Switzerland is currently witnessing an incredible wave of innovation in respect to crypto assets, with cantons like Zug leading the charge. This innovation is touching all aspects of business, with think tanks, regulators, law firms, incubation platforms, as well as hedge fund managers, all looking closely at how the underlying blockchain technology could lead to the digital transformation of global business.
As such, the following report will garner the views of a variety of Swiss-based actors on how they see the landscape evolving.
As reported by PwC, four of the largest initial coin offerings (ICOs) – which entrepreneurial start-ups use to raise capital by selling tokens – originated out of Switzerland. More importantly, it was home to the very first ICO, Ethereum. This has had a domino effect, attracting myriad blockchain-related start-ups and led some in the media to label Zug “Crypto Valley”.
“The tax authorities in Zug may have been more keen on adopting something novel, although I doubt it,” comments Fedor Poskriakov, Partner, Lenz & Staehelin. “After the Ethereum ICO, others followed and replicated the ‘foundation’ model. Last time I checked there were about 40 Swiss foundations, mostly in Zug, with some relationship to developing decentralised applications, blockchain and related protocols.”
Zug has done a good job of marketing itself. The Polytechnic University of Lugano is nearby, and it is home to the Crypto Valley Association. As reported by CTV News1, Zug is currently home to some 200 blockchain companies including the foundation behind Ethereum, the second largest cryptocurrency after bitcoin.
Crypto Valley might have caught the media’s attention but the Swiss Blockchain Association was established in Geneva and there are a wide variety of firms working with cryptocurrencies and blockchain technology beyond Zug.
Discussing the opportunities that lie ahead in crypto assets, Martin Eckert, partner at Swiss law firm MME, was quoted by the Financial Times2 as saying Swiss regulators and politicians want Switzerland to be the place “to make it happen” but “they don’t want to be seen as the ‘wild west’. It is Swiss pragmatism.”
Indeed, even though Johann Schneider-Ammann, the Swiss economics minister, was quoted as saying he wanted Switzerland to become the “Crypto Nation”, this was more a political aspiration than necessarily want Finma, the Swiss regulator, has in mind. It is, as Eckert refers to above, more pragmatic and prudent in its stance. That’s not to deflect the point that Switzerland sees a clear opportunity to evolve, but it goes beyond merely crypto; it sees the potential of digitisation as a whole.
“Where Switzerland now sees a development is with digitalisation of the financial industry more generally, in terms of fund distribution, reporting, client servicing,” says Francois Rayroux, Partner, Lenz & Staehelin: “That is where Switzerland could be at the forefront. Why? Because people here are highly educated, and due to the relatively small size of the country, with respect to reporting it could be relatively straightforward to create common standards compared to the wider European Union.
“Digitalisation, with blockchain as an important tool for transaction settlement and so on…that for me is the future.”
There are a number of initiatives in Switzerland around blockchain. These include a push to put the commercial register on blockchain, there are initiatives for electronic identity adoption; a lot of moving parts which, when taken together, could result in Switzerland becoming the Crypto Nation that Schneider-Ammann references; a country where people will be able to do everything on the blockchain and everything will be traceable and auditable.
“There is some positive appeal for distributed ledger technology implementation in various use cases, but there is a flipside, which people in Switzerland are cautious of, in terms of risks and potential abuses of cryptocurrencies. From that angle, it is not surprising that there are calls now in the EU and internationally to implement regulation around crypto tax evasion,” says Poskriakov.
As blockchains are decentralised, no intermediary is required and therefore it’s more difficult to ensure there is proper reporting to the tax authorities, proper AML reporting, etc.
“You could envisage an evolution that would connect a distributed ledger with an e-identity in a way which would still ensure privacy, whilst providing a reliable traceability record, so as to allow “on chain” AML checks and funds tracing which are impossible to falsify. Imagine combining such a system with a central bank cryptocurrency (CBCC), and you will have an AML resilient currency by design.
“There is still a long way to go, though. In the crypto world, entrepreneurs haven’t been affected by all of the issues that banks and other financial institutions survived through over decades, including multiple financial crises, AML and sanctions compliance, tax avoidance, litigation and regulatory investigations. Fintech startups are typically less sensitive to some of those risks, and are confident they are immune from those. It may well be, but eventually, those two worlds will have to meet,” continues Poskriakov.
