Fintech Regulatory Challenges Q&A

Blockchain's Role in Digital Payments and Cryptocurrency Q&A

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Question 1: Discussing Relationship between Blockchain, Peer-to-peer payment, cryptocurrency and digital payment

Blockchain technology system can be defined as a system that helps in recording information in a way which mainly makes it significantly difficult to hack as well as change and cheat. As per the views of Khan and Byun (2021), blockchains are mainly used for solving significant transaction issues in a peer-to-peer system. In this case, problems in terms of being unable to verify the payee mostly take place as one of the bitcoin owners does not double-spend coins. Therefore, introducing a time stamp server considering blockchain facilities mainly helps by taking a hash of block items in order to be successfully timestamped. Timestamp feature highlights the strong evidence of data which must have existed at the required time (Nakamoto Institute, 2008). It has been also reported that in the time peer-to-peer payment process, each and every timestamp mainly includes data regarding previous timestamps specifically in its hash in the form of a chain along with each and every additional timestamp that reinforces ones before it. In the below section, timestamp infrastructure has been presented.

Figure 1: Timestamp Server infrastructure

(Source: Nakamotoinstitute, 2008)

Figure 1 highlights the way how each and every timestamp along with its hash reinforces ones before it along with blocks. The use of blockchain, in this case, has ensured the way following which times cannot be edited or changed after implementation. In this way, peer-to-peer payment has defused the core concept of blockchain technology. As per the views of Bakar and Rosbi (2018), blockchain technology usage not only introduces a secure and credible timestamp server but also plays a vital role in ensuring authentic proof work. Henceforth, in order to implement a "distributed timestamp server" based on the peer-to-peer payment system, there is a high need of using proof-of-work similar to Adam Back's Hashcash. Also, thereafter, blocks cannot be changed till performing the work repeatedly.

As one of the native solutions for time stamping issues, a “digital safety-deposit box” has been introduced which could be used and it consists of specific safety concerns. As per the views of Haber and Stornetta (1991), the privacy of documents is mainly contained in the “digital safety-deposit box” in specific two ways. One of them can be stated as third-party access can eavesdrop during the time of transmitting documents and thereafter completing transmission successfully, it comes available specifically to TSS. Bandwidth and storage concerns of “digital safety-deposit box” are required in order to time-stamp documents and at the same time storage in order to store them in TSS successfully (Haber and Stornetta, 1991). This entire process directly as well as indirectly supports blockchain technological concepts in order to ensure the safekeeping of documents. On the other hand, the two-time stamping scheme also supports the concept of blockchain technology and at the same time facilitates appropriate time stamping activities.

Figure 2: Blockchain works in a proof-of-work system

(Source: Nakamotoinstitute, 2008)

Figure 2 highlights how blockchain concepts are being integrated in ensuring the appropriate working of the proof-of-work systems. It has been highlighted that this particular system addition to the peer-to-peer payment system mainly helps in solving the significant problems of determining appropriate representation in the decision-making process (Nakamoto Institute, 2008). In the case of discussing practices done by organisations, it has come into an observation that sandbox firms are currently testing tokens that are pegged particularly to fiat currency. At the same time, it also depends on services as well as the structure that is provided. In this case, those may be payment services institutions or e-money (Fca.org.uk, 2019). Here about, one firm is considerably associated with preparing the way to test a particular digital media system which incorporates medium standard proofing as well as transaction monitoring tool towards identifying transactions as it may involve effective terrorist financing or money laundering incidents. After sending the remittance financial amount to the testing firm by consumers, tokenizing financial funds and thereafter transmitting the specific financial amount are done across proprietary blockchain systems (Fca.org.uk, 2019). In this case, testing parameters include significant restrictions on effectively pegging tokens to USD at a particular rate and that is 1.1 to effectively minimise FX risks.

