Blockchain could help bust those shady business shams

Greed is the excessive desire for more than is needed or deserved — not for the greater good but for one’s selfish interest, and at the detriment of others and society at large.

Bad actors with the intention of committing fraud to one’s selfish interest will design an elaborated scheme to have full opacity within the organization.

In private companies, full internal controls are very often not in place which might be due to the nature of the industry where the company needs to be nimble.

This gives rise to opportunities for bad actors to plot fraudulent schemes at the expense of the company.

As actions are not verified, third parties and information are not readily available due to the nature of the system, where only decision makers hold all the information.

This creates an obvious point of failure, with severe information gaps between employees of an organization, resulting in the lack of transparency, therefore, allowing fraudulent activities occurring.

The agency problem is the fundamental cause of fraud

The agency problem is a conflict of interest inherent in any relationship where one party is expected to act in another’s best interests.

In corporate finance, the agency problem usually refers to a conflict of interest between a company’s management and the company’s stockholders.

Information Asymmetry is often held as the cause of many agency problems. The most famous such study is Akerlof’s “Market for Lemons”.

How blockchain can eliminate agency problems?

Blockchain uses algorithmic governance to reach consensus — creating valid blocks.

Its governance is formal and based on objective rules that nodes agree upon.

This completely removes the need for a third party to ensure governance/trust on a transaction/activity, instead governance/trust is being implemented across a transparent network that is not centrally owned by any individual or entity and accessible to all.

This basic characteristic of blockchain eliminates an age-old issue (Agency Problem).

Every transaction/activity that’s taken place is recorded onchain and this greatly reduces any information asymmetry that various stakeholders may have among themselves

This then creates a trusted network which is run by consensus, and therefore benefitting all stakeholders.

Information on the blockchain

Blockchain technology democratised data like never before, giving the public access to data that was once unavailable due to services that we run centrally or by government institutions that horde massive amounts of data for competitive advantage.

Accessing onchain data for blockchain gives complete granular information on an economy that gives us new insights into economic activity.

This not only empowers every stakeholder to make better decisions based on information that once eluded them, but also allows economists and researchers to make new breakthroughs with onchain data.

Historically, white-collar law enforcers can never eliminate fraudulent activities completely due to the information gap that exists between the fraudsters and other stakeholders — employees, investors/shareholders and creditors.

How fraud is committed — based on a personal experience

It largely involves playing on their fear of missing out on a good investment.

Usually, a charismatic individual like the CEO or senior manager will be pitching a “too-good-to-be-true” investment opportunity (eg. investing in a huge potential startup with exceptional technology at a pretty low valuation, while emphasizing on the potential of a billion dollar exit opportunity).

This would greatly tempt prospective investors to want to be part of the company. The company might even name drop some prominent investors or individuals who have invested in the company or have been involved previously.

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This adds credibility to the fraudulent company who is raising funds while hiring employees to “make up the numbers” and portray a functioning company all while misleading employees with fake information.

These actions seemingly manipulate them to either defend the scam that the company is building upon or to trigger behaviours that play into the story that the fraudster is narrating.

Very often in such settings, employees do not have the full picture of the scam as information is only released on a need to know basis, resulting in employees performing very specialised tasks and worked in silos.

The fraudster would also create distrusts amongst teams/employees thereby limiting the flow and exchange of information.

This becomes a vicious cycle where employees act with very limited information in a distrustful environment and become less willing to share information, which ultimately benefits the fraudsters where their lies will go unnoticed.

While the fraudster continues to raise funds from external investors, investors with limited information to make an assessment of the company would rely on their team to evaluate the investment opportunity.

While this team engages with the company employees to better understand the business, employees having only limited information (and being misinformed) would rely on inaccurate information or incomplete information to the investors, thereby misleading them unintentionally.

Investors are then led to make an investment in the fraudulent company with no substantial business operations, indirectly funding the fraudster’s grand scheme of things.

Through the use of round tripping techniques, the company artificially inflates its revenue to justify a larger valuation to new investors, thereby allowing them to raise an even large round of financing.

To further illustrate the mechanics of fraud, John Carreyrou wrote an exceptionally accurate account on Theranos and several of its fraudulent techniques described in the book were seen in real cases across the startup ecosystem.

A more recent case which illustrates a common fraudulent technique was described in Financial Times reporting of Wirecard Singapore’s scandal.

As eloquently reported by FT’s editor: “Mr Kurniawan then sketched out a practice known as “round-tripping”: a lump of money would leave the bank Wirecard owns in Germany, show its face on the balance sheet of a dormant subsidiary in Hong Kong, depart to sit momentarily in the books of an external “customer”, then travel back to Wirecard in India, where it would look to local auditors like legitimate business revenue. “

A whistleblower of the Wirecard scandal sums up the whole issue succinctly: “If a payments company can do this, how can you have trust in the system?”

The value of decentralising information

Trust built upon a centralised entity would leverage its position on other stakeholders, thereby creating a principal and agency problem where interests are slightly misaligned, where other stakeholders are held hostage to the actions of the centralised entity.

However, the game changes when blockchain technology was invented — allowing digital information to be distributed but not copied.

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This essentially removes information asymmetry between stakeholders. Investors, employees, creditors can then request for information to be published onchain and be verified by various stakeholders thereby achieving a collective consensus.

The credibility of information achieved through decentralisation gives stakeholders the confidence to rely on them for important decisions, as information onchain cannot be changed and are verified by more than 1 party.

Companies give investors dataroom access when they consider an investment, however, companies don’t typically give recruits dataroom access when they consider joining a company.

Both invest their time, reputation, and earning potential into the company yet the information is not disseminated equally.

Information is key to sound judgment and accessibility to information prevents collusion and fraudulent activities.

Therefore, blockchain technology could solve this problem due to its fundamental design as previously mentioned.

Information held on a blockchain exists as a shared — and continually reconciled — database.

The blockchain database isn’t stored in any single location, meaning the records it keeps are truly public and easily verifiable.

In other words, no centralised version of this information exists for bad actors to manipulate.

For centuries, mankind has tried numerous ways to prevent bad actors from acting in their own interest, and have tried implementing regulation, internal controls, strong corporate governance and yet — fraud still exist.

Blockchain presents itself as a glimmer of hope where mankind can finally take a significant step towards eliminating fraud within society.

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