Fintech 🧠 Food - Feb 13th 2022 - Web 3 is new risk, new opportunity. Sequoia leads $450m into Eth L2 Polygon & Fiserv acquires Finxact

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☀️ gm Fintech frens. It seems two things are true at the same time. Everyone is concerned about Crypto regulation, and everyone is trying to build their Web 3 strategy. We're caught in between it will never be, and it always was, which is such an exciting time.

There's such a huge opportunity for us to remake broken things by tinkering with incentives. That theme runs throughout this entire Brainfood. It's time to build.

PS. I'm in the bay area week of 21st Feb if you want to say hi (with a fairly full schedule but first come, first served) 👋

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Weekly Rant 📣

In Web 3, you can see the whole Elephant.

One of the central criticisms of Web 3 and Crypto has been its "anonymity" or pseudonyms. Critics argue that you can't prevent crime or hold individuals and businesses to account if the networks are anonymous. This is one of the most frustrating misconceptions about Web 3 and is a classic example of people applying the wrong logic for the right reasons.

The legacy financial system is incompatible with anonymity.

In finance, we bake in the idea that we always have to "Know your Customer." Meaning a person has to reveal their legal, government-issued identity to interact with the world of financial services. This is the primary way the industry prevents, detects, and reports any wrongdoing. If someone does a bad thing, the financial institution that KYC'd that person shares the identity with law enforcement, who will arrest the wrongdoer for all of their wrongdoing. 

Except it doesn't work in practice.

As I've ranted before, Anti Money-Laundering (AML) policy and rules are wildly ineffective at preventing, detecting, and later prosecuting financial crime. The best research into the topic suggests it is 99% ineffective. 

Imagine having a car that didn't work 99% of the time.

Sometimes useless things are quite funny. Glass nails, stripey paint, GDPR, etc. But AML is important. AML processes and rules are the primary way to prevent horrible things like human trafficking, modern slavery, terrorist financing, illegal arms dealing, or illicit drug dealing. If you care about preventing children from being sold into sex slavery, you should care that AML is broken. 

Quite rightly, then, governments and financial institutions take AML very seriously because this stuff matters. For governments, the answer to the question "how do we prevent terrorist financing" is "we enforce strict AML rules." So the idea that new anonymous technology, group, or person is accumulating wealth in ways that don't fit AML is scary (e.g., Crypto). It would be logical if your only defense were the existing AML processes you would implement those processes. 

Politicians just accept this as if it's our best option, but what if it's not?

In the process, every individual has to hand over personally identifiable information (PII) to every Fintech company and FI they interact with. 

As consumers, we have our identity held by countless organizations, which risk being hacked. When Equifax was hacked, 143 million people had their data exposed. 

So let's recap, the existing process is

• Wildly ineffective

• Relies on sending personal data to lots of 3rd parties

• Subject to massive data breaches

• Has data quality issues

The way we KYC, a person relies on a central actor (e.g., your bank or Neobank) to take your documents and store them if something goes wrong. Each bank or Neobank only sees its customers and their transactions. Each bank or Neobank has to report its transactions to the regulator (especially the suspicious ones), so in theory, the regulator or law enforcement should follow up with wrongdoing. 

But the problem is these records represent one view of the world and often don't always match. Each organization has its ledger, records, and way of identifying customers. So the regulator and law enforcement may receive reports, but the trail quickly runs cold because they lack data, or transactions vanish into the black hold of records that don't match or are of poor quality. 

I'm reminded of the parable of the blind men and the Elephant. The blind men have never come across an elephant before, discovering it by touching various parts. One man touches the tusk and thinks it's a snake; another touches a leg and believes the object is a tree; a third feels the tail and believes it's a rope. This is how we see the financial system today; it's a black hole that we all see bits of. 

New Fintech tools really really help here. Comply Advantage, Sardine AI, Unit 21, Hummingbird et al. bring much better visibility and control into the existing system and ruleset. Reducing fraud and AML at the source with better data is something Fintech has done an incredible job at. But ultimately, the weakness in the system is not the entrepreneurs; it's the assumptions baked into the rules we live by. We also see Fintech companies and incumbents work together to coordinate responses to industry trends and attacks

But can we do better?

Web 3 brings pseudonymity and transparency.

Services like Etherscan or Dune Analytics provide real-time feeds and dashboards to what's happening in these networks. In Crypto, you have eyes and can see the Elephant; but you might not know its name.

