Posted on Categories blockchain, fintech

Blockchain and the new reality of decentralised financial services

While the market is captivated by initial coin offerings as they continue to attract dizzying returns on invested capital, the capabilities of blockchain technology reach much further. Indeed, some blockchain solutions currently in development or already available throw into question the sense of existing financial regulations.

ICOs are just the start

More and more is being written and said about ICOs—a new method for raising capital through creation and distribution of blockchain tokens. ICOs have become a topic of mainstream discourse, treated as synonymous with the blockchain technology.

Sometimes tokens (as I discuss here) are a vital and integral element of innovative blockchain solutions, but their issuance via an initial coin offering can be a controversial topic. There are many doubts surrounding the economic and business sense of utility tokens, i.e. tokens for consumer use or with other utility functions. But security tokens, by contrast, tend to generate lots of legal issues because they may be deemed to be financial instruments. On top of that, the overheated token market raises justified fears of a speculative bubble.

But in many respects, ICOs do not take advantage of some of the most fascinating characteristics of public blockchains. Typically, an ICO is organised by a specific entity. While ICOs do use smart contracts (more about that here), the proceeds usually go to a single entity which exercises complete control over them. For this reason, the legal treatment of ICOs is not all that complicated, as it is fairly easy to identify the entity responsible for carrying out the ICO. (In practice, in this area lawyers focus on the legal assessment of the tokens and advice on selection of the appropriate jurisdiction, as ICOs are usually aimed at global investors.)

Meanwhile, projects are underway making much greater use of the advantages of blockchain technology. We may refer to them generally as “decentralised financial services.”

Financial services without intermediaries

In simple terms, decentralised financial services consist of shifting specific financial market activities “on-chain”—i.e., directly onto a blockchain. Consequently, the transactions making up financial services occur on the blockchain and are confirmed by the consensus of the network. Examples include:

  • Lending solutions enabling borrowers to take out loans secured by a pledge against specific assets, but sometimes there is no specific “lender” involved and the collateral is maintained by a smart contract
  • Decentralised exchanges for various assets, including financial derivatives, functioning in an entirely distributed infrastructure without a central operator
  • Systems for issuance of stable stores of value, sometimes using tools reminiscent of algorithmic monetary policy.

These types of applications of blockchain technology on financial markets reveal the potential of this technology and its successors (naturally bearing in mind that blockchain will find numerous applications outside the world of finance). First and foremost, it consists of replacing existing intermediaries with a distributed peer-to-peer network.

Decentralised financial services are still in the early phase of development, and their market expansion is also being held back by the immaturity of public blockchains (e.g. their still relatively low scalability). But it can easily be imagined that within a few years decentralised financial services of this type will become popular on the market. So how in that case should we assess them legally?

Legal framework for decentralised financial services

First and foremost we should realise that decentralised financial services represent not just a challenge, but also an opportunity, for the current financial market regulatory framework. Combined with an appropriate legal response, decentralised financial services could help reduce systemic risk, provide better protection to investors, and improve the transparency of the financial markets, thus furthering the traditional aims of financial regulators.

But for this to happen will require a new approach to regulations. The existing regulations, and even new ones like the EU’s MiFID II, were developed under the classic paradigm of the financial market. Consequently, they concentrate on identifying entities subject to regulation, creating relevant licensing and oversight schemes, and establishing numerous requirements such entities must fulfil.

This type of approach, which is after all characteristic not only of financial regulations, will simply not fit the reality of decentralised financial services. In many instances there will not even be any entities that could be subjected to such regulations (just as it is difficult to regulate the distributed Bitcoin network).

Theoretically we could leave these challenges unanswered, thus halting the development of decentralised financial services. But we must realise that the European Union is just one of the world’s markets, and cannot ignore technological changes potentially vital for the future of the world of finance. The sooner we realise this in Poland as well, the better it will be for the safety, stability and innovativeness of our financial market.

Jacek Czarnecki