THE NEW ERA OF ENCRYPTED FINANCE

1.1 The traditional financial system and its main counterparts

A broad definition of the “financial system” is that it is a set of interrelated activities or services structured to facilitate the flow of funds from where they stand to where they are needed. Specifically, for a set period of time, the in-come of some economic units (households, firms, government) is greater than their expenses, while the income of some others is lower than their expenses. Thus, there must be a way for the funds of the former, surplus economic units to flow to the latter, deficit economic units (Figure 1.1). This is what the financial infrastructure does; it facilitates this flow of funds from where they stand to where they are needed.

This financial infrastructure consists of two main parts: the financial markets (direct finance) and the financial intermediaries (indirect finance). In direct financing, lenders (savers) channel their funds directly to borrowers (spenders), while in indirect financing, lenders (savers) channel their funds to an intermediary, which then decides how to allocate the pool of money they have accumulated to borrowers (spenders). Just two simple examples, one per case. When Bob buys ten shares in the primary market of Sea and Sun plc., a listed company in the London Stock Exchange (LSE), he knows that his money is going directly to Sea and Sun plc. When Mary deposits £100 into her account in a bank, this amount of money is pooled with the deposits of millions of other depositors, and it is for the bank to decide to provide a loan to Sea and Sun plc. In both cases, all participants, Bob, Mary, and Sea and Sun plc. use the infrastructure of a financial market or financial intermediary, respectively, but Bob knows exactly where his money is going (direct finance), while Mary does not (indirect finance). There are plenty of other differences between these two main parts of the financial infrastructure, but this is the broad picture.

For a financial system to function properly, there has to be trust in the system. In fact, “a sufficient level of trust” is a necessary precondition for the stability and maintenance of any social, political, and economic system. When trust breaks down, the social system is threatened with unrest, and this is particularly true for the market-based economy, of which the financial system is a part. The notion of trust is of such high importance in finance that if trust is lost, the entire system might collapse, giving rise to what is known as “systemic risk”, a type of risk that is widely referred to in finance, especially in the aftermath of the Global Financial Crisis of 2008.

Turning to the basic functions of the financial system, the core objective, as already mentioned above, is to facilitate the allocation and deployment of eco-nomic resources, both spatially and across time, in an uncertain environment. This objective can be fulfilled via an efficient payment system, through which all transactions are cleared. The payment system is a core function of the financial system, alongside markets and institutions. Payment, clearing, and settlement arrangements are of fundamental importance for the functioning of the financial system and the conduct of transactions between economic agents in the wider economy. All economic units need to have effective and convenient means of making and receiving payments. Banks and other financial institutions are the primary providers of payment and financial services to end users, as well as being major participants in financial markets and important owners and users of systems for the processing, clearing, and settlement of funds and financial instruments.

Other, subsequent, but equally important, functions are those of: (a) fundraising, where capital is raised for economic units that need it, (b) finance pooling where small amounts of capital are transformed into larger amounts of funding, (c) liquidity transformation, where the short-term investors’/savers’ horizon is transformed to long-term funding for fundraisers, (d) cost reduction, due to the large volume of repeated transactions, (e) risk pooling, which is the practice of sharing risks among a group of other companies, and (f) information and advice providers because of their expertise in the field of finance.

All these functions are carefully embedded in the way the financial infrastructure is developed. Trust is a necessary precondition for the entire system to function properly, while the payment system is a horizontal service that can be seen as the circulatory system of the financial infrastructure. Over time, technology has been constantly creating innovations of how the infrastructure evolves and how the notions of trust and payments can be facilitated, so that the efficiency of the entire system is improved. The most recent innovation that disrupts the way this infrastructure works is the blockchain technology, which is the core technological application in the new era of encrypted finance.

1.2 The new era of finance: encrypting the financial system

The previous section described the basics of the traditional financial system, briefly summarizing the main counterparts, participants, and functions thereof. This section explores how the recent technological innovation of blockchain has already started introducing new and more efficient ways to facilitate certain processes that the financial system currently offers.

It all started back in 2008, when an unknown person or group of people, using the name Satoshi Nakamoto, invented bitcoin. In October 2008, Satoshi Nakamoto published a white paper titled “Bitcoin: A Peer-to-Peer Electronic Cash System”1 describing bitcoin as “a purely peer-to-peer version of electronic cash, that would allow online payments to be sent directly from one party to another without going through a financial institution”. It is worth mentioning that the idea of having a digital currency was already a three-decade-old idea by 2008. From David Chaum’s “ecash” in the early 1980s to Wei Dai’s “B-money” and Nick Szabo’s “Bit Gold” in 1998, this idea was already there. But the main issue of all these early efforts was the double-spending problem, namely, how to make sure that a digital asset is only used once, and how a system can be designed to prevent copying and counterfeiting it. Satoshi Nakamoto’s idea of a peer-to-peer electronic cash system, based on the blockchain technology, provided answers to these problems. So, on 3 January 2009, Satoshi Nakamoto mined the Genesis Block, the first mined block in Bitcoin (Figure 1.2), and a new era of encrypted finance began.

