a sense of data-backed philosophical inevitability, but as Nic Carter and Felipe Pereira point out (links and charts below), these are just meta-stories for why followers should keep following, and the direction in which they should go. You can think of these stories as marching orders for the army of disruption.

The two examples we will call out are (1) Pantera Capital's Open Finance and (2) the debate around crypto law. In the former, the argument is that the "primitives" (i.e., Lego pieces) of the financial system are being open sourced and built in a permissionless, global manner. New generation versions of timeless services like banking, lending, and investing will grow outside finance on parallel rails and be better than the existing system. We agree with the vector of change, though deeply question short term practicality and the framing from which the argument is made (i.e., protocol maximalism). A symptom of this change can already be seen in the repurposing of ICO offering platforms and liquidity into STO brokers and exchanges -- e.g., $400M marketcap biotech company Agenus is using Atomic Capital to launch a token that gets a royalty payment on a cancer treatment which is still in clinical trials. Or take SWIFT's trial implementation of R3's Corda to combat Ripple.

The second discussion is around norms that have emerged in the ecosystem, harking back to questions about whether "Code is Law". As we have seen from the regulatory blowback and the application of sovereign power, Law is Law (and jail is jail). The crypto-anarchist revolutionary fervor ended up being statistically incorrect in the short term, and a new narrative is needed to keep marching. We see these debates as similar to a Constitutional Moment, with online personalities jockeying to be Jeffersonian-framers of how the future should be negotiated and governed. Linked below is a piece by Vlad Zamfir on proposed norms (like keeping Crypto within the legal bounds of the real world and not intentionally breaking blockchains), and it is worth reading to understand what this community believes and how it reasons. No other part of Fitnech, but for AI ethics perhaps, does this much thinking and narrative building about itself. This is why it is a fundamental Black Swan threat to the financial industry, whose narrative has been rotting since 2008. 


Source: Token Economy (Decentralized Finance, Visions of Ether), Pantera Capital (Open Finance), Agenus (STO), Vlad Zamfir on Crypto Law, Fluence on Dapp Usage, Unrelated but interesting (Narratives of Economic Catastrophe)

PAYMENTS: $3 Billion revenue video game Fortnite used for money laundering using in-game currency

Human nature does not change. We can have arcane towers of financial services and regulatory architecture, but the outcomes are a rhyming echo of our DNA. Let's start with this: Fortnite, a virtual place where 200 million people spent time playing a game in 2018, earned $3 billion for its parent company. The video streamer most popular for playing Fortnite on (essentially) TV earned $10 million for the entertainment he provided to 20 millions followers. One of his videos gathered nearly 700,000 views -- for comparison, Conan O'Brien gets about 1.3 million per night.

Fortnite makes money by selling cosmetic upgrades to players, and since they inhabit this rendered world like any other social network, our dopamine center and social pressures motivate purchases for status. Given the payments infrastructure of this game and its virtual currency (not on the blockchain!) are comparatively weak, criminals have started using in-game value for money laundering. A report from The Independent linked below finds that stolen credit card credentials are being used to purchase game currency and then cashed out at discount on eBay. Additionally, over 50,000 instances of online scams related to the game made their way to social media per month. Welcome to the Internet, everyone! We can't help but remind you that Steve Bannon (yes, that one) and Brock Pierce (EOS, Tether, Puerto Rico, etc.) once ran the largest World of Warcraft virtual money exchange.

So should we bring down the financial regulators on Epic (the maker of Fortnite) as hard as New York state came down on Bitcoin companies with the BitPay regime, freezing innovation? Should KYC/AML be required for all video games? Under the Chinese model, Tencent's "Honor of Kings" mobile game generates $2 billion in revenue per year and is under the same strict government control/license as financial products. Players are checked against a registration database to control for age and name, and (we expect) the play time data flows into a social credit score. But recent studies of KYC/AML policies persuade us otherwise. When looking at the amount of criminal proceeds actually seized by authorities based on those policies, the amount is less than 1%. The cost may not be worth the outcome.


