Are You Serious About Blockchain? Then Start Deploying It First Within Your Company’s Walls.

The market’s collapse

The crash of a stablecoin in May 2022 marked the start of a chain of collapses that brought down several lending platforms, a hedge fund, a leading crypto asset exchange, and a large US-listed crypto mining company in 2022. In January 2023 another crypto asset exchange filed for creditor protection; and in March an American crypto bank ceased its operations. Of all and so far, the filing for bankruptcy protection in the US by the cryptocurrency group FTX has rocked the world of blockchain companies.

FTX grew to become the second-largest cryptocurrency exchange in the world, an empire worth $ 32 billion. The Securities and Exchange Commission (SEC) alleged in a civil complaint that its founder had “orchestrated a years-long fraud” that concealed from investors the diversion of customer funds from FTX to his privately held crypto research hedge fund. In November 2022, concerns about FTX’s financial health and its balance sheet arose. On December 11, 2022 FTX filed for bankruptcy protection.

So, what do we know so far about the reasons?

First, FTX had a complex organisation, with no internal rules and regulation. It was run by a small cadre of executives out of a conjointly shared house in the Bahamas, and ultimately controlled by its founder, Sam Bankman-Fried. Contrary to all blockchain principles, FTX was operated as a centralised platform which additionally was based offshore. It became one of the major exchanges and was closely affiliated with a market maker. Its failure was rooted in a lack of transparency and conflicts of interest. Belonging to one involved Congressman, FTX failure appears to be “the same old-school fraud, just using a new technology”3.

Second, weak accounting practices left a shortage of liquidity to grow unnoticed. The FTX empire included $ 5.2 billion of illiquid venture capital investments. Bankman-Fried blamed mistaken accounting for its collapse. FTX newly appointed chief executive John Ray stated before the Congress that FTX collapsed because of the “absolute concentration of control in the hand of a small group of grossly inexperienced, not-sophisticated individuals”4.

Third, FTX lacked internal controls. The tipping point isn’t FTX per se, it’s the credit risk that its hedge fund was taking. Its founder planned to tell Congress how “internal failures” led the company to unravel. FTX unjustifiably lacked clear rules of separation of functions. Bankman-Fried claimed that FTX did not have a risk management team. He also blamed various failures on FTX’s internal controls5. FTX failed to implement virtually any of the control systems that are necessary for a company entrusted with other people’s money or assets6.

Fourth, FTX lacked an effective audit. FTX’s claims to have audited financial results left numerous questions unanswered, particularly in light of revelations about the complexity of its organisational structure7. It is, therefore, hard to understand how FTX 2021 financial results were audited, given the lack of documentation and the “paperless” character of its bankruptcy8.

All public testimonies stated so far that FTX bankruptcy was unusual in the sense that there was literally no recordkeeping or any other kind of documented evidence. It is unprecedented in terms of lack of documentation. John Ray, the appointed CEO of FTX, testified that the business was an “old-fashioned embezzlement: you take money from customers and use it for your own purposes”9.

Search for good governance

Reflecting on the FTX case, it quickly becomes apparent where the real pain points can be found. There is much evidence which suggests that the causes of the FTX's bankruptcy lie in the lack of orderly management and compliance rules: an overly complex organisational structure, acting in a risky setting, was relying on business processes and systems that were not subject to any internal definitions, regulations or controls. Good governance, as defined and regulated in all currently applicable laws - including ESG regulations, was completely lacking.

The blockchain industry, since its very beginning, has been confronted with scepticism relating to its anticipated vulnerability to serious criminal conduct. Critics focused on issues around anti money laundering. But pertaining to the year 2022, it might be worth mentioning that many of the failures that occurred reflect inadequate corporate governance structures. And it might be worthy of mention that in the case of FTX, it was because transactions were partly logged on the blockchain that they could be found fraudulent (a fact remaining to be proven).