The idea of transacting values without the need of a financial institution is a truly disruptive idea for the financial system. The previous section underlined the importance of “trust” as a fundamental prerequisite for the financial system to function without problems. Note that in the absence of trust, the financial system faces systemic risk, that the whole system (not just one participant of the system) might collapse. Financial institutions also make sure that all transactions are recorded in a way that the double-spending problem is eliminated. So, any-thing that could emerge to challenge the way transactions services work should fulfill the main prerequisites of trust and double-spending avoidance. Satoshi Nakamoto’s idea to create a cryptocurrency using the blockchain technology seemed to fulfill these two necessary requirements.

The key idea behind the notion of “encrypted finance” lies in how the block-chain technology works. Although this technology will be explained in more detail in Chapter 2, it is worth referring here to some main functions of the technology. Blockchain technology uses cryptography. Cryptography is the method of disguising (i.e., encrypting) and revealing (i.e., decrypting) information through complex mathematics. This means that the information can only be viewed by the intended recipients and nobody else. Cryptography is used in blockchain in two ways. The first is via algorithms called cryptographic hash functions, which create a chain of hashes and ensure that the order of transactions is preserved. This resembles the function that the financial institutions use to re-cord transactions in, what is called, a ledger. But unlike a centralized ledger held at one bank, blockchain creates the so called “distributed ledgers” system, where the ledger is distributed across many computers, with each computer having the same view of the ledger. The second way cryptography is used in the blockchain technology is to create digital signatures, which are used to ensure the data put on the blockchain is valid. In bitcoin, the digital signatures are used to ensure the correct amount of value is transferred from one bitcoin wallet to another.

This brief description of how the blockchain technology works shows how trust and the avoidance of the double-spending problem are dealt with. Encrypted transactions, which are practically impossible to break, bring trust to the system, while the distributed ledgers system, where all computers have the same view of the ledger, avoids the double-spending problem. So, when people transact using the blockchain technology, they trust the system for the fact that their transaction is recorded and cannot be counterfeited. For example, when Bob sends one bitcoin to Mary, they both trust that this transaction is valid and recorded, while anyone has access to the ledger that records transactions, thanks to the distributed ledger system, without necessarily knowing who Bob and Mary are.

These key features of the blockchain technology allow transactions to take place without the need of a financial middleman (markets and/or intermediaries). Bearing in mind that the main function of the financial system is to facilitate the flow of funds from lenders to borrowers, as discussed in Section 1.1, now it is worth looking at how certain participants and processes of the traditional system can be replaced via the use of the blockchain technology.

1.3 Introducing the main counterparts of the new encrypted financial system

Markets and banks act as middlemen in the financial system. They run, control, and own the necessary infrastructure needed for the financial processes to take place. The blockchain technology comes to disrupt certain functions that the traditional financial system offers by suggesting new ways of doing (financial) business. This section will briefly introduce what changes the technology seems to bring in the traditional players and parts of the financial system.

The purpose of this last section of Chapter 1 is to link the functions of the traditional financial system to a set of new processes/services/institutions that seem to emerge in the context of the new, encrypted financial system. Drawing direct links between the traditional and the new system aims to facilitate the understanding of how this new system works. Note that the subsections that follow practically offer a summarized context of the respective remaining chapters of the book.

1.3.1 The infrastructure

The infrastructure of recording transactions in a reliable and foolproof way is key to gain trust for the system. From Babylonian records on slabs of clay to the birth of bookkeeping in the 15th century and to the modern computerized programs, the evolution of infrastructure has been an important game-shifting factor. The gradual financialization of the economy that has taken place during the last 40 years has made the process of recording financial transactions, and mainly payments, an important and fundamental process to the financial system. To date, the payments infrastructure is mainly built and used by the markets and banks. As discussed in Section 1.2, blockchain technology questions this paradigm by allowing transactions/payments to occur without the need of financial inter-mediation. In the new era of encrypted finance, transactions can be recorded using the blockchain technology without the existence of a financial middleman. Chapter 2 briefly introduces how blockchain works and discusses the main recent advancements of this technology.

 1.3.2 The traded assets

Once there is trust that the infrastructure works well in recording transactions, a new system may appear that allows this same infrastructure to be used for multiple other purposes. For example, what if a new asset is created, based on this new technology, that can transfer value? And behold the cryptocurrencies. What if the technology can be developed in something like a self-operating computer program that automatically executes when specific conditions are met (smart contracts) that would allow to broaden the applications of the blockchain technology, from being only a peer-to-peer electronic cash system? And behold the Ethereum platform. What if there are ways to avoid the extreme value fluctuations that cryptocurrencies have to create a currency that respects the fundamental principle of being relatively stable to be accepted as a means of payment? And behold “stablecoins”. These are just some broad examples of the numerous applications that the blockchain technology allows.