Crypto (at the network level) turns the subject of AML on its head completely. In every Crypto network, every transaction is published and is a public record. Every NFT purchase, stablecoin transaction, or trade is published and searchable in real-time. Crypto forensics companies like Chainlysis and Elliptic use this publicly available data to follow activity and transactions across entire networks.

As an example, Chainalysis recently published a report that shows the vast majority of criminal activity in Crypto comes from a tiny number of actors (totaling $8.6bn in 2021, compared to the estimated $2trn in the global financial system). There is absolutely no way to know this in the existing financial system. 

Transparency is a double-edged sword.

But the problem with this transparency is it can be hazardous to individuals and undesirable for businesses if your transactions are connected to you. Think about your last three transactions, the last coffee you bought, the item you paid for on Amazon, car refuel, or groceries purchase. If each of those transactions were a public record, it would be effortless to harass you with spam, ads, or worse, attempt to steal from you or threaten your family. 

This is why not attaching identities to transactions in Crypto is a feature, not a bug. Individuals who have amassed millions become targets for criminals. 

If Crypto was truly anonymous, then we should see unlimited criminality. But because we have a global, transparent, and consistent record, the data speaks for itself. Yes, there are scams, wash trading, and things to be concerned about, but Crypto is an upgrade to financial services, especially if we're thoughtful about implementing new rules.

Pseudonymity isn't anonymity.

The DoJ just announced they seized $3.6bn in stolen Bitcoin, which had been moved through more than 25,000 transactions on different exchanges, mixers and darknet markets to evade law enforcement. But in following the trail of transactions, law enforcement found the Crypto exchanges at which the criminals withdrew their stolen funds, and were able to identify the criminals.

With Crypto, you can watch bad things happening in real-time. You might not know who's doing it, but you can "follow the money." Imagine having a GPS tracking a herd of elephants; you still don't know who they are until they interact with something close enough to tell what's going on. The Elephant might come into a reserve and be identified. In Crypto, the criminal will try and use their illicit funds to do something, like buy a house a car, or move it into a centralized exchange. 

This is how Crypto is regulated today; any centralized actor must identify individuals transacting with them. And that's how the law enforcement folks were able to catch the darknet market operators by watching for interactions with the existing system. 

In Crypto, you're not anonymous; you're pseudonymous. But there's a push for that to end publicly and with regulation.

Why can't we have nice things?

What triggered this rant was Buzzfeed journalists unmasking the founders of the NFT project Bored Ape Yacht Club. The journalists claimed this was in the public interest, arguing that these founders are wealthy, wealth is power, so what they did was like publishing the Forbes rich list. The journalists pointed out that all of the information they published was publicly available, so there was no invasion of privacy.

I think two things can be true at the same time.

1. We should be able to live in a world with privacy and pseudonyms. 

2. We should be able to hold people accountable for wrongdoing. 

But the journalists and several media outlets acknowledge there has been no evidence of wrongdoing by the BAYC founders. 

The thing I can't get past is if there has been no wrongdoing, why do this? While the project's founders are not artists themselves, they have built a brand that has become widely known and spurred a wave of innovation in branding. "unknown founders" mystique adds value to the project, its investors, and the wider community. 

For me, this is a sad case of doing it for the clicks. Those clicks and ad-revenue fund a journalist's salary that are nowhere near what the NFT project founders could make. Those journalists could also potentially make more themselves as an independent writer. (So there's a question about incentives here that has two sides to it. Some will mourn the passing of journalism as a profession, others, the rise of journalism for clicks).

What has any of this got to do with Fintech or AML?

Now we have regulation coming for Web 3 that's taking away nice things.

Nobody can see your transactions in Crypto unless you're registered with a centralized exchange or Fintech who's helping you access that network. If you use a software wallet (like Metamask or Rainbow) that is non-custodial, those transactions are yours. They're genuinely private, like cash in a leather wallet until you take them to the bank. If you wanted to take that cash to the bank, the bank would first want to identify you to make sure the cash isn’t stolen, etc.

