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February 18, 2020 · Regulation Fintech Banking

On Financial Regulation

One would be hard pressed to find an industry that is more regulated than Finance. There’s a reason for that too: people like money. And why shouldn’t they? It is the great enabler — with enough of the stuff, you can do just about anything. So it makes sense that where there is a high density of money, there are going to be people that try and abuse systems to get their hands on it. Any way they can.

Which is why regulation came about in the first place. It isn’t something that happened because regulators sat around a mahogany table, sipping on expensive cognac, discussing how to actively stifle innovation and throttle profits. In reality, there is no table big enough to accommodate all the stake holders, there is no cognac (not during business hours at least, although lunch is often pretty good) and the discussion is usually centred around three things:

  1. Law: people shouldn’t break or circumvent it, nor fund either of the two.
  2. Consumers: people shouldn’t take advantage of other unwitting people, especially if the law doesn’t protect them (yet).
  3. Economy: how can it be grown and developed, while ensuring systemic stability.

The fact that regulation often ends up screwing with 2 (hamstringing needed innovations) and 3 (high barriers to market entry) is usually an unintended byproduct of 1 (laws that are no longer relevant).

What must be emphasised is that regulators have a vested interest in a growing economy, which means they have a vested interest in successful businesses, which means that they are most definitely not trying to stifle innovation nor profits. They’re just trying to make sure that innovations are safe and that profits are above board.

So why not just change regulation when it is no longer relevant? Well, my dear friends, it’s a lot more complicated than that. First, regulation is based on law and laws are not easy to change for a reason. Second, because of the first, it is easier to add regulation than it is to change or take it away and that inevitably results in an increase in administration burdens and a need for more resources (that’s fancy talk for tax). Third, all consequences need to be assessed and discussed, usually with existing and potential stakeholders. And lastly, risk needs to be managed; a regulator simply cannot afford to make mistakes.

What has been happening recently, is a move from rules-based to principle-based regulation, specifically to try and accommodate for innovation in the financial industry. Regulators are also trying to leverage technology to reduce the administration burden for themselves, but also the administration costs of the market participants. Lower costs means lower barriers to market entry, and that leads to bigger economic potential.

Unfortunately, there is a catch 22: technology implementations are far easier for rules-based regulation because principle-based regulation requires intelligent discernment.

So what is the way forward?

Iterative improvements. It isn’t feasible to solve all problems straight away, but there are many that can be tackled now, even with principle-based regulation.

Data transfer. A big part of regulation is reporting. And reporting is essentially just a succinct word for “relevant data exchange”. Many banks and regulators still rely on file-based solutions for reports. Not only does this require a lot of work to produce, it also means that the burden is at least partly proportional to the frequency of reports. And that frequency can vary depending on multiple variables, like the needs of regulators, the health of the market participant in question, or the types of transactions.

Moving from file-based reports to an API driven data exchange is an excellent first step. Not only does it reduce the burden of creating the reports, it also ensures that regulators have real time access to the exact data they need, when they need it. Some banks, however, are hesitant about giving regulators carte blanche access to their data and would prefer to batch it, but either way, it reduces the overall burden dramatically.

Data management. Once regulators have data from market participants, technology can go a long way to reducing the burden of processing it. While full automation might be difficult, categorising and storing the data in a user friendly manner could reduce the burden for regulators substantially.

This is a solution that can be as simple as a dashboard with great UX, but can also manifest in better categorised storage and data access, effectively reducing the time required to find relevant data.

Machine Learning. With a little more time and resources, regulators can move into the arena of Artificial Intelligence. For all intents and purposes, this is technology’s answer to principle-based regulation and intelligent discernment.

But it will not be perfect at first and will require time and enough data to improve. It will also require some human involvement in the short to medium term and, initially, it might require even more than now. There is a going to be a teething phase where regulators have to check decisions, and market participants are going to have to deal with the burden of incorrect calls. But many would argue that it is an inevitable solution. One step back, two steps forward, as they say.

Regulation is something that is not going to go anywhere anytime soon, likely never. While society (and the systems comprising it) has evolved dramatically over the last 100 years, humans have arguably not evolved much in the last 200,000. Our behaviour has changed, sure, but that is more a function of societal structures and stories than core drivers; those are still the same. And that means there will always be those that will try and take advantage.