Source: Fortnite (IndependentSlateBitcoinist), Fortune (Streaming), (Ron Pol on AML ineffectiveness), GamesIndustry (Tencent database), AML fines 

REGULATION: It's opposite day in the United States: protect the banks, not the innovators

Here's an odd one. FDIC Chairman Jelena McWilliams attended the American Banker's Association conference and focused on how to simplify regulatory supervision in order to help banks compete with Fintechs. In a similar vein, US State regulators continue the legal fight against the OCC, a federal agency trying to allow tech companies -- mostly lenders and payments companies like Square and SoFi -- to have a special Fintech charter. Part of this grind is the alphabet soup of American regulators and inevitable conflict over jurisdiction. As an example, the SEC just launched a new hub for innovation and financial technology, much in response to the rise in digital assets. Still, a meaningful portion of the American regulatory apparatus is functioning to protect its banking coral reef from competition.

When you look at the spirit of regulation in Europe, much of its mission is actually to increase competition with banks, helping Fintechs and other innovative players take market share from incumbent national champions. PSD2, the major directive in this regard, is colloquially referred to as "Open Banking" -- quite the different mindset. The desired strategic outcome is that many incumbents will be low cost capital-providing utilities, and some players will be platforms or aggregators of tech, capital and user attention. Tech companies can back into these positions as well. If regulators instead protect the capital providers and hurt competition as a result, you will end up with disconnected tech infrastructure and a 20th century financial product-push economy. 


Source: MarketWatch (Cards), CNBC (Amazon Lending), Autonomous NEXT (Travelers), Statista, Amazon

INVESTMENTS: New York on Crypto Exchanges, Robinhood and the Ethics of Trading

The Attorney General of the New York State just released a report on the integrity, traditionally speaking, of the crypto asset markets. The exchanges surveyed included Bitfinex, bitFlyer, Bittrex, Coinbase, Gemini, HBUS, itBit, Poloniex and Tidex. Notable, it excluded Binance, Huobi, and Kraken who refused to participate -- as well as another 100+ crypto exchanges that operate globally but steer clear of New York. Kraken is known for having rebuked the questionnaire from the Attorney General as overbearing and disrespectful, and at first glance we had agreed that perhaps it was overreach. But after reading through the report, we changed our mind entirely. It has great information and provides transparency around best practices, or lack thereof, helping investors focus on the right concerns and conflicts of interests.

Let's snooze the questions about KYC/AML, poor security or service, and instead focus on conflicts of interest. Unlike in traditional online brokers, crypto exchanges are both a venue connecting parties, broker/dealers that represent trades as agents, proprietary traders for their own accounts, large owners of the underlying traded assets, and also issuers of their own tokens. Why do we care about conflicts of interests like this? Because misalignment leads to rent seeking, corruption and manipulation. Think about the separation between equity research and investment banking that came about after the DotCom collapse (e.g., Henry Blodget). Or something simpler, like an exchange giving better pricing to large institutional traders that can trade ahead of retail sentiment.  Or worse, an exchange using its own large capital to trade, creating the impression of volume or price movement. We care about things like this because the retail investor is literally having value transferred out of their pocket into that of an arbitrage robot, unknown and unpoliced so far.

Let's now take a 90 degree turn into Robinhood, the free trading app with millions of Millennial customers eyeing an IPO in the billions. A recent take down article on Zerohedge walked through the start-up's business model. How can you give away something that has hard marginal costs, other than burning venture money? Freemium and selling your customers. On the freemium side, Robinhood does have the margin offering and can earn interest on cash sweep. But on the latter, it certainly does get paid for the activities of its customers in the aggregate. How? By directing order flow (i.e., those millions of little trades for AAPL) to quant trading firms like Citadel (70%) and Two-Sigma (16%). In turn, those firms can use the retail sentiment to make directional bets, or to mask large block trades without moving the market, or perhaps to find another pricing advantage. Robinhood users don't see the costs, but they could be in the execution -- though we note that Robinhood has released a statement re-affirming they deliver best execution. Tense!