But in the US and Europe, regulators want non-custodial wallets to perform KYC too. The logic being if Crypto becomes mainstream and displaces the existing system, we need a way to identify wrongdoers. It reminds me of asking a leather wallet manufacturer to identify everyone who uses the wallet and where they go. Not only is it impractical, but it also destroys a lot of the value of Crypto and creates a privacy and data nightmare. How is KYC’ing every Crypto wallet even compatible with Europe’s right to be forgotten? 🤦‍♂️

Crypto presents us with a global rail for commerce that's interoperable across countries, regulators, companies, and people. Each country and jurisdiction will want to impose its rules on Crypto, and it can, but the right starting point isn't what we always did. The right starting point is to lean into what's new.

What would be better?

Old laws never die. But we get to be thoughtful about new laws. We need to regulate the activity, not the rail or the software.

We need to do two things

1. Have a much more sophisticated on-off ramp

2. Have an elegant way to make Web 3 backward compatible with KYC.

The on-off ramp is critical. Companies that operate with a leg in Crypto and a leg in the "real world" are essential to manage and prevent risk. But these companies can't individually take responsibility for the entirety of Crypto (as the EU is currently proposing). Imagine every internet service provider taking responsibility for the entire internet? But Crypto on-off ramps know who their customers are and can make sure those customers' source of funds look as clean as possible before off-ramping into Fiat or spending those funds.

1. The more sophisticated on-off ramp.

TradFi and DeFi are like parallel universes. Each one has its own risks that need to be understood and managed.

I imagine the two worlds side by side, TradFi with all of its risks and DeFi with its risks. Not only does every company now need to understand both of these worlds, but they also have to manage the fraudsters who arbitrage and find gaps between TradFi and DeFi.

As every Fintech becomes a Crypto company, the ability to manage risk in these two parallel universes is something everyone will face. 

TradFi and DeFi risk universes look something like this

(Yes, as you can tell, I’m an artiste)

If you’re used to TradFi there’s a whole new skill set to rapidly learn to move into Crypto. Also if you’re straddling DeFi and Crypto, now you need to understand how attackers arbitrage those two worlds.

The learning Fintech companies who want to step into Web 3 have to do is significant. This new world is coming fast, but there are solutions; people understand both worlds and how they interact (e.g., Sardine AI, who just raised their Series A led by a16z 👏).

2. Managing Web 3 Wallets elegantly.

Web 3 wallets that are non-custodial, like your leather wallet, present a different challenge. But perhaps we can do more too. We can end in a world where it's possible to know and identify a Web 3 wallet without exposing that person as they transact in Crypto. What if we could store a non-transferable NFT in a wallet that tells any regulated actor that this wallet has been KYC'd (and who by) but didn't reveal the identity? That's what Burrata is building, and I love the simplicity of it.

If a wallet has an NFT, each jurisdiction could see what rules are followed by the issuer of that NFT and, therefore, feel comfortable interacting with that wallet. They could see every transaction ever connected to that wallet and risk score the likely source of funds.

Maybe we can have nice things.

With a sophisticated on-off ramp, and elegant backward compatibility with TradFi we don't break the potential for a future global, inclusive, efficient, and fair financial system.

We might also have a more private world that prevents hacks and allows us to see the whole Elephant.

And that would be a nice thing.

ST.

4 Fintech Companies 💸

1. Gelt - Web 3 DeFi savings for normies

• Gelt is a non-custodial DeFi wallet that allows users to deposit up to $25,000 for free and earn interest in real-time. Gelt acquires US Dollars from your bank, converts to digital (stablecoin) dollars (e.g., USDC), and deposits those stablecoin dollars into a DeFi protocol called mStable. 

• 🤔 Countless centralized apps offer a similar experience to a consumer (e.g., BlockFi, Juno, Eco), but what Gelt is doing is different. Custodial wallets take your funds and manage them for you. Gelt is purely pass-through and has connected DeFi services that already existed. Gelt is a user experience but not an intermediary in a classic sense. The KYC of dollar in / dollar out is handled by the payments company Wyre. I expect we'll see more like this in time that takes advantage of the wide range of DeFi protocols with a better UX. 

2. Silvr - Revenue-based Finance in Europe

• Silvr provides non-dilutive capital to marketplaces, e-commerce businesses, and SaaS platforms. By connecting existing tools (such as accounting and payments), customers can receive financing in 24 hours to help drive more sales. Silvr also offers a debit card to allow users to finance their opex from future revenue. 