Once again, regulators are feeling the heat of the market and struggling to respond in a coordinated and effective way. Once again, regulation bodies fail to keep up with the sector’s pace of change. What is new this time around is that regulators are seeing themselves confronted with large-scale corporate failures. One of the latest regulations to take on governance issues is the EU’s Markets in Crypto Assets (MiCA) regulation, which agreed text was given final approval by the European Parliament on April 20, 2023. By regulating the main activities related to crypto assets, the tailored crypto asset regime shall ensure a high level of consumer and investor protection and market integrity10. The proposed regulation is also expected to reduce the level of fraud related to crypto assets by imposing requirements to governance (e.g. prevention of money laundering) or operational aspects (e.g. establishment of common rules on supervision and customer protection) on the companies involved. MiCA will cover crypto-assets that are not regulated by existing financial services legislation11.

What’s more, the European Commission started an initiative12 to improve the EU regulatory framework on company law and corporate governance. It would help companies (blockchain-based ones included) focus on long-term sustainable value creation rather than short-term benefits. It aims to better align the interests of companies, shareholders, stakeholders and society.

As FIBREE stressed in past Industry Reports13, in the “ESG” world, the most problematic of the three components is G, Governance, for it is not an outcome in itself but rather an ongoing procedure. Risks emanating from a lack of leadership can cause ambiguous chains of command and execution processes.

Introducing “Smart Roles”

Researchers and developers unanimously praise blockchain for enhancing trust in business. But after the inglorious legacy of 2022 one fundamental issue surged: Can a blockchain-based business itself be trusted at all? A look in research papers shows – at an interval of one year – a changing look at blockchain standards from within the industry. In 2022, non-public and permissioned networks were praised as a solution for avoiding fraudulent memberships for risk-averse companies14. In 2023 organisations were taught to cement their credibility by helping reinvent public blockchains15.

Let's get back to basics. The idea behind a blockchain is bigger than having distributed ledgers which can be used to register transactions.

The underlying concept of blockchain is that:

• it can not only replace middlemen but rather intermediate steps of whole processes
• it is not only about recording transactions but rather saving proofs of evidence
• it can not only establish trust between business partners through immutable records of transactions but rather through strengthening reliability in processes
• it ultimately not only enhances the effectiveness but also the performance of the business – most notably if the blockchain is complemented by other new technologies like Artificial Intelligence, AI.

A blockchain-based business works better the better the underlying processes and actions are reflected on the blockchain. One crucial lesson learned from 2022 is that a blockchain-based business is first and foremost, a business. Like in every business, companies need a clear and assured corporate governance. If governance lacks, weakens, or fails, the underlying blockchain will perform poorly. The better governance issues are determined in a company’s mission and vision, its culture and internal frameworks, the more reliable its governance issues get on the blockchain. This notion applies to the stakeholder-crowded and process-rich real estate business.

As mentioned above, failures which occurred in 2022 were due to management deficiencies. Therefore, rebuilding trust requires a consequent handling of good governance and compliance issues. A solution could be at hand: The development of a business transaction and the underlying decision-making process within an enterprise can themselves be brought to the blockchain. All involved stakeholders can, in this case, check the authenticity, correctness and integrity of an action by tracing its origination. One of the blockchain-based trust use cases, tracking provenance, which covers supply chains (e.g. to verify their adherence to ESG-rules) can be extended to internal enterprise processes. Similar to “smart contracts”, which are used between external partners, “Smart Roles” can be implemented within an enterprise. As part of the enterprise architecture, “smart roles” become verification gates of business actions. A step in the decision-making process can then only be concluded, if and when the manager in charge attests its compliance with the book of rules. A separation between chains of command – that is between the “Do” line and the “Check” line – can materialise, personal responsibility and liability become the drivers of management choices and a conflict of interest is adequately addressed. All details immutably recorded.

Smart Roles within a blockchain-based real estate enterprise as means to prove good governance

All use cases in the real estate business, where blockchain can be put to work, share on the risk side the intrinsic need to comply with regulations, and avoid costly wrong-doings. The chart shows how smart roles can be mapped within the enterprise landscape and assigned to different decision-independent parties in the real estate business.