Regulations of the New Economy

Major scientific and infrastructural breakthroughs often yield many benefits and improvement, though they may come with danger and harm too. The flame, which many philosophers agree to be one of the most major (and likely one of the first) human discoveries, can provide the means to many needs from heat to the combustion engine. However, if left unattended they can also bring destruction and injury.

From this point of view nothing has really changed with humanity’s development — innovations must be regulated in order to serve the public good and order.

The Organization of Economic Cooperation and Development has outlined in its most influential document (or … plan) — Base Erosion and Profit Shifting, the biggest challenges arising from digitalization of the economy. And indeed, with rapid digitalization of economies not only will entirely new types of businesses emerge, the basic, principal notions of regulation like territoriality of income, residency of business, place of supply, permanent establishment get squeezed and turned upside down to the extent that regulations simply stop working the way they should.

What is true is that the approaches and decisions taken by legislators in the past were taken in a different reality when most cross-border transactions were conducted by and between large corporations and/or organizations. The possibility of a cross-border business to client (an individual, common consumer) supplies were regulated as something out of line, something outstanding that must be so rare, and if it happens, something important enough to address significant government efforts to, let us say, forcibly create a permanent establishment. That was adequate for some time, until the means of infrastructure and, first and foremost, the means of communicating and passing data and information were poorly developed. But now most people on the planet have a smartphone, which is almost 24/7 connected to the Internet. Any consumer can purchase a service (or a digital service) almost invisibly now and does so daily and thus the core principles of regulation are being looked at again.

The drastic change has a key factor — invisible [and cross-border] transactions cannot happen en masse without access to the ability to rapidly effect payments to any point of the world with a single click. My thanks to VISA, Mastercard et al. The development of Internet acquisition was the last drop that shook and shred the bucket of regulations. Then again, cryptocurrencies started to pop up whereto different governments expectedly took different approaches.

But what was in the bucket before it was shred? The EU has been undergoing the Lamfalussy process to reform its financial sector since 2001. The idea behind it was to implement the USA model of financing where stock exchanges dominated as the main means of raising capital. Before it, the financial infrastructure of EU member states was reliant on conventional banking for raising finance. That is, the banks raised deposits from their customers at a rate lower than they would subsequently lend to a borrower [at a higher rate], thus creating a margin and de facto making the finance more expensive for the borrower. The said turn of events has been en masse inexistent in the US where borrowers traditionally borrowed without an intermediary — directly from the ordinary investor (depositor in the EU) through the stock exchange. In the opinion of the Committee of Wise Men chaired by Baron Alexandre Lamfalussy, the bank’s margin [or its absence] was the main reason behind the difference in size of the US and the EU economies. Thus, the EU began the respective policy, started to adopt regulations and take measures aimed at pressing traditional banks into either purely transactional banking business or investment banking, which by then was mostly practiced by Swiss banks. From the point of view of the said committee the current traditional banking system must become inexistent per se and be divided into either pure investment or transactional banking.

Therefore, new laws and regulations began to be implemented to address and use the issues of digitalization of the financial sector. First and foremost, laws (and EU directives) introducing Payment Institutions (or PIs) and Electronic Money Institutions (or EMIs) were adopted.

In their essence, despite some severe fundamental distinctions in legal and factual background, PIs are financial institutions which have the privilege of engaging in transactional banking business — i.e. execute payment instructions on behalf of their clients and respectively effect money transfers/remittances. EMIs can, in addition to what PIs are licensed to do, also maintain clients’ accounts [in electronic money though].

Currently (mostly and in the biggest part), EMI licenses serve as a legal basis for the functioning of so-called “neobanks”. For example, Revolut, Transferwise, Paysera et al. The EMIs and PIs benefit from less regulatory requirements and the respective burden in contrast to ordinary banks, mainly because they are not licensed to provide investments and savings-related services — most importantly EMIs are not allowed to grant interest on deposits i. e. cannot offer savings’ accounts, monies on which might be invested (more commonly — lend) by the financial institution. If an EMI cannot manage/invest funds of its clients there are no risks that these monies will be lost due to the financial institution’s bankruptcy, insolvency, or simple failure by the investor. The funds on current accounts with an EMI are simply there and cannot be ‘touched’ by the EMI. Therefore, they are also not protected by the deposit savings schemes.

So basically, from a customer’s point of view, an EMI is ‘just a bank’ which offers current bank accounts and cannot be asked to help with saving and investments. Yet, an Electronic Money Institution is much more than that. EMIs de facto offer current bank accounts, but the legal mechanics behind them are much more intricate. The truth is that Electronic Money Institutions … issue electronic money i. e. the instruments of saving value nominated in a certain object. In market practice, in order to mimic the current bank accounts offered by ordinary banks, an EMI will offer electronic accounts in their own ‘electronic euros’, one ‘electronic euro’ nominated and equals one ordinary euro which is held on the EMI’s own bank account (the object). Once a customer decides to top up his account in electronic euros, the customer sends ordinary euros to the Electronic Money Institution, which upon receipt issues an equivalent in electronic euros and tops up the account of that customer with them. The customer can pay with the electronic money he has within the EMI (i. e. to the other electronic accounts held with the same EMI), or if the customer decides to transfer the funds elsewhere — to an account set with another financial institution — the customer, upon making the ‘payment instruction’ will, in fact, instruct the EMI to accept back the electronic money from this customer’s account and to send the equivalent in euros to the designated third party financial institution. Therefore, transfers of actual money happen only when the funds are credited with an EMI’s own bank account and are withdrawn from it.

What possibilities do such mechanics offer and what purpose were EMIs created for? The answer is to provide an alternative to ­ordinary money and provide a possibility for the payments to be affected in something of ‘more solid’ value than banknotes. For example, in theory an EMI can issue electronic money nominated in Bitcoin or precious metals, and the clients of the same such EMI will be able to transfer such electronic Bitcoin between each other, without having to actually transfer the Bitcoin from one cryptocurrency wallet to another (which is known to be a lengthy and complicated process) — the Bitcoins will be held on the EMI’s crypto wallet and transfers between electronic accounts will be effected only as an accounting operation within the EMI’s system. Understandably, if a customer decides to return the Bitcoins to his cryptocurrencies’ wallet — the customer will repay the electronic Bitcoins to the EMI and an EMI will provide the cryptocurrencies in return.

There is still a great deal ahead for the modern financial system, which received a considerable push once it began to implement most modern IT technologies and systems. Will ordinary money become a rudiment and its function evolved? Time will show, as the technological and legal frameworks for this are already available.