In the current scenario, money is considered to exist along with debt, which is considered a contract for an extended range of deferred payments and price lists. Besides, price lists are also considered as part of the money which plays a vital role as an offering of a significant contract for purchase or sale (Davidson, 1972). In this case, money funding mainly operated following centralised methods of transactions. On the other hand, digital currency such as cryptocurrency follows a decentralised transaction process and at the same time ensures an easy transaction process which requires short settlement times (Ku, 2002). Blockchain technology has enabled the highly reliable existence of cryptocurrency. Almost every variety of cryptocurrencies use blockchain technology in order to be transferred digitally. In this case, each and every transaction is done securely and follows an authentic verification process. Bitcoin, one of the cryptocurrencies, is using the concept of blockchain technology in order to facilitate safe digital transactions as well as payments and at the same time is considered the first decentralised cryptocurrency. Cryptocurrency uses the digital mode of transaction process using blockchain technological concepts.

Apart from all of these, it can be stated that digital payment systems and blockchain technology usage is highly connected in the way blockchain facilitates secure, fast, low-cost international payment processing service through using end-to-end encrypted distributed ledger function. As per the views of Zetzsche et al. (2021), DLT is considered as well as reported potentially improving factors in case of increasing the efficiency of significant cross-border payments. Besides, Distributed ledgers following blockchain technology concepts are not supported by either minimal or no central administration process as well as centralised data storage. On the other hand, cross-border payments through intermediaries are currently suffering from low speed, insufficient transparency in payment transactions along with limited access across servers and low-level transaction experiences (Zetzsche et al. 2021). Digital payment options have been introduced to secure, safe, easy, time-efficient, transparent financial transaction processes using blockchain concepts. In this case, DLT facilities have become very much effective in ensuring a transparent ledger system which allows both parties to access transaction details for verifying authentic purpose-based transactions.

On the other hand, it has come into an observation that DLT in the era of technology has introduced a new distributed payment infrastructure which allows effective PSPs participation and use of technology along with institutional design application. On the other hand, (Karthika and Jaganathan, 2019) reported that enhancing the significant efficiency of major to minor cross-border transaction processes is extremely essential to oversee significant law and regulatory functions in order to effectively avoid the chances of rising risks. Besides, consideration of a significant regulatory approach needs to be undertaken for ensuring both end-user transaction parties such as Herstatt risk. Blockchain technology has introduced a “closed-loop payment system” along with “multilateral transaction platforms like Target2” or “peer-to-peer payment process” in order to ensure a hazard-free cross-border transaction process. These above-discussed facts associated with blockchain technology have established positive relationships with cryptocurrency, digital payment as well as peer-to-peer payment processes.

Question 2: Discussing significant regulatory challenges in Fintech

In the current scenario, the financial industry is undergoing a significant transformation which is significantly brought by rapid technological development and its worldwide expansion. Tech-driven financial transactions have become effective and at the same time challenging for performing traditional financial activities (Bancomundial, 2017). Implementation of the regulatory system according to the rapid growth of fintech has become challenging to understand the regulatory needs of fintech, regulators need to be familiar with economic goals that are underlying significant innovative additions within the financial process (Theregreview, 2022). Touch technological innovative inclusion within the financial service system has improved efficiency but at the same time has become requiring appropriate security measures in addition to it. Significant regulatory, as well as legal challenges, have started to be faced in time of developing a significant regulatory framework for ensuring effective DLT implementations which can bring security as well as fundamental changes in the responsibilities of stakeholders, especially within the financial sector. Some of the main regulatory challenges those are faced in Fintech are as follows -

Challenges at Industry standards and Regulatory Vetting

Regulatory vetting is highly important for conducting thorough investigations of industry especially financial service-based industry in order to make significant changes in existing regulatory bodies. As per the views of Rabbani et al. (2020), changing traditional financial activities at the industry level is highly required in order to support the successful implementation of fintech technologies to maintain efficiency. Global financial regulators are currently studying the technology instead of a regulatory framework for supporting the fintech process and are yet towards emerging effectively. The development of companies within the financial industry standard is also at an early developmental stage which needs to be developed as well as efficiently to cope with rapid changes regarding innovative fintech technologies (Anagnostopoulos, 2018). For instance, there are fewer concerns, especially about fewer border DL systems regarding jurisdictions of specific underlined data as well as information. Regulating a permissionless, open DL system is quite complicated as there is no kind of legal entity that exists at the time of controlling distributed ledger.