The local government of Zug has said that one of the biggest issues is the prevention of AML. Leila Khazaneh is General Counsel and Director at Jabre Capital. On the AML issues, she remarks: “It’s very important and presents specific challenges. As long as you trade Cryptocurrencies through an intermediary, like an exchange, you can fit them in your current AML structures. But the philosophy of Bitcoin was based on eliminating intermediaries. And when it comes to peer-to-peer transactions, the current structures no longer work. It means that as hedge fund managers we need to learn to use new tools, like provenance tools, that analyse a wallet’s blockchain history.”
Provenance tools look at the digital wallet holding the cryptocurrencies to analyse its transaction history, determining whether it has been connected to illegal activity, looking for example for any connections to the Silk Road specifically, or the Dark Net more broadly. Done correctly, with the use of myriad new tools being developed, cryptocurrency trading could become a lot more secure, transparent, and, as Khazaneh hopes, support a more institutional investor base.
“Regarding compliance tools, we’ve found a few companies that have developed a real expertise in this space. Ones we like currently are London-based Coinfirm (a blockchain AML risk and compliance platform), Elliptic (blockchain surveillance) and Chainalysis (blockchain intelligence platform).
“You have to get up the learning curve, which takes time and energy. And you need to adapt your systems to plug in these new tools, which requires resources.
“Custody is one of the main challenges for institutions looking to invest in this area. But I know that a lot of smart companies are working on developing solutions and these will be released throughout 2018. By the end of this year, the challenge will be very different. We are currently looking at a number of solutions, trying to diversify and stay as nimble as possible so we can move to new solutions as they develop. This a rapidly evolving space, so its important to stay flexible,” Khazaneh confirms.
In many respects, the proliferation of Fintech companies has led financial institutions, including hedge fund managers, to decide themselves whether to disrupt or be disrupted.
“We feel that all the intermediaries whose business model is solely based on establishing trust and exchanging value are going to have to change their business model or be disrupted. That applies to intermediaries in all sectors – financial services is just one of them.
“In the same way we believe that all financial organisations should have an AI strategy, soon they will also need to have a blockchain strategy. I think we will see that kick in with the tokenisation of securities, when assets such as bonds, equities, derivatives start to be represented by a digital token. The pace of blockchain innovation is hard to ignore,” says Khazaneh.
The emergence of cryptocurrencies as an alternative monetary asset class was a subject that Derek Queisser, Founder, Qanalytics LLC, began to write about back in 1999; he noticed that a fundamental structural shift was occurring with the digitalisation of the world’s economies.
Qanalytics is a think tank that focuses on new monetary economics, digitalisation and the structural shifts occurring within our economic and financial systems. Private and public sectors are looking at digitalisation and new themes are emerging, which could present tremendous investment opportunities. A think tank approach is important, in Queisser’s view, because it provides a framework which goes beyond traditional frameworks.
“We look at crypto in three dimensions. The most obvious dimension is using coins or tokens for trading either actual value or symbolic value; bitcoin is purely symbolic. Today its value lies mostly in the eyes of the beholder. The second dimension is the decentralised ledger architecture potentially removing trusted intermediaries. That’s where we feel a strong structural theme is emerging. The internet up until recently was all about information replication but today, with blockchain, the double spend challenge is being addressed. That is the unit of value can be transferred from one agent to another without the risk of being replicated and sent to a third agent.”
That transfer of value component is key. Blockchain is essentially a new decentralised trust mechanism. This is giving rise to transactional tools such as smart contracts and could facilitate the emergence of fundamental new business models. Queisser and his team look at the way incumbent business models could be disrupted and what type of new, innovative models could emerge using the blockchain technology.
The third dimension is incentives. Through incentives and earning coins one can shape behaviour. One example of this is governance. It is one of the key challenges for cryptocurrencies and tokens. Any type of currency issued by a government has an implicit obligation, which is to uphold a social contract or governance contract.
By extension, any cryptocurrency or token issued should strengthen the community and should have transparency – otherwise you don’t know who is behind the governance.
“You need flexibility but at some point, governance will be key to sustain trust. That’s why some people have decided to come to Switzerland. It is a bottom-up decentralised democracy. You don’t have one person running the show. Switzerland has made a good start on the path towards making governance more transparent to the benefit of the widest community,” adds Queisser.
The issue of trust in relation to crypto assets is interesting in that it will, by default, require individuals using the blockchain to give up some of their privacy rights.
