DATE DOWNLOADED: Wed May 13 06:31:08 2020 SOURCE: Content Downloaded from HeinOnline Citations: Bluebook 20th ed. Douglas W. Arner, Janos Barberis Barberis, J.; Buckey, R. P. (2017). Fintech, regtech, and the reconceptualization of financial regulation. Northwestern Journal of International Law Janos Barberis; Ross P. Buckey, FinTech, RegTech, and the Reconceptualization of Financial Regulation, Northwestern Journal of International Law the substantial input of Dr. Cheng-Yun Tsang, and the research assistance of Jessica Chapman. 371 Northwestern Journal of International Law Ross P. BUCKLEY see also INST. OF INTL FIN., REGTECH IN FINANCIAL SERVICES: TECHNOLOGY SOLUTIONS FOR COMPLIANCE AND REPORTING 5-8 (March 2016). 4 INST. OF INTL FIN., REGTECH: EXPLORING SOLUTIONS FOR REGULATORY CHALLENGES 2 (Oct. 2015).5 See SANTIAGO FERNANDEZ DE LIS, ET AL., REGTECH, THE NEW MAGIC WORD IN FINTECH I (March 2016). 6 Penny Crossman, IBM Buying Promontory Clinches It: Regtech is Real, AMERICAN BANKER (Sept. 29, 2016, 4:42 PM), 373 Northwestern Journal of International Law EY, FINTECH: ARE BANKS RESPONDING APPROPRIATELY? (2015); Andrew Meola, I in 5 European Banks Would Buy FinTech Startups, Bus. INSIDER (July 17, 2016, 11:01 AM), businessinsider /1 -in-5-european-banks-would-buy-fintech-startups-2016-6/?r=AU and then move on to consider the rise and roles of FinTech startups and RegTech. A. Postcrisis Regulation The 2008 crisis and resulting postcrisis financial regulatory reforms have transformed the way in which financial institutions operate, combining to reduce their risk-taking, the spectrum of their operations, and their profitability.25 The mass of new postcrisis regulation has dramatically increased the compliance burden on financial institutions, in addition to the direct cost of regulatory penalties (over $200 billion globally since the crisis).2 6 These changes were the intent of the postcrisis regulatory reform agenda.27 in previous work, we (and many others) have analyzed in great detail the development, implementation, evolution, and effectiveness of postcrisis regulatory reforms and their implications. 28 This new regulatory environment is one of the major drivers leading to the emergence of RegTech; we return to this issue in Part III. B. FinTech With this dramatically altered regulatory, operating, and compliance environment has also come the rapid evolution of technology and its application to finance, namely FinTech. While FinTech as a term has only risen to prominence in the past three years,29 the interaction between 25 For a brief overview of the postcrisis global mandated reforms and the profound changes in global finance over the past 40 years, see Ross P. Buckley, Reconceptualizing the Regulation of Global Finance, 36 OXFORD J. LEGAL STUD. 242 (2016). 26 See Cox, supra note 8. 27 See FINANCIAL STABILITY BOARD, IMPLEMENTATION AND EFFECTS OF THE G20 FINANCIAL REGULATORY REFORMS: REPORT TO THE G20 (Aug. 2016). 28 See BUCKLEY RECONCEPTUALISING GLOBAL FINANCE AND ITS REGULATION (Ross P. Buckley, Emilios Avgouleas Andrew Lo, Moores Law vs. Murphys Law in the Financial System: Whos Winning? (Bank for International Settlement, Working Paper No. 564, May 2016). 31 Arner, Barberis Brian Milligan, The Man Who Invented the Cash Machine, BBC NEWS (June 25, 2007), news.bbc.co.uk/2/hi/business/6230194.stm. 33 SWIFT was founded in the 1970s. SWIFT History, SWIFT, us/history. 34 VISA was launched in 1958. History of Visa: Our Journey, VISA, visa/our business/history-of-visa.html. 3 See PETER ALLSOPP, BRUCE SUMMERS Reuters, Forex Volumes in June Hit Above $5 Trillion a Day, FORTUNE (July 14, 2016), 3 For example, they attempted to reduce risks like Herstatt risk (cross-currency settlement risk). The Long, Dark Shadow of Herstatt, THE ECONOMIST (April 12, 2001), node/574236. 3 For example, the IIF highlights in its RegTech Report that near real-time settlement could be achieved through automation and global consensus on the blockchain. These capabilities could automate compliance aspects in use cases including cross-border payments, syndicated loans, and repo markets. Institute of International Finance, supra note 3, at 15. 40 See Henry Helgeson, How China and Kenya are Winning the Payment Wars - and Why the US Should Worry, FORBES (Aug. 18, 2014), china-and-kenya-are-winning-the-payment-wars-and-why-the-u-s-should-worry/#1503b8c56241. 41 See MICHAEL LEWIS, FLASH BOYS: A WALL STREET REVOLT (1st ed., 2015). 42 Nasdaq s Story, NASDAQ, 43 For a brief but comprehensive summary of the role of regulators and regulations in the development of electronic markets and high frequency trading, see ANUJ AGARWAL, HIGH FREQUENCY TRADING: EVOLUTION AND THE FUTURE, CAPGEMINI, at 19-20 (2012). 