• 🤔 There are now several revenue-based finance providers in Europe (not least Pipe.com itself launching in the UK), following Uncapped and Vitt with big valuations and investor mind share. There's still an adage that tech is a winner take all category, and power laws play out, and I agree, but I also see these businesses specialize in different areas and market segments. I suspect we see either consolidation or M&A later in several years, but not by the banks. The banks will find this financing too scary and new to touch for a good while because, in theory, the APR % of these loans is unlimited. How do you explain that to a regulator? (Yes, I know there are good ways, but that argument in a bank would be a nightmare, trust me).

3. Infina - Robinhood for Vietnam

• Infina allows users to invest in stocks or funds, including fractional investments meaning users on a low income can begin to build an investment portfolio. Infina also supports real estate investment and has a lottery/rewards mechanic where users can win a random number of shares.

• 🤔 The focus here is probably more Public.com for Vietnam than Robinhood since they're avoiding Crypto and high-risk options products. The addition of lottery / randomized rewards is also a neat cultural addition and one we haven't seen much of in the west. (I know Freetrade in the UK does free shares for referrals, but not the lottery model). 

4. Pluto - Ramp for the Middle East 

• Pluto is an SMB expense management platform with unlimited cards, cash management, and automated receipt capture. Pluto also offers all of the virtual card restrictions and single-use cards you'd expect in this category. 

• 🤔 There's real momentum in Fintech for the Middle East, but there's some essential market nuance. Unlike the US or Europe, where there's an ecosystem of developed APIs and partner banks, the MENA region's incumbents are not as advanced. Pluto's investment from Ramp is interesting too. Pluto's execution has that Ramp feel to it (no, really, check their website). Having used many European expense cards, Ramp is just better in the details. The amount of effort that makes receipt capture and reconciliation just work is astonishing and a joy for the user. Pluto has that feel, and that's an excellent sign.

Things to know 👀

Sequoia leads $450m in Eth scaling network Polygon.

• Polygon the Layer 2 Ethereum scaling solution, has raised at a $13bn valuation from major investors like Sequoia, Tiger, and Softbank. This is the first time these later-stage investors are making a bet on an Eth scaling solution. Polygon enables faster and cheaper transactions for Web 3 wallets and use cases like NFT trading or DeFi trading.

• 🤔 Everyone entering Crypto and buying their first NFT has the shock and horror of (relatively) slow transactions and high gas fees. It costs anywhere between $25 to $100 to buy an NFT (depending on the day and transaction type). A transaction costing $100 when you're sending $300m is cheap, but it's costly when sending $10. L2 scaling solutions reduce fees and make the network more efficient while leaving the underlying Ethereum chain to remain much more secure. 

• 🤔 There are countless L2 scaling solutions; why is Polygon a potential winner? Polygon has two things going for it, mindshare and diversity of scaling approaches. While there are other L2s (Arbitrum, zkSync, Optimism, and x-Dai to name a few), Polygon has low-key become the default option adopted by DeFi and NFT projects (for example, Superfluid, that couldn't run on Ethereum). That traction places Polygon in a potential "category winner" spot. Secondly, Polygon isn't betting on one particular technology but all of them. There are many ways Eth L2's could work, and many projects trying out different approaches. This diversity is good but will likely coalesce under a handful of projects. 

• 🤔 What about alternative L1 chains (e.g., Solana, Avax, and Luna)? Crypto networks are evolving to serve different use cases. The core feature of most alternative L1s initially is that they're still early, and people back them, so the token price grows. But in turn, they're also winning developers by being different, faster, or cheaper. This race isn't over, and we'll likely see several Crypto networks co-exist for a while, but ultimately I buy the Bankless argument that decentralization matters. Ethereum is slow and expensive but robust and consistent. Solana is fast and cheap but has downtime. L2s like Polygon are fast and cheap but can always fall back to Eth. It's also possible L2's evolve for different use cases or even jurisdictions and use cases. Imagine an entire L2 dedicated to payments that are travel rule compliant. 

• 🤔 This is a major valuation for the Indian tech ecosystem and its global impact. India has Tech giants that serve its massive home market, but Polygon, by its nature, is international. This follows the Indian government setting a 30% tax rate for Crypto after years of having tried to ban it. The tide is slowly turning.

2. FiServ to Acquire Finxact

• FiServ, the banking payments and tech giant has acquired cloud-native core banking software provider Finxact. Finxact (founded in 2016) has a marketplace of partnerships with Fintech companies (e.g., Codat, Feedzai, and Anchorage). 