Source: New York State (report), Zerohedge (Robinhood), Medium (Robinhood privacy arbitrage), Robinhood (statement on orders)

ONLINE BANK: Varo Money Banking License and the OCC Charter

Let's review. In the US, the OCC hands out national banking licenses at the federal level. States also regulate and charter banks at the State level. Such regional banks and credit unions are subscale relative to players like Bank of America or Wells Fargo that have a national branch footprint and digital apps. But these small banks have community ties and are protected business interests within the States through lobbying. If the OCC makes it too easy for digital players to create online banks that live in our pockets through mobile phones, regional banks (with poor technology and digital client experience) will lose out. That dynamic actually has not at all played out with roboadvisors, who face the same regulatory jumble with the SEC and local Registered Investment Advisors, but so the story goes. 

Digital lenders perform a banking function (i.e., lending), but don't have a banking license or FDIC insured deposit capital. Their money comes mostly from investment funds, which is a shadow banking set up. They got around licensing by partnering with Bank-as-a-Service players. Some, like Square and SoFi, have looked at becoming an Industrial Loan Company in Utah -- a sort of quasi bank entity -- but haven't been able to pull the trigger. Neobanks in Europe got around licensing by riding the rails of pre-paid cards from the likes of Visa and MasterCard, pretending to have checking accounts while really just digitizing gift cards. Until now, as Monzo and Tandem have powered up the ability to take deposits via the FCA. So now we come to the point.

Recently, the Treasury encouraged the OCC to issue Fintech bank charters, and the OCC opened its doors for business. And immediately, the Board of Directors of the Conference of State Bank Supervisors (CSBS) announced that it is moving forward with litigation against the OCC. Way to kill the vibe! But that has not stopped fintech Varo Money / Varo Bank from getting a conditional de novo national bank license -- it can take deposits, move money and underwrite lending. Almost none of these have been granted since 2008, and so such a charter going to a digital-first player is a shot across the bow (granted, Varo needs to raise $104 million). The other interesting piece is that Varo is going to use Temenos, a European B2B2C bank platform for its core processing. Not FIS and Fiserv, the US versions of the same that power that long tail of State banks and credit unions. That's a big shot across the bow.


Source: CrowdfundInsider (Varo Money), CSBS (States suing OCC), Davis Polk (Varo Charter)

CRYPTO: Enterprise Blockchain Back in Vogue as SEC goes after ICO fraud

There was a moment in the development of peer-to-peer file sharing when the music labels, with cheerleading from Metallica, began to sue teenagers for millions in damages. We are ramping up to a similar period in crypto land. Davis Polk documents the bump in SEC enforcement actions targeting companies like TokenLot, Crypto Asset Management and FINRA registered brokers like Timothy Ayre. None of the violation descriptions are a surprise, especially if you've been listening to Preston Byrne: (1) TokenLot selling ICO tokens that qualify as unregistered securities without registering as a b/d and, (2) CAM raising a fund without registering as an investment vehicle while lying about having done so, (3) and Ayre brokering unregistered security tokens personally. Separately, the New York court in the ongoing United States v. Zaslavskiy has applied the Howey test in a motion to dismiss by the defendant, and found that a reasonable jury could conclude that the ICO was a securities offering.

This is good news, cleaning out the opportunists trying to sell everyone their fake lottery tickets. The flip side, however, is that we now have far more human and financial capital in the space, and it needs to be directed at something. And as far as we can tell, it is again directed at the enterprise blockchain space, which is morphing to become part custody, part digital assets, part OTC trading, part consulting implementations. Remember, enterprise blockchain is a cost-cutting effort by an oligopoly of financial firms to mutualize processes and costs around the back office. Now that ICOs posited scarce, functional digital objects into digital economies, the Security Token wave is re-running the traditional crowdfunding theme through token-based securitization on public blockchain rails.

Which is why the recently announced acquisition of Chain (a payments enterprise blockchain company) by Stellar (a public chain with a built-in exchange and strong throughput capabilities) makes sense. In this way, Stellar and Chain are moving closer to Ripple's model, owning both a public digital asset and a private enterprise software. This allows the firm to build both equity value in the company, and monetary value in the tokens. Not that we think Ripple's model is necessarily right, but it's right for this market, where token prices are collapsing and good news are scarce. As another example, we attended R3's CordaCon and were impressed by the progress of the bank consortium. There are over 50 apps and 200 different company implementations, including big tech, finance, and supply chain. One example is the ECB's TARGET Instant Payments Settlement for large payments and settlements. The borders between this world and the next are getting erased.


