How Blockchain Technology Can Mitigate the Risk of Fintech Fraud

Fraud is a pervasive issue that plagues the financial industry, and fintech startups are no exception. From identity theft and payment fraud to Ponzi schemes and, more recently, blockchain technology-related cases such as cryptocurrencies or security tokens scams, the fintech sector faces a multitude of threats. In recent years, fraudulent behavior paired with weak and hazardous practices involving fintech companies like FTX and BitConnect have underscored the need for robust solutions to combat fraudulent activities within the industry. This article explores how blockchain technology can effectively mitigate the risk of fraud linked to security tokens and traditional false custody records, with a specific focus on a real case study on Moniflo, a fintech startup based in Luxembourg.

Within the regulated spectrum of financial services, blockchain technology has introduced both promising innovations and unique security challenges, particularly concerning security tokens. These tokens represent ownership of real-world assets (i.e., financial securities that are subject to stringent regulatory oversight). Yet, instances of fraud within this domain have not been entirely eradicated. Security token fraud, unlike some of its unregulated counterparts, operates within the boundaries of established financial regulations. Fraudsters may attempt to issue counterfeit security tokens, misrepresent the underlying assets or engage in deceptive practices to attract unsuspecting investors. The regulated nature of this space implies that fraudulent activities could have significant legal and financial consequences for both issuers and investors.

Despite the robust regulatory framework, maintaining vigilance is crucial in this evolving landscape. Security token offerings must adhere to compliance standards, including know-your-customer (KYC) and anti-money laundering (AML) procedures, to ensure the legitimacy of investors and the integrity of the assets being tokenized. Moreover, regulatory bodies are actively enhancing their oversight and enforcement mechanisms to combat security token fraud and foster trust within the regulated fintech sector.

Blockchain technology has gained prominence mainly due to its association with cryptocurrencies like Bitcoin. However, it offers much more than just digital currencies. Blockchain is a distributed ledger technology that can enhance transparency, security and trust in various industries, including the financial sector. One common misconception is that blockchain technology is solely associated with cryptocurrency investments. While it's true that cryptocurrencies often leverage blockchain, the technology itself has far-reaching applications beyond cryptocurrencies. Blockchain can be used as a powerful market infrastructure to record and verify various types of transactions, including legally binding ownership records of financial securities, supply chain management and identity verification.

Moniflo's innovative approach

Moniflo aspired to innovate the investment landscape by providing direct access to mutual funds for retail investors. The fintech startup created a platform where financial growth meets sustainability and can be accessed by any individual, regardless of their background or expertise. What set Moniflo apart was its decision to leverage blockchain technology for the custody of financial assets, particularly for UCITS (Undertakings for Collective Investment in Transferable Securities), regulated mutual funds in the European Union.             

Considering the risks and challenges, Moniflo recognized the imperative to not only address its internal vulnerabilities to fraud and errors but also to build trust within the broader financial ecosystem. This encompassed establishing robust internal controls to safeguard against fraudulent activities, ensuring regulatory compliance and enhancing transparency. By doing so, Moniflo aimed to gain the confidence of regulatory authorities and provide a reliable and secure platform for customers who had fallen victim to deceitful players in the industry.Moniflo adopted a hybrid approach due to regulatory constraints and the evolving nature of blockchain technology. While the actual subscription and redemption transactions are settled off-chain, Moniflo tokenizes the units and records the ownership of UCITS on the Stellar blockchain. This hybrid system allowed them to comply with existing regulations while harnessing the benefits of blockchain.

Addressing risks of fraud and error while navigating regulatory landscapes

As Moniflo made efforts to secure its investment firm license in Europe, one of the company’s main concerns was to enhance the guarantee to investors that assets exist. By doing so, they could minimize the risk of fraud related to fraudulent attempts to prove ownership of financial assets. They aimed to set up strong internal safeguards and enhance the security of their custody system to prevent any problems like those seen with FTX or Bernie Madoff. (Exchanges, in the FTX aftermath, have published their wallet addresses; they call it proof of reserves. This has been criticized because it shows how much crypto you own but not your liabilities. Similarly, Bernie Madoff was able to manipulate custody records and statements to investors over the years without raising any doubts.) To avoid these risks, Moniflo went one step further in designing a tokenization process, which makes it quasi-impossible to fake ownership records. All the holdings recorded in the public Stellar blockchain infrastructure are prior to minting (recording), independently checked and are double signed with the actual custodian who settles the underlying assets and keeps them in custody.

In the financial landscape, where trust and security are of utmost importance, the significance of automated internal controls cannot be overstated. These controls serve as a robust defense against fraudulent activities and underscore the importance of automation in ensuring the integrity and security of financial operations. While the classical approach of organizing custody records along the delivery chain consists of silo-recordings established independently by each player, the new process establishes a collaborative interconnection between independent players to agree upfront on the existence and accuracy of the ownership record to be published in the blockchain infrastructure.  Multiparty priori control is strongly enhancing the security of the recording process and will likely replace costly posteriori silo reconciliation processes in the long run. 

To address these concerns, Moniflo engaged with its custodian, IFSAM, and with Fireblocks to adopt a co-signature mechanism by using a Multi-Party Computation (MPC) protocol. MPC is a cryptographic protocol used in blockchain and other fields of computer science that allows multiple parties to jointly compute a function over their inputs—while keeping those inputs private. In the context of blockchain, MPC can be used to enable secure and private computations of data stored on the blockchain without revealing the raw data to any party involved in the computation. In addition to privacy use cases such as decentralized finance (DeFi) applications and smart contracts, MPC solves the issues of single point of failure, distribution of control and business continuity.

This innovative approach requires two independent parties to sign off on any record created on the blockchain before minting or burning could occur. By using this mechanism, Moniflo established an extra layer of governance, further ensuring that each record created on the blockchain was backed by a real asset, reducing the risk of fraudulent activity.

Moniflo's vision of safe and efficient recordings of proof of ownership consists of all participants in a settlement process agreeing and confirming upfront to the existence and accuracy of a transaction through an MPC Protocol. This agreement produces the  unique golden record legally binding all of them in a single process: the investor, the issuer and the custodian.

This case study highlights how blockchain technology can offer robust solutions to mitigate fraud risks, regardless of a company's size or the regulatory framework in which it operates. Notably, this solution was recognized by the regulator, culminating in Moniflo obtaining its investment firm license and becoming one of the pioneering companies to offer digital custody for retail investors on the blockchain.

The future of blockchain in fintech

In conclusion, blockchain technology has the potential to revolutionize the financial industry by mitigating the risk of fraud and enhancing transparency. As blockchain technology continues to evolve, it is plausible that the entire ecosystem will adapt to its capabilities. The journey towards a fully on-chain operation may still require regulatory adjustments, but the potential benefits in terms of fraud prevention and operational efficiency are undeniable.

Blockchain is not just about cryptocurrencies; far away, it is an infrastructure that will transform the way we conduct settlement of financial transactions and ensure the integrity of the financial system.