4 Trading is now dominated by high-frequency and computerized trading. Bradley Hope, 5 Things to Know about High-Frequency Trading, WALL ST. J. BLOG (Apr. 2, 2014), briefly/2014/04/02/5-things-to-know-about-high-frequency-trading/. The Financial Times also reports 379 Northwestern Journal of International Law Daniel Runde, M-Pesa And The Rise Of The Global Mobile Money Market, FORBES (Aug. 12, 2015), mobile-money-market/. 380 Fin Tech and RegTech 37:371 (2017) 3. FinTech start-ups The third major element, and the one that typically receives the most press attention today, has been the emergence of new entrants, often start- ups, focused on combining new technology and finance for the benefit of consumers. While successful FinTech start-ups are by no means new (e.g. Bloomberg in the 1980s and PayPal in the late 1990s), their numbers and profile have increased dramatically since 2008. This is reflected in the rise of the noun FinTech (meaning a new start-up company applying technology to finance). While the focus is often on alternative financial techniques such as crowdfunding, P2P (peer to peer) lending and robo- advisory services, in fact, this trend also embraces established IT and ecommerce firms (such as IBM, Tata, Apple, Amazon, and Alibaba) and new start-ups, all applying technology to address challenges and create opportunities across the financial sector. Today, FinTech impacts every area of the financial system in virtually every part of the world, with the most dramatic impact perhaps in China, where technology firms such as Alibaba, Baidu, and Tencent (BATs) have transformed finance and raised new challenges for regulators and regulation.49 Furthermore, since 2016 regulators in a range of countries including the United States, Australia, Singapore, and the UK have been actively engaged in better understanding FinTech market dynamics and seeking to develop new regulatory approaches.o C. RegTech Unlike the UKs Financial Conduct Authority (FCA), we argue that RegTech cannot be simplified as a category of FinTech. According to the FCA: RegTech is a sub-set of FinTech that focuses on technologies that may facilitate the delivery of regulatory requirements more efficiently and effectively than existing capabilities.1 This is a pragmatic assessment of where RegTech is today, but it is made from an overly narrow perspective. In our view, this definition lacks vision as to the true potential of 49 See Weihuan Zhou, Douglas W. Amer Amer ASIC, Further Measures to Facilitate Innovation in Financial Services (Consultation Paper No. 260, June 2016). 51 Feedback Statement, Financial Conduct Authority, Call for Input on Supporting the Development and Adopters of RegTech 3 (2016) (emphasis added). 381 Northwestern Journal of International Law 56 (2) developments in data science (for instance Al and deep learning) that allow the structuring of unstructured data; (3) economic incentives for participants to minimize rapidly rising compliance costs; and (4) regulators efforts to enhance the efficiency of supervisory tools to foster competition and uphold their mandates of financial stability (both macro and micro) and market integrity.5 8 The emergence of FinTech is attributable to: (1) financial market deficiencies caused by the GFC and the regulatory response to it; (2) public distrust in the financial services industry, particularly in the United States and EU; (3) political pressure for alternative sources of finance for small and medium enterprises; (4) unemployed financial professionals looking to apply their talents; and (5) the commoditization of technology and the market penetration of the internet and mobile phones, particularly smart phones.5 9 From a market dynamic perspective, FinTech since 2008 has grown organically as a bottom-up movement led by start-ups and IT firms, whilst RegTech has grown mainly in response to top-down institutional demand. RegTech can therefore be seen encompassing three distinct, but complementary, market sectors and groups of participants. 56 See Institute of International Finance, supra note 3, at 5-8. 5 The HF identified a number of new technologies that could improve data management and analysis which include new cryptographic technology, data mining algorithms, machine leaming, blockchain, robotics, and visual analytics. Id. at 12-14. 5 For example, Principle 9 of the BCBSs Core Principles for Effective Banking Supervision requires financial supervisors to use an appropriate range of techniques and tools to effectively implement the supervisory approach and deploy supervisory resources. This includes a criteria that tlhe supervisor uses a variety of tools to regularly review and assess the safety and soundness of banks and the banking system. BASEL COMMITTEE ON BANKING SUPERVISION, CORE PRINCIPLES FOR EFFECTIVE BANKING SUPERVISION 30-31 (2012). 5 Arner, Barberis see generally CHRIS BRUMMER, SOFT LAW AND THE GLOBAL FINANCIAL SYSTEM: RULE MAKING IN THE 21ST CENTURY (2011). 