One area that Queisser is looking at is the concept of permissioned networks. Each person joining a private or semi-private network would need to be verified and confirmed. This could address the trust issue while reducing energy consumption and revolutionise the way business models operate. For example, the use of Digital Credit Notes in the commodities trading sector.
“Most of the cost reduction could be achieved through digitisation of the transactional documentation and processing trades in a permission network. More conceptually, you could say this technology could become a new value transfer protocol – that for me would unleash the most value for everyone,” suggests Queisser.
Swiss banks are involved in a number of blockchain projects to streamline processes and reduce costs, as well as ensure data integrity. And as Poskriakov confirms, there are large players in the commodity trading industry who are joining forces and investing significant amounts of money to develop distributed ledger based solutions and platforms.
“In trade finance for instance, it can take two or three days for a bank to receive an original document, verify signatures, validate genuineness and then release the payment. With distributed ledger technology, this whole process could be reduced to 20 minutes or even less,” suggests Poskriakov.
Antonio Gambardella is Director of FONGIT, a Geneva-based incubator platform, which stands for the Foundation for Technology Innovation Geneva. It is a private non-profit foundation supported by the State of Geneva and the Swiss federal government. Gambardella is quick to confirm that many of the business models being developed by entrepreneurs make sense for blockchain, including those that relate to commodity trading.
“Every year, banks spend millions buying paper for credit letters. There are two blockchain projects in Geneva focusing on this; one within the banking system, the other being a company called CommoChain; this is very interesting in terms of how blockchain could be applied to commodity trading,” says Gambardella.
If one goes to CommoChain’s web page, it points out that from a blockchain innovation perspective, 60 per cent of global trade finance transactions are done in Switzerland. That the company is based in Geneva further demonstrates that the creative fire of crypto innovation burns bright beyond the city limits of Zug.
Gambardella confirms that seven out of 10 entrepreneurs coming to FONGIT are non-Swiss entrepreneurs.
“Since the foundation was born in 1991 we’ve hosted more than 150 start-ups in cleantech, IT, engineering and medtech. Currently, we support more than 60 companies. We host entrepreneurs in more than 5,000 square metres of office space in Geneva. We offer complete back-office support for them, we provide coaching services – we are often the interim CFO or COO of many of our start-ups – and we offer seed financing, providing up to CHF150,000.
“In Geneva, the crypto angle (as it relates to the financial industry) is naturally an important one. We have one project on the platform that is set to become the first, fully regulated trading platform for Swiss-based crypto assets. Switzerland is establishing a very favourable environment and we have a number of companies preparing ICOs,” adds Gambardella.
While Zug has attracted a lot of businesses focusing on the first dimension that Queisser refers to – namely crypto tokens and cryptocurrencies – Geneva is better positioned to capitalise on the second phase of the evolution, with respect to governance and trust. This is where innovation in commodity trading could lead to the establishment of better risk controls – and by extension apply them to the wider financial markets.
One might imagine that those with the greatest leaning towards exploring the investable opportunities on offer within the cryptocurrency space would be quantitative hedge fund managers. Given that there are believed to be more than 1,500 different cryptocurrencies, there’s no shortage of trading opportunities. Much the same argument could be directed towards factor-based systematic fund strategies, with a focus more on building equity exposure in crypto-focused companies.
However, despite the flurry of innovation in all things ‘crypto’, many institutional investors, including pension funds and insurance companies, remain in ‘wait and see’ mode. Some are comparing the speed of blockchain innovation to the dot.com boom that emerged at the end of the last century. As history has shown, many tech companies were grossly overpriced and investors lost fortunes. Those lessons have not been forgotten. And while there will undoubtedly be stellar companies that become the standard bearers of digitalisation, the risks to over-extending one’s exposure are all too familiar.
“I would be worried if they (quantitative hedge funds) were investing in crypto assets right now, on behalf of their investors,” says Jean François Hirschel, the former Head of Marketing and executive board member at Unigestion who has just launched a strategic marketing agency, H-Ideas to advise clients in the asset management arena including hedge funds.
“In two or three years’ time when crypto becomes more mainstream, I would trust those hedge funds who had tested investment ideas and learnt from their mistakes with their own money, not external investor money.”
That being said, Hirschel is optimistic about the role that Switzerland is crafting in the digital asset space. He perceptively points out that the country has a pretty good track record of reinventing itself.