Source: Davis Polk (SEC Enforcements), Reuters (Stellar / Chain), Preston Byrne (on ICOs), R3 (marketplace)

CRYPTO: A utopia that can buy its own Sovereignty

Power. Sovereignty. Utopia. A recent piece from Daily Fintech points us to Sol, the Puerto Rico crypto billionaires experiment; Bitcointopia, an experimental city in Nevada; and Varyon, an artificial island off the coast of French Polynesia. These attempts at a new world are ostensibly about cryptocurency adoption, but their precedents trace to the DNA of humanity itself. A utopia (or dystopia for that matter) is a dream of the world defined by its impossibility. It may be a guiding light, or it may be a warning, but it is not reality. To carve out a utopian experiment has immediate connotations – cult-like, counter culture, naïve. See the utopias of Russian architects in the clutches of the Soviet Union, building cities on paper that could never be, or today’s techno retreat of Burning Man, where billionaires recreate Mad Max landscapes to feel human outside their corporate castles.

For most of human history, the frontier was a real place. It was the place where water dripped off the world into oblivion, the place where the pantheon of Gods looked down on mankind, a land unconquered by ships and swords. As humanity lifted the fog across the globe, the physical frontier disappeared. Sure, hard military power still applies in redefining borders between neighbors. But there is no more room left for Manifest Destiny, other than in our imagination. From this mental frame, we bring forth economic and technological frontiers, conquering not the Earth, but ourselves. But let’s not be fooled. Sovereignty, that embodiment of lethal force in the hands of the law, may have maxed out across the geography. But control of sovereignty can still be bought. After all, we are human, and our power comes from belief in the source of that power. Economic and technological conquering results in the re-shaping of sovereignty. Facebook’s 2+ billion users are larger than any country on the planet. Does it’s soft power echo across governments? You bet it does. Tech giants spend millions per year in lobbying, driving their desires into the body politic.

At the heart of every tech company with aspiration to go public is a utopia waiting to be unleashed. Uninspired by the political realm, we burn our hearts into capitalism. And these are beautiful creations. But once they taste power over people, once billionaires hold monopolies (e.g., from Bezos to Bitmain), utopias start wanting an army and a police. Small sovereigns and peripheries of large ones give first, yielding their regulatory apparatus to help perpetuate the new paradigm. Want to launch a crypto investment vehicle wrapped in a legal veneer that purports to be of equal stature to European (Malta), American (Puerto Rico) or British (Gibraltar) law? Or maybe build a new bank under custom-made Lithuanian regulation? But it won’t be enough for Crypto, which is not merely information flow, but information married with money. Crypto will buy its way into being a sovereign, if it can’t persuade the incumbent ones to let it be.


Source: Daily Fintech (Crypto utopias), Utopias (SolBitcointopiaVaryon), Lithuania (Fintech bank), Palace of the Soviets

REGULATION: Landmark Treasury Report Supports Special Charters for Fintech Banks and Lenders.


The recent trend has been that Fintech and Crypto startups can jurisdiction shop across the world for a friendly location, like Singapore. But in reality, the United States is still a massive gravitational force for both innovation and technology, and is the world's deepest capital pool in financial services. So with that context, we are thrilled to see a landmark 200+ page fintech report from the United States Treasury, touching on issues from payments, to lenders, to financial planning, to artificial intelligence (where we contributed our thoughts from Augmented Finance). Not crypto yet, though we are sure that will come. 

There is little to say, other than download and read it. Here are a few of the choice takeaways. First, the Treasury sides with the OCC on the idea of a special bank charter for technology firms. This charter would be less onerous than both an industrial loan company (ILC) and a full banking license, making life easier for digital lenders like Lending Club, On Deck, Square and SoFi. Digital Lenders could built out deposits, rather than relying on the shadow banking systems (i.e., credit hedge funds) for funding. The OCC has immediately jumped on this recommendation and is inviting fintech firms to apply. But remember, this hurts small and regional banks -- just imagine a local bank trying to compete with Stripe's new card issuing API. Such regional players have strong lobbies into industry groups and State regulators, so expect some type of allergic legal reaction to come. 

