FRAUD: The Common Denominator in Traditional Finance and Web3
The headlines in the past few weeks have been inundated with FTX - the once high-flying cryptocurrency exchange that went from being one of the most lauded upstarts in the industry to being mired in scandal and embroiled in lawsuits. As shocking as this may be for the crypto ecosystem, which has yet to be regulated, one may be surprised to know that in the traditional world, where financial services have been regulated since the Civil War, financial institutions are still constantly facing regulatory concerns and financial crime.
Just this year JP Morgan Chase and UBS were charged upwards of $1M each for not including policies to identify risks for identity theft through customer accounts. Last year, Robinhood, the fractional trading app, had to pay $70 million for outages and misleading customers. Capital One faced one of the biggest penalties last year for violating U.S. anti-money laundering law. They were fined $390M for not having an effective program to guard against money laundering. As for consumers, they reportedly lost more than $5.8 billion to fraud in 2021, a 70% increase over the prior year.
Nonetheless, these issues were identified and addressed because of industry standards of transparency and accountability to ensure regulatory compliance. FTX allegedly caused customers to lose $8 billion, yet lawsuits will be difficult to justify because it must be proven that FTX’s products are applicable under U.S. securities law. Accordingly, the first wave of regulation in the crypto space would certainly be for centralized exchanges such as FTX; meanwhile decentralized systems inherently promote trustless transactions that render external oversight unnecessary.
Despite the enhanced security features, Web3 protocols afford users compared to their predecessors in Web2 technology, fraud continues to proliferate as new sophisticated financial crime schemes arise - making room for innovative solutions from companies such as Chainalysis and Fireblocks. As this area develops further we can expect not only a heightened presence from current competitors but also rising challengers that merge traditional finance principles with web 3 applications.
While we have just begun to scratch the surface of how to ensure crypto market integrity, there is still much to do in traditional financial services, as regulation is constantly evolving due to the changing macro environment, including the proliferation of alternative currency. To keep up with these regulations as well as to manage the rise in fraud, companies are increasingly leveraging RegTech (regulation technology), which is a sub-vertical of Fintech. Accordingly, I think this is an interesting space to explore for investment opportunities.
According to Bloomberg, the global RegTech market is projected to reach $23.6 billion by 2029, growing at a rate of 16.5% from 2022 to 2029. This growth is driven by the increasing number of fraudulent activities and rising customer expectations for more convenient and faster financial transactions.
Sub-Categories of Regtech
There are 5 primary components of RegTech – identity management, compliance, risk management, transaction monitoring, and regulatory reporting. As these components typically leverage interconnected flows of data, technology solutions tend to span across multiple use cases.
Client Identification and Onboarding
Customer identity verification is critical in reducing fraud. Identity management evolved over the past decade with innovative startups like Onfido and Alloy revolutionizing the space by digitizing the identity verification process and automating decisions. Advances in biometrics provided further opportunities for tech-driven solutions to decrease friction throughout customer onboarding processes - leading to more secure authentication methods such as Face ID for accessing mobile accounts or even hand palms for conducting payments at Whole Foods. There is a potential opportunity for another wave of digital identity startups entering into this expanding space by offering even faster or more convenient verification methods such as eliminating passwords, reducing the need for clients to upload documents, or leveraging unique data points to accurately verify identity and quickly onboard customers.
Transaction Monitoring for Fraud and Anti-Money Laundering
Amidst a surge of fraudulent activity, transaction monitoring solutions are quickly becoming essential to protect against criminal behavior. ComplyAdvantage and Unit21 are prime examples of solutions harnessing the power of AI to analyze the flow of funds and recognize any irregularities between transactions. Another example is Plaid’s newest product, Signal, a machine learning risk engine that conducts real-time analysis on ACH returns by using insights collected on Plaid. This product is an expansion of Plaid’s identity verification solution which conducts facial authentication from selfies. Like Plaid, startups can capitalize on this surging demand by leveraging a distinctive technological feature such as proprietary data or advanced rule-based engines that can identify overlooked anomalies in transactions.
Compliance and Risk Management
Today's businesses require in-depth and dynamic compliance solutions that keep up with the ever-changing regulations. As risk and compliance standards vary across industries as well as divisions within organizations, RegTech solutions in this space tend to be verticalized. For example, there are companies like Makersite for supply chain risk management and Complyant for small business tax compliance, that provide tailored structures for staying ahead of new requirements. As more organizations lean into a digital landscape, particularly those in foundational industries and small businesses, I anticipate increased innovation in safety measures that protect growing companies from threats such as data theft while allowing them to thrive within their industry standards.
As technology advances, we can expect to see more solutions for protecting the integrity of both traditional finance and web3. It's exciting to see what new innovations RegTech has to offer. If you are a founder or expert in the space, let me know what you think.
-Kiswana