Author: Peter Merc
Source: Lemur Legal
Blockchain is with no doubt one of the most disruptive technologies of recent times. Tokenization of assets and smart contracts are only some of the possible implications of blockchain technology in business processes and business models. With some successful security token offerings already completed and with many more in the pipeline, tokenization of assets is slowly gaining traction. Regulation will be the biggest obstacle to mass adoption. But what is the reason for as of yet no mass adoption of smart contracts in the fintech business?
Costs of trust
Fintech innovation is striving towards reducing transaction costs between the stakeholders in financial transactions. Smart contracts acting as an escrow are decreasing so-called “costs of trust”, namely monitoring and enforcement costs. With this added value applied to financial transactions, smart contracts are materially improving market efficiency in clearing, settlement, as well as transactions management.
However, smart contracts have one important weakness. Only cryptocurrencies can be deposited into smart contracts as a payment and money transfer method (i.e. it is not possible to use fiat currency in the form of electronic money). It is true that cryptocurrencies are very versatile and have many different forms, including a huge number of so-called stable coins. Nevertheless, cryptocurrencies other than stable coins are not suitable for acting as a payment method due to the huge short-term price fluctuation. There are also some other obstacles why such cryptocurrencies are not suitable for payment transactions, especially when we are talking about micro transactions. One of them is transaction speed, while the second one is transaction price.
Moreover, some publicly known events proved that some fluctuation risks are related even to stable coins, meaning that they are not as stable as previously thought. This includes Tether as a stable coin with the most dominant market cap. What is even more important, however, is that none of the above-mentioned cryptocurrencies are regulated, meaning that none of them qualify as an electronic money under applicable regulation.
So what could be a solution to make smart contracts really useful for the fintech industry and even for insuretech? A bullet-proof solution would obviously be electronic money issued on the blockchain platform, in full legal compliance with the Payment Services Directive 2 (PSD2). The latter means that such electronic money would be issued by regulated financial institutions (electronic money institutions), which would be able to offer cross-border payment services within the European Economic Area (EU + Iceland + Norway + Liechtenstein).
On 9 January 2019, the European Banking Authority (EBA - EU regulator for the banking sector) issued a document entitled “Report with advice for the European Commission on crypto-assets”. In this document, EBA elaborates how and if the existing legal framework for banks, payment institutions and electronic money institutions should also apply to crypto-assets and if so, under what conditions.
The most important message from EBA’s document is that conditionally crypto assets (e.g. cryptocurrency) can qualify as electronic money. This can happen in case a financial instrument (e.g. electronic money) issued with underlying blockchain technologies fulfills all legal criteria for electronic money.
At Fintech Factory, we see this message from EBA as a huge breakthrough for the whole fintech industry. It is becoming clear that at least in the financial industry, which is generally highly regulated, blockchain is going mainstream. We are one major step forward towards a cashless society, with safe, seamless and cheaper instant payments, with a possible smart contracts layer as additional features provided by some innovative payment service providers.