Other recommendations that jumped out at us include: (1) develop regulatory sandboxes like that of UK's FCA, (2) make it easier for bank holding companies to invest in tech, (3) smooth out the various regulatory bodies and interests that touch Fintech firms, (4) develop digital identity and strengthen the protection of consumer financial data (e.g. Equifax breach and GDPR), (5) digitization of the workflows in the mortgage sector and exploration of new approaches to credit modeling, (6) update the IRS income verification system, (7) modernize payments through faster retail payments systems, (8) level set digital wealth regulation (e.g., fiduciary rule from DOL vs SEC), and (9) take strategic efforts towards creating artificial intelligence within finance. We think these are all in the right direction of travel, and hope that the appropriate regulatory and legislative bodies are able to turn these non-binding recommendations into reality.


Source: Treasury (SummaryFull Paper), Bank Charter (OCC response), Stripe (Issuing)

ROBO ADVISOR: SEC Fines Betterment $400k, while SigFig & SmartAsset Raise $50mm and $28mm

Growth is expensive and risky. The brightest example is Facebook, with its now outdated mantra -- move fast and break things. Facebook did move extremely fast, and it may have broken some fundamentals, like the concept of privacy for an entire generation, as well as functioning democracy. But we digress. Even in Fintech, companies like Zenefits (and SoFi, culturally) have run into walls by taking shortcuts encouraged by growth. From that perspective, we are not shocked to see a $400,000 fine levied on leading roboadvisor Betterment for accounting practices between 2012 and 2015. This amount is half of the Zenefits fine (about $1 million) for unlicensed insurance brokerage,  and far less than the millions in wire fraud penalties associated with Theranos. But it does throw a wrench into the roboadvisor growth engine. 

From an investor's perspective, however, legal and regulatory exposure is just risk. And roboadvisor assets are still attractive. As proof points, SigFig has just raised a $50 million check from growth equity firm General Atlantic, with participation from prior investors like USV, Bain, and UBS. Remember, SigFig powers the UBS roboadvisor. In order for a company to raise growth equity capital, it likely needs to be running at $10-50 million in revenue, which means that the Wall Street contracts that SigFig has signed are probably quite juicy. 

As another example, consumer finance website SmartAsset raised $28 million from Focus Financial and Citi Ventures, among others. Unlike the roboadvisors, SmartAsset is a destination site with massive traffic, claiming to reach 35 million consumers a month. Financially, this is a far more scalable model than trying to gather assets under management. That traffic can then monetize through advertising or lead generation -- for comparison, look to LendingTree (public at $3B) or ClearScore (Experian acquired for £275m). Focus Financial, a conglomerate of independent financial advisor businesses, is looking for its own exit soon, and this investment may give it some runway in a more traditional business. Regardless, there are not that many credible independent roboadvisor assets left, as most have been snapped up by incumbents. Despite profitability questions in the space, the direction of travel is growth.


Source: Business Insider (Theranos), Techcrunch (Zenefits), Investment News (Betterment fine), General Atlantic (SigFig), WealthManagement (SmartAsset), Autonomous NEXT (Clearscore)

CRYPTO: Ethereum not a Security Because it is Decentralized

Let's parse today's state of regulation for crypto assets, and the glimmers of what the future will look like. Ethereum and Bitcoin are not securities, said a senior SEC official a week ago. Why? The argument rotates around decentralization -- not because regulators care about decentralized networks, but because you need an entity to lead an offering. The Howey test demands a common enterprise that gives purchasers an expectation of profit solely from the efforts of others. Does that make sense in the world of (1) decentralized networks set up by communities for mutual gain, and (2) changing expectation about tokens as platforms are built? Probably not, but until the courts create a new model, it's what we got, and it is beneficial for Ether.

