Financial market regulation has become a hot topic: With the advent of Fintech, startups building their novel business models flock to jurisdictions that offer them the best regulatory environment. Switzerland’s reputation as a crypto-friendly jurisdiction has awarded the country the title “Crypto Nation“ .
The U.S., in turn, while not being as welcoming to crypto businesses as the alpine country, is still the leading place where entrepreneurial minds find the largest pool of venture capital for the pursuit of their innovative ideas.
Other jurisdictions such as the European Union, meanwhile, have, because of their sluggish political situation, remained in regulatory sleep mode when it comes to Fintech.
The end of ‘Swiss banking’
For the last ten years, Switzerland’s banking industry has found itself in the most profound transformations – probably of its history. The change started with the global financial institution UBS nearly closing its doors at Zurich’s luxurious Bahnhofstrasse as a result of a massive depreciation of its subprime assets in 2007 and 2008. The bank’s failure to anticipate the subprime mortgage price decline led to an unprecedented bailout amounting to approximately 66 billion Swiss francs.
In 2013, the oldest Swiss bank dating back to 1741, Bank Wegelin & Co., was forced to discontinue its activities as a result of criminal tax proceedings in the U.S. In addition to individual bank insolvencies and the harsh tax dispute between the U.S. Department of Justice and the Swiss government, the overall conditions for providing banking services were fundamentally reshaped: The G20 leaders and with them FATF and OECD pressured the Swiss government to implement the automatic exchange of information between tax authorities by putting the alpine country on various “blacklists”, thus effectively bringing an end to the era of bank secrecy (at least for foreigners).
The G20 was taking advantage of the momentum brought about by the financial crisis declaring in its 2009 summit communiqué: “Major failures of regulation and supervision, plus reckless and irresponsible risk taking by banks and other financial institutions, created dangerous financial fragilities that contributed significantly to the current crisis. […] Our commitment to fight non-cooperative jurisdictions […] has produced impressive results. We are committed to maintain the momentum in dealing with tax havens, money laundering, proceeds of corruption, terrorist financing, and prudential standards.”
As a result, Switzerland started in 2018 for the first time in its history to exchange information related to about two million financial accounts with more than 90 countries. No wonder that the global financial crisis of 2007-08 has been declared the unofficial end to what had proudly been referred to as “Swiss banking” for more than 80 years. Today, Zurich and Geneva, while still being the two leading places for wealth management services, have lost part of their appeal as financial centers.
It would for this reason not be surprising if the local banking industry had sought to reinvent itself. But this has not been the case. In fact, until this very day, the big players were not very keen to innovate and take the future into their own hands.
Three crucial reasons for this can be found within the banks themselves. Their IT systems have typically been structured at the end of the last century (where systems are more recent, banks invested dozens of millions just to keep up with the latest mainstream technology). The second reason is concerned with legacy bank customers, such as U.S. and French residents owing taxes to the Internal Revenue Service and the Ministre des Finances et des Comptes publics, corrupt politicians robbing their South American citizens, or Russian oligarchs laundering dirty money through Western European banks. Finally, the regulatory burden has continually been raised in the aftermath of the financial crisis. This has most clearly been the case with regard to anti-money laundering regulations. In other words, exploring new shores and thereby taking unpredictable risks are not among the viable options of a typical Swiss bank anymore.
The neologism Fintech has become a buzzword, only being surpassed by the excessive use of the terms “blockchain” and “crypto-something”. It is obvious that Fintech is a much broader concept than the other two comprising areas as diverse as, for example, risk management in banks, crowd-based platforms for raising capital, portfolio strategy tools built on machine learning algorithms as well as cryptocurrency trading engines. In fact, Fintech is yet another term to describe what has been happening for years: The banking industry with its anachronistic paperwork and computer mainframes from the 70’s has long been overdue.
While incremental improvements have certainly been undertaken, incompatible legacy systems have become so onerous for banks that today’s most delicate bank projects are the ones involving the restructuring of existing IT systems.
By contrast, technological progress outside of the banking system has been taking place without showing any signs of a slowdown. Almost ten years ago, for example, Bitcoin’s genesis block was “mined”. The Bitcoin cryptocurrency network has been up and running since then amounting to a market capitalization of more than $300 billion at the peak in December 2017. While Bitcoin’s success may have been unexpected for most of us, its fundamentals are fairly simple: The cryptocurrency wisely combines the long-tested technology of cryptographic proofs with the concept of a decentralized computer network.
Today, despite its scalability problems, bitcoin and other cryptocurrencies have shown the world that cross-border payment transactions can happen as easily as sending an email, and that secure asset custody does not depend on traditional institutions any longer but can be done in the palm of your hand. Undoubtedly, the shift from an Internet as a “mere” channel of communication to an Internet of value has been initiated with the emergence of blockchain technology.