• 🤔 Finxact main client base is regional and smaller banks and FIs who need a modern core. These smaller banks are often easier to win than Tier 1 because they are accessible and make decisions faster. The downside is they usually don't create as much revenue as a single top 20 bank would. There's a power law in banking software sales; one big customer brings massive volume. Instead of hand-to-hand combat with 1000s of smaller banks with less volume. Distribution partners here really help, so someone like Fiserv, who already has a customer base, is a natural partner. Plus, it's not like IPO in this market is great timing.

• 🤔 Compare this with Mambu or Thought Machine, who's gone after growth companies and Tier 1's, respectively. Mambu is behind growth companies like N26 and Oaknorth, Thought Machine Standard Chartered, and (potentially, one day) JPMC. One can bring an enterprise value worth 10 to 100 smaller banks or more. 

• 🤔 So $650m as an acquisition price looks small compared to the current valuation of a Mambu or TM, but it's not apples to apples. Big banks are a long sales cycle, but the folks that have a wedge in; win. And growth customer is a great place to be, too (just look at Marqeta with Square). Also, let's be real here, $650m is a great exit for the founders.

• 🤔 "Core transformation" is hard, especially for a smaller bank. First, as a provider, you have a long sales cycle to get someone to change; then, you have to deal with all of their procurement. Once you get past that, you have to figure out how you will integrate with their legacy tech. The bank throws some tech consultancy charging by the hour at it and doesn't care if the project goes live. The bank has complete confidence that it can switch on new customers and tell the regulator they're doing that. Finxact got that done not once but several times is a huge credit to them. Under Fiserv's wing, they now have existing deals with procurement with many banks and many more wedges in.

• 🤔 Core transformation needs a new model. Launch a new product to a new segment on a new core. Treat the old bank as a partner bank to the new product. Then as the new product expands, gradually fill out the stack underneath it and reduce reliance on the partner bank. Rinse and repeat.

• 🤔 There aren't many cloud-native cores available to buy. Jack Henry bought Banno several years back; Finastra has a few, but where do FIS and Fidelity go from here?

Good Reads 📚

1. Flexport and Supply Chains

• Forbes interviewed the founder of Flexport (the provider of software to buy space in shipping containers). Having started by automating paper forms in the global shipping industry, Flexport examines a customer's entire supply chain and finds ways to automate it. 

• Shipping carries about 11% of global GDP, but post-pandemic supply can't keep up with demand. Goods take one month longer to arrive than in 2019, and the cost of a shipping container has risen from $2000 to $15,000. 87% of US consumers report being impacted by shipping struggles, and half said they'd canceled orders in recent months. 

• When he visited Long Beach harbor, Founder Petersen hit the news and identified steps to ease shipping problems (like stacking containers higher and building a new railhead). The Long Beach mayor sent it to his staff, and staff implemented the ideas rapidly. 

• 🤔 If you want to understand why inflation is up and tech is down, understanding supply chains is a great first step. Supply chain finance is a remote part of Fintech and financial services that very few nerds get exposure to but impact everything. Increases in costs or delays hit the whole economy quickly, just like a blockage in your arteries would. Yes, inflation is also being driven by massive central bank money printing, but that's now ending, and interest rates are rising.

• 🤔 The global supply chain is literally a chain of goods delivered to the last mile, just in time to meet demand. The supply chain is built for cost efficiency, not resilience. In a webinar in March of 2020, Tradeshift's founder compared the supply chain to software engineering from the 1980s. A big interconnected set of processes built for scale and efficiency. Old software engineering worked hard to avoid failure. Modern software engineering is the opposite. Many tiny processes do the same thing or complimentary things, so the cost of failure is reduced. We need a supply chain built for failover, redundancy, and modern software practices for the real world. This will mean re-localizing and changing the cost structures and is a massive opportunity for Fintech companies.

• 🤔 Sometimes, it takes a crisis to fix things, and the global supply chain is carbon-intensive, rewards waste, and incentivizes the lowest cost of production from anywhere in the world. What if we had a supply chain that incentivized sustainability? Playing with incentives is exactly what decentralization and Web 3 are good at. Many have dabbled at global supply chains in Crypto, but nobody has nailed it yet. And fixing global supply chains could be one of the most meaningful things humanity can do. Wen supply chain DAO? 

Tweets of the week 🕊

That's all, folks. 👋

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