385 Northwestern Journal of International Law Brummer, supra note 67.71 See Ross P. Buckley, The Changing Nature of Banking and Why It Matters, in RECONCEPTUALIZING GLOBAL FINANCE AND ITS REGULATION 9-27 (Ross Buckley, et al. eds., 2016).72 How 37 Banks in 1990s Became 4 Banks in 2009, Mega Consolidation in US, LETS TALK PAYMENTS, (Jan, 29, 2014), mega-consolidation/ (citing Federal Reserve; GAO). 386 Fin Tech and RegTech 37:371 (2017) I 1FW* r tI I Figure 1. Infographic based on information from the Federal Reserve and GAO depicting how thirty-seven banks became the Big Four between 1990 and 2009. Source: How Banks Got Too Big to Fail, MOTHER JONES (Jan.-Feb. 2010), As financial institutions expanded their scope and scale across jurisdictions and sectors, they faced increasing operational and regulatory challenges. This led to a major expansion of risk management and legal and compliance activities, particularly throughout the 1990s and 2000s. Risk management from the 1980s was increasingly achieved by using financial technology as finance became increasingly quantitative and IT became ever more powerful. The combination of quantitative finance and IT was reflected in the emergence of financial engineering and Value at Risk (VaR) systems in major financial institutions.73 These systems were a major element of the transformation of finance prior to the GFC, but also one of the greatest risks and failures underlying the crisis itself.74 Put simply, by 7 See Joe Nocera, Risk Management - What Led to the Financial Meltdown, NY TIMEs (Jan. 2, 2009), 74 The VaR model is unreliable in many ways. See Simon Johnson estimates are based on past data that is unrepresentative of the future; and because financial returns exhibit fat tails (extreme outcomes are 387 W . , , - - W4 Northwestern Journal of International Law Staffs of the International Monetary Fund and The World Bank, Implementation of Basel II - Implications for the World Bank and the IMF, INTERNATIONAL MONETARY FUND (July 22, 2005), imf/ extemal/np/pp/eng/2005/072205.htm#s2. 7 One example is that Basel IIs Internal Ratings-Based (IRB) approach was perceived to achieve two major goals: the enhancement of risk sensitivity, and the promotion of incentive compatibility. Nevertheless, in hindsight, the pursuit of risk sensitivity was mostly accomplished by banks pushing assets off their balance sheets, leading to a false sense of security. 388 Fin Tech and RegTech 37:371 (2017) Over-reliance on complex, prescriptive and lengthy post-GFC regulations led to massive compliance and supervision costs for the regulated and the regulators. Carrying out financial supervision, in response to the growing level of regulatory complexity, inevitably required greater granularity, precision and frequency in data reporting, aggregation, and analysis7 8 Examples can be easily found in the case of capital and liquidity regulations under Basel III, stress testing and risk assessments in the UK, United States, EU, and elsewhere, and the reporting requirements imposed on OTC derivatives transactions resulting from Group of 20 (G20) and Financial Stability Board (FSB) agreed approaches and as implemented (in conflicting fashions) in the context of Dodd-Frank or the EUs EMIR.79 Compliance costs rose significantly as a result of the increasing regulatory burden that made the use of innovative technologies a natural and promising solution to compliance requirements.so As reported by Lets Talk Payments, the annual spending by financial institutions on compliance is estimated to be in excess of US $70 billion. In this situation it is no wonder the industry turned to RegTech for cost-effective solutions. Second, the deepening regulatory fragmentation displayed in many different markets has given rise to an additional layer of compliance burdens for financial institutions. Despite the push by global policy makers for similar postcrisis reforms, the requirements and rules for implementing these reforms range from being slightly different to significantly dissimilar between markets. The overlaps and contradictions in regulations led financial institutions to turn to RegTech to optimize compliance management.82 Third, the rapidly evolving nature of the postcrisis regulatory landscape introduced uncertainty on future regulatory requirements which 7 Institute of International Finance, supra note 3, at 5-8. 79 Id. at 7. For discussion in the context of the US, see FINANCIAL STABILITY OVERSIGHT COUNCIL, STUDY ON THE EFFECTS OF SIZE AND COMPLEXITY OF FINANCIAL INSTITUTIONS ON CAPITAL MARKET EFFICIENCY AND ECONOMIC GROWTH CARRIED OUT AT THE DIRECTION OF THE CHAIRMAN OF THE FINANCIAL STABILITY OVERSIGHT COUNCIL (March 2016). 80 See Eleanor Hill, Is RegTech the Answer to the Rising Cost of Compliance?, FX-MM (June 13, 2016), fx- compliance/ (noting that as rules of thumb go, judging regulatory complexity by the amount of paperwork being issued by global regulators is not a bad proxy. Between 2009 and 2014, G20 regulators increased their document output by 500%); Andrew Comell, AgTech, ResTech, RegTech, FinTech - A