What's probably not really beneficial for Ether as a development platform are ICOs (vs DApps). Yes, they are still the killer app for crypto, but they have also sapped ETH of its role as a currency for DApps. Instead of a single currency that can power a digital smart contracts economy, we have thousands of disparate tokens of questionable liquidity and value. And while Ethereum itself may have avoided being a security, the tokens launched using it as an offering platform are exposed to continued regulatory risk. The CBOE president, for example, expects to see SEC prosecution of many large token offerings, and potential class action lawsuits against projects that fail to deliver. No amount of disclaimers and structuring will help against an angry mob. 


To reiterate the point, ICOs have been narrowing Ethereum towards a crowdfunding offerings platform. Compare an entrepreneur's choice of Ether vs Stellar, for example, as the choice between the corporate law of Delaware or New York. In choosing a state, you have access to all the common law that has emerged from centuries of litigation. This is like choosing a programming language that has the best code libraries. Regulating this choice for financial disclosure makes no sense. When looking at a particular use case, however, regulatory approval will still be a gate. Square needed to get the BitLicense in New York in order to process crypto payments. The same type of regulation may come to Canada for exchanges and payments companies (KYC/AML for $1k transactions, reporting to regulator for $10k transactions). For a sovereign regulator, the best strategy is to control the choke points.


Source: CNBC (SEC on Ether), CrowdfundInsider (CBOE), Autonomous NEXT (Howey test), Coindesk (Square), Cointelegraph ($10k transactions), Techrunch (Square cash), NY State (Bitlicense), (creating a token)

REGULATION: Crypto Funds, RIAs, Regulations in a Box

The cost of launching a startup has fallen from a few million to a few thousand dollars. Why? Amazon and its cloud have collapsed the needed IT infrastructure to a cheap off-the-shelf subscription. Stripe Atlas has made corporate and payments gateway setup a breeze. But what if you're starting a financial entity, and not a software company? What if you're starting a Registered Investment Advisor, and not a wealth tech platform, or if you're starting a hedge fund offering a crypto index, and not a blockchain of blockchains? For that, let's take a look at compliance in a box. 

One of our favorite companies in the independent wealth management space is RIA in a Box. It does what it sounds like -- it sets up a Registered Investment Advisor entity, registers it with the SEC and the appropriate States, and manages ongoing compliance requirements as an affordable service. So if your advisory practice manages $5 million or $500 million, this solution can get you started. In fact, out of 12,000 RIA firms in the US, RIA in a Box has 3,000 as clients. Not surprisingly, Aqualine Capital Partners just acquired the firm through an LBO at an undisclosed price, which tells us that the firm is a cash cow -- an LBO requires a slug of debt that can be serviced by reliable, steady cashflow. And if you control the compliance reporting aspect of a financial entity, it's a very short reach to start selling regulatory, administrative and value-add software.


Now think about crypto funds. It's the same problem -- nobody has any idea how to structure them, which regulatory jurisdiction to pick, what bank to use, or how crypto assets are treated. Traditional counsel could easily cost over $100,000 to go through the motions. Enter the Crypto Fund-in-a-box companies! Take Vauban, which provides an interface to select a type of investment fund, its jurisdiction, target size at launch, while a real-time entity structure is built on screen indicating the cost of setup. Other similar plays include Fundplatform, Otonomous, and Bluemeg (note: we don't know or endorse any of these). Could the ease of solving this international puzzle lead to a similar growth outcome for crypto fund entities? Looking at the data, the first 5 months of 2017 saw 40 new crypto funds; there were 45 new entrants over the same period in 2018. Market volatility has not deterred fund formation. That doesn't mean funds won't fail (e.g., Apex Token Fund shutting down after failing to raise $25mm), but it does mean more will keep trying if it's as easy as clicking a button.


Source: RIABiz (RIA in a box), Crypto Fund in a Box (VaubanFundplatformOtonomousBlueMeg), Financial Planning (RIA totals), Autonomous NEXT (Crypto Fund totals), Stripe Atlas

ARTIFICIAL INTELLIGENCE: Machine Readable Regulations


We started with two difficult entries to highlight how the major platform shift technologies, blockchain and AI, are bringing out some of the worst impulses in human beings to take advantage of each other. And further, these tendencies become enshrined in software -- from decisions learned out of data, to bots endlessly begging to steal your money. From this perspective we pivot to Regtech, and in particular to projects that we think could be antidotes for the malaise.