KYC & CDD

Significantly for adopting financial a system “Distributed Ledger Technology (DLT)” system needs to consistently comply with “Know-Your-Customer (KYC)” and Customer Due Diligence (CDD)” requirements especially in “Anti-money combatting the Financing of Terrorism (AML/CFT)” regulations. As per the views of Restoy (2019), most of the DLTR systems can be accessed following permissionless features that disguise the significant identity of members belonging to a specific network by using process name public key encryption. This particular system accessibility mainly makes it difficult to effectively comply with “Anti-money combatting the Financing of Terrorism (AML/CFT)” regulations which already exist and at shame times also allow t financial transactions between un-vetted parties. For instance, Coinbase provides quick transaction time along with a verification process, verifying more information in order to comply with initial KYC requirements can be also done by users (Bancomundial, 2017). Particularly for solving these problems permission-based DLT systems are highly required and at the same time verification of participants significantly for conducting the vetting process is most required. Besides, in the account of verifying users' identities, AML/CFT compliance has become a requirement, especially for all network participants.

High cost of regulatory compliance

Over the past few decades, the cost has become one of the biggest factors stopping compliance and numbers regarding backing up claims. It has been officially reported that the rapid growth of fintech concepts has become one of the major issues regarding enhancing money laundering cases which require “anti-money laundering compliance” (Ahern, 2020). LexisNexis Risk Solutions, UK has reported that financial institutions in the current scenario have associated spending £28.7 billion as much as on an annual basis on managing “anti-money laundering (AML) compliance” (Baus, 2022). On the other hand, Thomson Reuters has conducted a survey which reveals that 62% of financial companies within the financial service sector have reported desiring a significant increment in time commitments, as well as compliance, cost this year as fintech features have started growing rapidly.

Figure 1 highlights that most of the companies within the traditional financial sector have reported hoping to increase the rate of compliance cost in order to manage “anti-money laundering (AML) compliance” (Baus, 2022). Therefore regulatory changes need to be implemented as fast as possible by understanding the industrial development phase which is currently under the developing primary phase.

Cost-effective Technology consideration

Effective regulatory change implementation mainly requires highly efficient decision-making activities which are allowed under AI technology consideration as it allows reducing costs associated with making suitable decisions, and predictions as well. Despite helping with decision and prediction-making sessions, the data-dependency nature of AI technologies initially comes with a cost, data integration and privacy concern (Huang, 2021). Besides, effective stifling innovation has taken place on account of AI's focus on near-term incremental solutions in comparison to human-focused innovation as well as significant new ideas. This particular fact has driven significant challenges for changing and implementing regulatory changes in borders to manage and cope with the rapid implementation of fintech support in the traditional transaction processes (Reyes, 2017). Wide adoption of safe transaction processes introduced by blockchain might be effective as serving alternative options to managing currencies which are effectively backed by the Government. In this case, derailing the significant abilities of countries towards effectively implementing stabilised economies along with monetary policy can be done properly. In addition, the adoption of blockchain transaction facilities has started giving more authority to digital players such as Facebook in order to establish significant control over central banks as well as on markets. Regulators need to consider and conduct effective vetting for understanding crypto assets fundamentals which mainly consist of financial products as well as virtual property (Huang, 2021). It has been also reported that a significant trade-off still exists in the case of policy-making between financial inclusion and regulations in terms of strict crypto asset regulations which would be effective for impeding technology investments along with implementations.

Numerous problems with DeFi

The combination of AI and blockchain, decentralised financial options, DeFi helps in reducing cost by effectively reducing interference of financial managers as a process of traditional financing and other intermediaries. As per the views of Taylor et al. (2020), DeFi allows users to create significantly complicated financial transaction details which can be managed without intermediaries and at the same time securely recorded in the blockchain system. Reducing intermediating costs regarding transactions can not overcome the issues regarding considering it as one of the substitutes for traditional financial systems. At the same time, numerous problems regarding using the DeFi concept have been reported and the most important issues include a lack of price volatility as well as deposit insurance, coding issues and high risk of cyber risks (Theregreview, 2022). Due to posing different types of risks over time, Fintech has been associated with requiring a new regulatory framework rather than appropriately fitting within the existing regulatory framework.

