Movies like Forgetting Sarah Marshall sometimes manage to bury deep truths in apparently puerile humor. One scene has the protagonist, played by Jason Siegel, on a Maui beach getting a first-time surfing lesson from a beach bum instructor, played by Paul Rudd.
In seeking to explain that ineffable “edge” that a surfer must find, Rudd explains that one can’t just learn by “method” since, as he puts it, “The less you do, the more you do…” Taking this apparently sage instruction to heart, when asked to demonstrate his technique, Seigel instead lies flat on his long board. Seeing this, the instructor states the less romantic but even more obvious conclusion, “Well … you gotta do more than that!”.
This modern parable expresses well the bind the financial technology ecosystem – the realm of financial technology (“fintech”), decentralized finance (“DeFi”), blockchain, and artificial intelligence (“AI”) – finds itself in, between regulatory inaction on the one hand or micro-management on the other. Recent regulatory actions have illustrated these extremes in the context of blockchain’s evolution. At the end of 2020, the Securities and Exchange Commission (SEC) filed a lawsuit against Ripple (XRP-USD), the San Francisco-based software company, claiming that XRP, the token they use on their cross-border payments network, is a security. While Forbes has dubbed this move the “crypto trial of the century”, it has been assailed by securities law experts as deeply flawed. Others have assessed that the lawsuit is a byproduct of the lack of a clear set of rules. Though we may not have all the details of the Ripple case, this feels like the right diagnosis. If that’s right, then this will feel to Ripple like having the rug pulled out by the SEC after billions of XRP coins were sold over seven years during a period of little clarity. While adding clarity is important, unexpected rule changes are never encouraging to industry and investors. As a result, one must imagine that more than one innovator has looked at the current rulebook for putting more capital at risk in these incredibly promising markets and said, “you gotta do better than that”.
Alternatively, the swing to sudden new regulations can also quash innovation. For example, the Treasury Department’s Financial Crimes Enforcement Network (FinCEN) recently proposed some stark rules to impose a set of know your customer (“KYC”) requirements on cryptocurrency exchanges. While there are surely important goals intended here, the specifics of this proposal and it’s very short time-line for public comment (15 days is like the blink of an eye in Washington) has led leading U.S. exchanges like Coinbase (COINB) to sound the alarm, saying these rules would be so burdensome that they would threaten its existence.
So how shall we find that “edge” these markets need to thrive? One of the lessons I learned as a risk officer at J.P. Morgan (NYSE:JPM) was that the essence of having authority to approve transactions is the responsibility to enable virtuous and well-structured risk taking as efficiently as possible. In other words, a good overseer wants to enable and encourage good risk-taking decisions at the grassroots of any enterprise or market under their scope. Perhaps we should seek to emulate in this respect that jeremiad of old: “I will set my law in their hearts.” Far better to set things up to encourage market participants to do the right thing themselves than the heavy handed alternative. Moreover, when creativity can be unleashed in this way, increasing the size of the economic good for everyone, then the other crucial mandate of regulators (i.e., to prevent and control bad behaviors) becomes much easier.
To remind us what is at stake, as many industry observers have predicted for years, fintech has progressed rapidly. These advancements have been aimed at providing greater and more direct access to financial services for a broader set of people. From the non-finance savvy to young adults entering the market for the first time, this expansion is especially relevant when it comes to investing and payment and transaction services. The underlying and important story is one of innovations that can potentially revolutionize key components of economic activity for the better. Capital raises, payments, and transparency are just a few areas that stand to gain exponentially.
For example, blockchain could be developed and shaped to bring structural efficiencies to the economy. By leveraging decentralized ledger technology (DLT), a host of advantages become evident. The real strengths of DLT are significantly lower costs, higher security for participants, and complete traceability of “things” both digital and real. This transparency is perhaps DLT’s greatest asset. While it might sound Orwellian to some, if it is structured properly, it is does not have to be.
Additionally, cross-border payments and transfers, now slow and expensive, could become rapid and nearly cost-free. As investor Steven Fiorillo has pointed out on these pages, “XRP has real-world utility in the form of payments, allowing cross-border payments in as little as 3-5 seconds.” Furthermore, if countries adopt digital currencies (e.g., Central Bank Digital Currencies, or CBDCs), they could lay the foundation for mass adoption and profound savings in cost and capital. This is one of the many applications that could be developed and brought to market. Fed Chairman Jerome Powell also seems to support that at this stage.
All this sounds great, but achieving it requires slaying one more dragon worth mentioning: finding the way to govern the digital markets of the future can’t rely on simply translating older methods into new forms. Very few readers of this article will have missed recent illustrations of this in the form of the GameStop (NYSE:GME) trading controversy. A few may have missed a similar set of events around Dogecoin (DOGE-USD). In any case, these two stories are eye-catching examples that both traditional equity and next generation fintech markets alike are not keeping pace sufficiently with the way markets of the future are likely to work. This new world has startled some into realizing they need to learn more; and it is apparent that government officials and regulators are now taking much more interest. A recent Congressional hearing on Robinhood, GME, and the meme trading fervor attested to this fact.
To me, one of the most interesting things about the GME mania was that it was a triumph of “game theory” – the power positioning of trading interests – over “reality.” That is to say, the swings in value did not appear to be the epiphenomena of a true debate on GME’s prospects as an enterprise. Traditionally, one point of regulating markets is to allow the tension between buyers and sellers to externalize a debate about the correct value of the thing being traded, in this case GME stock. As a society, we should want market participants focusing on what GME is worth. It appears from the outside that, sadly, few were really asking that question. Whatever view one takes on whether the “shorts” or the “short squeezers” were more justified, the problem appears to be that power, in this case the purchasing power of GME equities, is more fundamental than truth. It is the regulators job, like the eponymous method made famous by Socrates, to keep the marketplace focused on asking the right questions. In these episodes, the question of fundamental value was hardly in the frame.
The future of fintech and innovation can be truly an exciting one as we all re-think the best ways for markets to function and capital to be deployed. The best maxim for regulators and legislators might well be some amalgam of surfer wisdom and Socratic thought. While we must build the right guardrails to protect from fraud, money laundering, and market manipulation, too often the “the less you do, the more you do.” But we must step out anyway, and this begins by asking the right questions focused on transparency, access to data, and workable uniform rules.