The first is an effort by the FCA to explore offering regulations in a machine readable format. That means that a regulator would provide standards and perhaps even executable code that could plug into Fintech software stacks. Imagine Python's Django, but with a regulatory module that pre-packages data formats for compliant reporting. Similar ideas have been floated by self-regulatory organizations in Crypto, looking to build into tokens the ability to determine regulatory requirements, like accredited investor status or KYC/AML. But to do this at the level of the regulator is far more meaningful because (a) there is way more law that needs to be translated, which relates to real rather than imagined economic activity, and (b) this regulation is a result of an established governance process, which is still immature in decentralized communities. Imagine putting all of the FCA on Github and satisfying requirements through something like the Digital Asset Modeling Language. Compliance costs would actually become trivial.

But now is a moment of transition. Case in point, last week we attended the fifth London cohort of the Barclays Techstars, where a RegTech startup called Audit XPRT introduced their automated audit and compliance solution that uses machine learning to extract structured rules from unstructured paper documents. The aspiration is to reduce compliance-related costs ($270 billion) by 90% and achieve 5 months of work in 5 minutes. Another example is Governor, which creates dashboards of real-time tracking across Risk, Compliance and Corporate Governance. Or take Suade, which tags existing data with an overlay that maps to regulatory requirements and provides apps out of the box against which the data can be checked, no disruption to the bank’s current architecture. It may feel slow, but the law's getting digital.


Source: Github (Ethereum proposals), FCA (machine readable initiative), Digital Asset (DAML), Thomson Reuters/Tabb Forum (Infographic), SuadeGovernor (infographic), AuditXPRT

BLOCKCHAIN: Scams in Crypto: 20% of ICOs, 5% of Twitter


Getting a wrap around just how much scamming and fraud there is in the crypto ecosystem is a challenge -- but not impossible. As the industry continues to put up impressive fund-raising figures (with new issues at about 2% of Ethereum market cap per month), just how much of this will become valuable projects? We've written before about how creative destruction is natural for startups, and that failure rates in the mid 90% are a reasonable outcome. We've also pegged hacking of Bitcoin and Ethereum to have been responsible for about 14% of money supply in those pools. But what about outright theft and lies?

Two ideas. First, the WSJ analyzed 1,450 ICOs and found that 271 or 18% of them are just total raw scams. Fake copied white papers, team member photos taken from stock photo websites, nothing behind the project but malfeasance. Yikes. And another version of the same was The North American Securities Administrators Association going after nearly 70 ICO issuers in a coordinated action of regulators across the US and Canada called "Operation Cryptosweep". Which is a totally sweet name, for what is a really regrettable but required clean-up of the crypto ecosystem. A 20% chance to lose your money, for no philosophically meaningful reason, is the wrong price to pay for good financial technology in our opinion.

And second, don't forget the propaganda bot armies. Sure, they can influence elections and spread misinformation, but we didn't expect that they would be used for financial warfare this quickly. The practice in question is copy-cat accounts on Twitter that look like a Twitter influencer claiming to give out free crypto currency, if only you send them money first. This is hacking of the human kind and we monkeys fall for it all the time. As a comparisons: (1) email phishing maxes out at 0.70%, according to Symantec, and (2) bot automation is at approximately 10% of all activity on Twitter. Given that the crypto ecosystem is more prone to Internet memes and bounty programs, we would expect the rate of phishing to skew higher, say up to 5% for crypto-related conversations. So watch where you point that digital wallet.


Source: WSJ (18% scams), NASAA (Operation Cryptosweep), Bloomberg (Bot PhishingHacks at 14%), Autonomous NEXT (Failure rates)

ARTIFICIAL INTELLIGENCE: Chinese Government AI is the new Japanese MegaCorp

The 1980s gave us Bladerunner, with its Japanese-inspired future paranoia. Today's Japan has not taken over the world; though that may change with Mitsubishi UFJ Financial Group testing its own cryptocurrency, and Rakuten planning to tokenize $9 billion of loyalty points. But China is the new boogeyman, offering a rival vision of the world to Western consumer protection. Where Europe has GDPR, with its protected data categories, China uses each of those categories as swords -- to power omnipotent artificial intelligence machines that determine the educational, financial and social fate of citizens.