“Everyone thought the introduction of the digital watch would signal the end of the Swiss watch making industry but that proved to be unfounded. And more recently, that the end of banking secrecy would spell disaster for Switzerland. Could crypto assets be to finance what Swatch was to the Swiss watch making industry? No one knows for sure but I’m confident innovation will drive Switzerland’s financial industry to a new, exciting place,” says Hirschel.
Anne-Cathrine Frogg Spadola, co-founder and Managing Partner, Hugo Fund Services, a subsidiary of ACOLIN Holdings, says that crypto assets have become a topic of discussion within the Swiss regulatory landscape, in terms of how to remain at the forefront of the trend. However, like Hirschel, she notes that this hasn’t yet translated into many crypto funds coming to market; although that seems to be starting to change.
“We have only seen a few examples, up until now. That said, we had a very early discussion with a cryptocurrency FoFs, which clearly shows there is enough supply of products globally. There are several crypto funds with Finma waiting for approval for public distribution. It will be interesting to see how Finma will handle them.
“It could be a big opportunity. The Swiss regulator has shown willingness willing to be flexible on everything Fintech in general,” remarks Frogg Spadola.
In order to fully capitalise on digitalisation, Finma is committed to pushing itself outside of its comfort zone, because comfort zones are the “antithesis of innovation”, said Mark Branson, Finma’s Chief Executive Officer, in a speech he delivered in London on 13th March 2018.
He went on to say: “Innovation-friendliness, however, does not mean carelessness. We are as passionately anti-crime as we are pro-innovation. And innovative environments are prone to abuse and even criminal behaviour. The world of the gold-diggers was exciting, occasionally profitable, and lawless. And the miners of cryptocoins could be seen as the gold-diggers of today. It is our duty as a regulator to fight misuse of the financial system and protect investors.
“As an integrated supervisory authority with responsibility for all market participants, their stability and their conduct, we at FINMA are in a unique position to address investor protection, money laundering risks and banking and payment issues out of one hand.”
Finma’s position for many years has been technology neutral and generally speaking, they look at principals rather than prescriptive rules.
For ICOs, there are two ways of looking at what Finma did. The have issued ICO guidelines on how they look at submissions and adopted a relatively straightforward framework, which some people criticised saying they didn’t go far enough. But on balance, what they did was a smart move.
“They didn’t create any new laws or regulations, what they did was explain how they treat ICOs through a purely regulatory prism, giving the market a much needed reliable and stable guidance, so that project promoters can anticipate what requirements apply in which situation.
“Other regulators have issued no guidance and will proceed to so only once someone crosses a red line. That’s not Finma’s approach. They will gradually educate the market and will ask questions to those involved in launching ICOs; it’s a learning curve for Finma and they welcome that. They want to learn, to discuss, to debate and at the end of the day, they will apply the existing regulations in a ‘technology neutral’ manner whilst protecting financial markets and investors. That’s why for me the ICO guidance was a very good marketing move,” argues Poskriakov.
Gambardella believes it is a winning strategy, noting that security token ICOs, in particular, are very consistent with existing securities regulation. He welcomes this and thinks it could foster a new era of fund raising for companies.
“However, ICOs are not a way to seed a company. Rather, they should be used as a way to raise capital for A, B and even C rounds,” warns Gambardella.
In other words, they need to be real ‘bona fide’ companies going down the ICO route, not raw start-ups.
If the ICO does indeed issue security tokens, Switzerland’s regime is very liberal in terms of self-issuance of securities. One might need to produce a prospectus but it doesn’t need to be approved by Finma. Capital markets are very liberal in Switzerland from that perspective.
In five or 10 years’ time, an ICO might very well become the standard funding model for small and medium-sized companies as opposed to trying to do a costly IPO.
For this to happen, further work is needed on the governance and custody issues that are, at present, not robust enough. That Finma has issued ICO guidelines is a positive step, such that to participate in a Swiss ICO, the KYC checks one has to go through are much higher and much more stringent than non-Swiss ICOs.
With so much innovation under way in Zug, Geneva and Zurich, a history of self-regulation and a financial regulator that is throwing its doors open to embrace the digital transformation taking place, there are many reasons to believe that Switzerland could indeed live up to its Crypto Nation moniker. And steer the marketplace towards adopting best practices. n
Sources:
1. https://www.ctvnews.ca/business/switzerland-at-epicentre-of-cryptocurrency-revolution-1.3866304
2. https://www.ft.com/content/c2098ef6-ff84-11e7-9650-9c0ad2d7c5b5