Ensuring the stability of the Financial System

In the current scenario, it has come into the observation that central banks especially in the UK, Canada as well as Australia have become associated with assessing the risks as well as benefits of digital currency over fiat currency. In addition, investigating its impacts on the economy as well as on financial stability has taken place effectively as central banks across the globe are significantly exploring a wide range of “DLT-based” digital currencies. On the contrary, Brown and Piroska (2022) have reported that digital fiat currencies can enhance financial stability by providing additional policy tools to the Central Bank in order to reduce significant interest rates below the lower bound that indicates under zero amount. In addition, digital fiat currency has the ability to fund adequate asset purchases effectively especially by non-banks without high requirements for intermediaries in banking activities.

References

Ahern, D.M., 2020. Regulators nurturing fintech innovation: global evolution of the regulatory sandbox as opportunity based regulation.

Anagnostopoulos, I., 2018. Fintech and regtech: Impact on regulators and banks. Journal of Economics and Business, 100, pp.7-25.

Bakar, N.A. and Rosbi, S., 2018. Robust framework diagnostics of Blockchain for bitcoin transaction system: A technical analysis from Islamic Financial Technology (i-FinTech) perspective. International Journal of Business and Management, 2(3), pp.22-29.

Bancomundial.org (2017). Distributed Ledger Technology (DLT) and Blockchain FinTech Note | No. 1. Available at: https://documents1.worldbank.org/curated/en/134831513333483951/pdf/WP-PUBLIC-Distributed-Ledger-Technology-and-Blockchain-Fintech-Notes.pdf. [Accessed on: 5.12.2022]

Baus, A. (2022). 7 common compliance challenges for fintech apps. Available at: https://decode.agency/article/fintech-compliance-challenges/.

Brown, E. and Piroska, D., 2022. Governing fintech and fintech as governance: The regulatory sandbox, riskwashing, and disruptive social classification. New Political Economy, 27(1), pp.19-32.

Davidson, P. (1972). Money and the Real World. The Economic Journal, 82(325), 101.

Fca.org.uk (2019). Guidance on Cryptoassets. Available at: https://www.fca.org.uk/publication/policy/ps19-22.pdf.

Haber, S., and Stornetta, W. S. 1991. How to Time-Stamp a Digital Document. Lecture Notes in Computer Science, 437–455.

Huang, S.S. 2021, "Crypto assets regulation in the UK: an assessment of the regulatory effectiveness and consistency", Journal of Financial Regulation and Compliance, Vol. 29 No. 3, pp. 336-351.

Karthika, V. and Jaganathan, S., 2019. A quick synopsis of blockchain technology. International Journal of Blockchains and Cryptocurrencies, 1(1), pp.54-66.

Khan, P.W. and Byun, Y.C., 2021. Blockchain-based peer-to-peer energy trading and charging payment system for electric vehicles. Sustainability, 13(14), p.7962.

Ku, R.S.R., 2002. The creative destruction of copyright: Napster and the new economics of digital technology. The University of Chicago Law Review, pp.263-324.

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Rabbani, M.R., Khan, S. and Thalassinos, E.I., 2020. FinTech, blockchain and Islamic finance: An extensive literature review.

Restoy, F., 2019. Regulating fintech: what is going on, and where are the challenges?. Bank for International Settlements, pp.1-7.

Reyes, C.L., 2017. Conceptualizing cryptolaw. Neb. L. Rev., 96, p.384.

Taylor, M.C.R., Wilson, C., Holttinen, E. and Morozova, A., 2020. Institutional arrangements for Fintech regulation and supervision. International Monetary Fund.

Theregreview.org (2022). The Regulatory Challenges of FinTech. Available at: https://www.theregreview.org/2022/06/14/moss-regulatory-challenges-of-fintech/. [Accessed on: 5.12.2022]

Zetzsche, D.A., Anker-Sørensen, L., Passador, M.L. and Wehrli, A., 2021. DLT-Based Enhancement of Cross-Border Payment Efficiency–a Legal and Regulatory Perspective–. Available at SSRN 3984523.