The 2014-Bitcoin report
The development of blockchain businesses in Switzerland really gained traction in June 2014 when the people around the mastermind Vitalik Buterin were looking for a place to set up a foundation to further the development of their cryptocurrency and smart contract protocol called Ethereum. They needed to rely on a legal structure to carry out what later became a rather dubious way of raising capital, the so-called “initial coin offering” (ICO). They found a small town in central Switzerland, Zug, which is now the domicile of more than 2’000 Fintech companies and thus known as “Crypto Valley”. Since then, this new part of the Swiss financial industry has grown enormously attracting more and more entrepreneurs, venture capitalists, IT pundits, attorneys, tax professionals, accountants, and, of course, regulators.
The Swiss regulator first got interested in the topic as members of the parliament asked the Federal Council to publish a report on the legal implications of being involved with Bitcoin. The Federal Council’s report of 2014 clarified that cryptocurrency can be embedded into the existing legal framework. The report also classified bitcoins as a lawful asset, stating that there are no provisions prohibiting private parties to voluntarily use the cryptocurrency.
The 2014-report being a big relief for the still emergent crypto-industry allowed it to grow further (and probably also faster). What followed was an extensive public debate of the question whether coin holders may have property rights with regard to digital assets since Swiss property law technically restricts ownership to physical objects. In fact, blockchains perfectly replicate the economic theory of property rights: Blockchain-based assets are excludable and rival; public-key cryptography allows for the clear allocation of digital assets to their owners. In other words, unlike data stored in one of Facebook’s data centers, the data underlying a bitcoin transaction cannot be copied and transferred to third parties while retaining possession of them at the same time. Another hot topic under Swiss law is concerned with the transfer of tokenized assets, such as a stock or a legal claim. The main problem here arises from the statutory requirement that the transfer of legal rights (“assignment”) must be carried out in written form. It is highly likely that the legislator will amend certain parts of the Code of Obligations in order to take into account new ways of transferring ownership of digital assets, such as signing a transaction with the private key that is stored in a smartphone wallet.
The first wave of Fintech “deregulation” took place in 2017, particularly covering crowdfunding platforms that bring together borrowers and lenders. In addition, the Swiss regulator introduced a sandbox regime for companies allowing them to accept public deposits as high as 1 million Swiss francs without any regulation or supervision. A new banking license “light” currently under way aims to reduce the amount of banking regulation for Fintech companies seeking to obtain a regular banking license. Such companies shall be permitted to accept public deposits of up to 100 million Swiss francs, essentially enabling them to offer the whole range of crypto-services, such as storage, brokerage and trading.
The rise of the ‘Crypto Valley’
The good thing about Switzerland’s regulatory environment is that it is fairly decentralized. While this is not true for financial market regulation and supervision, which is spearheaded by the Swiss Financial Market Supervisory Authority (FINMA), it is an accurate description of fiscal and tax matters. In short, Swiss cantons as well as municipalities compete against each other for individuals and corporations. The Canton of Zug is the perfect embodiment of this crucial policy: It has attracted international companies looking for competitive tax environments for more than two decades. So, Switzerland’s political system of federalism has perfectly suited the underlying paradigm of blockchain technology.
Since the Canton of Zug was the first choice for most foreign blockchain companies moving to Switzerland, the City of Zug started accepting bitcoin and other cryptocurrencies as a payment for their government services. This obviously made the headline of major publications around the world. It was then simple but smart marketing to rebrand the area, which had previously been known for its commodity industry, as “Crypto Valley”.
While in particular the U.S. Securities and Exchange Commission has put most blockchain-issued tokens into the “securities” bucket, thus effectively bringing them under its jurisdiction, FINMA advocated a more industry-friendly approach by dividing crypto-assets into three groups in February 2018:
- Payment tokens, such as bitcoin or ethereum, do not convey any legal rights to their holders. They are solely used as a means of exchange. Such tokens are typically not subject to prudential supervision but still fall within the scope of anti-money laundering regulation.
- Utility tokens are basically contractual rights to certain services, similar to digital keys enabling access to a specific piece of software.
- Asset tokens comprise all tokens representing rights that have traditionally been traded on financial markets, such as stocks, bonds, and derivative contracts, as well as any other claim to “something” that does not qualify as a utility token.
While FINMA’s division intro three token classes allows for more pronounced regulation and supervision, it is also more complicated than the U.S. approach. However, the current main problem of blockchain companies is not how FINMA but banks treat them when applying for a corporate bank account. However, in September 2018, the Swiss Bankers Association standardized the opening process by publishing non-binding guidelines for their member banks.
The emergence of Swiss Banking 2.0?
Being fully aware that Switzerland lost its fight for the protection of financial privacy, it is the legislator’s stated goal to encourage the development of blockchain technology, in particular with regard to asset tokenization. In the meantime, former high-level bankers have joined start-ups that seek to obtain an approval from FINMA as “crypto-banks”. Unlike the Principality of Liechtenstein with its separate “Blockchain Act”, Switzerland will likely not go for a completely new set of regulations but will try to “deregulate” existing laws by taking into account the ways of doing business in the age of FinTech.