Take, for example, the news that schools are using video surveillance technology on students to monitor whether they are engaged or paying attention in class. Cameras built by Hikvision Technology, which uses the same software to prevent crime, leverage machine vision to apply Foucault's Panopticon to kids. That's only the entry drug. Data like this flows upstream into a government controlled reputation system, which is made of 4 pillars: “honesty in government affairs”, “commercial integrity”, “societal integrity” and “judicial credibility”. From cheating at video games to overdrawing your credit, all sins are remembered by the great machine, and come into play next time you apply to school, for a loan, or simply want to book a vacation. And since your only way to pay for things is with a tech-company messaging app, which uses government payment rails for the money, the sovereign appears impenetrable.

Maybe the West is just over-comfortable colonialists, mired in regulation and about to lose the next industrial revolution. Yes, more and more finance companies are using chatbots and modernizing their channels. But our reaction to accidents is to eradicate rather than lean in. Consider the freak case where an Alexa device in an Oregon woman's home misinterpreted background conversation as a series of instructions to send recordings of those conversations to a random contact in the address book (repeatedly). The customer is decidedly creeped out, and Amazon apologetic. At least these things aren't going to the CIA, right? We are going to have a hard decade.


Source: (Mitsubishi Bank), Reuters (school surveillance), Guardian (Chinese reputation machine),. Bloomberg (Payments rails), WSJ (Chatbots in finance), NBC (Alexa recordings)

REGULATION: Why Coinbase would want an OCC bank license


What do you do if you business prints $1 billion per year (Coinbase) or $200 million per quarter (Binance), but people in suits still think what you do is at best a bubble and at worst a scam? Sure, you can hop from jurisdiction to jurisdiction trying to find a friendly regulator. Or, you can try to play by the existing rules and pay for the compliance overhang. While many Fintech companies complain about how expensive and time consuming licensing is (looking at you digital lenders and neobanks), crypto exchanges can afford it. Especially crypto exchanges that want to build out a custody business and make a spread on customer funds.

The WSJ reported that Coinbase approached the OCC earlier in 2018 about a banking license. This should not be a surprise, but a natural institutionalization of the crypto sector. Unlike Fintech, which still struggles to persuade customers that they need financial products over the web, crypto is actually something that consumers want. In an age where Millennials are saddled with record generational debt, everyone wants to buy lottery tickets. And if you accumulate a large enough consumer base, building from crypto to payments, from payments to deposits, and from deposits to financial advice is a natural path. We've written before about the links between regulatory custody and legitimacy -- and symptoms like Nomura partnering with Ledger to offer this, given the popularity of the asset class in Japan, prove the point.

Unlike Coinbase, which may cash in its chips into the traditional financial system, exchanges like Binance and Huobi have gone the other direction by pursuing token offerings to the crowd. For an upcoming analysis, we looked deeper into Huobi and again come away with a raised eyebrow. The token is a discount coupon on future trading fees, with a vague promise attached to exclusive access and events, and a promise to link to airdrops. It trades into other crypto currencies on the, you guessed it, Huobi exchange, which means that belief in its value can be monetized immediately. And there's now about $250 million of this belief, according to Coinmarketcap. That reflects very short-term thinking in our view, but such financial engineering isn't unique to crypto. Last we remember, JP Morgan and Goldman were called out for "laddering", i.e., manipulating the price trajectory of Initial Public Offerings during the tech bubble. Now laddering is built into software and promoted by bots. History rhymes!

Source: WSJ ( Coinbase ,  Laddering ), Cointelegraph ( Nomura custody ), Coindesk ( Huobi ), American Banker ( graphic ), Harvard Law School ( laddering )

Source: WSJ (CoinbaseLaddering), Cointelegraph (Nomura custody), Coindesk (Huobi), American Banker (graphic), Harvard Law School (laddering)