The problem with these assets is that they differ in some fundamental principles when compared to the well-known, traditional financial assets. For example, if we compare shares with cryptocurrencies or with crypto tokens, a fundamental difference is that most cryptocurrencies do not carry company ownership rights. Another difficulty of these traded assets is that the already thousands of crypto-currencies that currently exist differ inherently in their functions and in what they offer. For example, we know that the premium segment of the Main Market of the London Stock Exchange trades only equity shares and we understand what the term “shares” means. On the other hand, Binance, one of the biggest global cryptocurrency exchanges to date, allows trading hundreds of cryptocurrencies where each has different attributes and does different things. And to make things more complicated, the means of trading is not a “fiat” currency (i.e., pounds, dollars, euros, etc.), but another cryptocurrency; for example, if Bob wants to buy “Steem” cryptocurrency he would first need to exchange his fiat currency (pounds, dollars, euros, etc.) with bitcoins, and then exchange his bitcoins with Steem.

To sum up, there are brand new traded assets in the new encrypted finance world, with fundamental differences from the traditional financial assets (i.e., stocks, bonds, derivatives, etc.). These new assets are traded in global markets, and the main means of trading is not a fiat currency but other cryptocurrencies (such as bitcoin and Ethereum). Chapter 3 introduces the main features of these crypto assets.

1.3.3 “Tokenomics” and valuation

Valuation is the analytical process to determine how much something is worth. There are several approaches in finance to evaluate traditional financial assets, such as technical and fundamental analysis, the comparative ratio analysis, and the discounted cash flow analysis. There are also several models in economics that regard price determination, such as the simple supply and demand model and the economics of utility. Some of these approaches can also be applied to the crypto assets (i.e., supply and demand, technical analysis), but most of the traditional valuation techniques cannot be applied because of the fundamental differences between the crypto and the financial assets. For example, how can we apply fundamental analysis to cryptocurrencies when there are no financial statements to analyze? Cryptocurrencies are not corporations but are rather digital currencies that represent value or assets within a network. Also, the crypto market is still in its infancy, where most projects are still developing, meaning that there is a lack of track record to use.

The fundamental differences between crypto assets and financial assets, the inherent difficulty even to define what cryptocurrencies are, and the lack of track record have resulted in a very blurred picture of how to evaluate crypto assets. In fact, there is no widely accepted valuation technique that can be applied to cryptocurrencies, except perhaps from the techniques used in technical analysis. Researchers are still trying to understand what the main drivers of prices in the crypto market are, but unless the various crypto assets are clearly classified in distinct categories, and unless the projects financed via initial coin offerings (ICOs) develop their final products and services to start creating a track record, we should not expect big steps in the valuation field, as discussed in Chapter 4.

1.3.4 Fundraising

Perhaps the most important function that the financial system offers, at least from an economic perspective, is the allocation of capital. In the traditional system, this is done via issuing new securities in financial markets, such as issuing shares via an initial public offering (IPO) or the subsequent seasoned equity offerings (SEOs), issuing bonds of all kinds (government, corporate, etc.), and providing loans from financial intermediaries. The equivalent of this fundraising process in the crypto market is done via ICOs. Project owners use ICOs to fund their project, via offering “tokens” (conceptually similar to cryptocurrencies, but broader in scope), in exchange for other, main cryptocurrencies (such as bitcoin and Ethereum), which can in turn be exchanged with fiat currencies so that the project can be funded. ICOs resemble IPOs and crowdfunding, but they also have their own features, which are discussed in Chapter 5.

1.3.5 Regulation

The traditional financial sector is one of the heaviest regulated sectors in the economy. Especially in the aftermath of the 2008 Global Financial Crisis, much of the disaster was attributed to the relatively loose regulatory approach, followed by a belief in self-regulation of the financial industry, which proved to be disastrously wrong. In the years that followed, coordinated efforts from international bodies have gradually led to higher global standards in terms of capital adequacy and avoidance of misselling practices to fulfil the two major objectives that regulators should look at: financial stability and consumer protection.

These two core objectives are the starting points of regulators globally when it comes to regulating the crypto market ecosystem. A main difference between the traditional system and the crypto market system is that in the case of the former, financial stability has played a more important role than consumer protection, whereas in the crypto market ecosystem, consumer protection leads a head start. However, within consumer protection, which is the common objective for all regulators, the approaches are very different. Some national authorities have adopted a positive approach toward this new type of financial innovation, whereas others have decided to follow a stricter approach, moving as far as to ban certain functions, such as the ICOs.

The common belief is that regulating the new crypto market ecosystem is not an easy task. The previous subsections discussed the fundamental differences between crypto assets and financial assets, not only between the new crypto market ecosystem and the traditional financial system, but within the crypto market system itself. Some of the core questions that regulators are trying to answer are: Are cryptocurrencies financial assets? Do ICOs resemble traditional fundraising practices? Can cryptocurrencies be used for money laundering and if yes how can this be prevented? Chapter 6 explores the regulatory approaches of the main global jurisdictions, focusing mainly on the ICO issue, since fundraising and capital allocation in general is perhaps the most important function that a financial system offers.