The regulatory challenges of FinTech

Virtual bank branches open in the metaverse. Digital pictures of cartoon monkeys sell for $ 2.8 million. A couple was arrested for money laundering of over $ 3.6 billion and Bitcoin.

New financial technology is worth a lot of money – but do regulators do enough to monitor the enormous risks posed by these new services and platforms, while allowing flexible innovation?

In a recent study, Jillian Grennan, a professor of finance at the Fuqua School of Business at Duke University, examines the US regulatory landscape around so-called fintech, such as digital payments, blockchain, cryptocurrencies, and financial applications of artificial intelligence (AI). Because fintech represents “the birth of a new technology, a new tool for entrepreneurship, a new investable asset class and a new way of controlling financial decisions,” Grennan argues that financial regulation has not been able to keep up with this rare area of ​​innovation. .

To understand the regulatory needs and challenges of fintech, Grennan encourages regulators to first understand the economic goals underlying financial innovation.

AI, for example, reduces the costs associated with making predictions and decisions, Grennan explains. But AI’s reliance on data to make predictions also comes with costs – concerns about data privacy and integrity, as well as stifled innovation as AI focuses on incremental solutions in the short term instead of more human-focused innovation and new ideas.

On the other hand, blockchain – a type of digital shared storage database – allows users to make secure transactions without the need for a third party, such as a bank. Grennan explains that financial services and institutions can benefit most from blockchain’s cost reduction capabilities because finance is a highly centralized industry. The use of blockchain and non-fungible tokens by financial services – digital certificates that reflect a unique right to ownership – can ultimately reduce customer fees and the cost of verifying authenticity, according to Grennan.

But blockchain-backed transactions, if widely adopted, could also serve as an alternative to government-backed currencies, which could derail countries’ ability to implement monetary policy and stabilize economies, Grennan warns. Widespread use can also give players launching these currencies, such as Facebook, too much control over markets and central banks.

By combining the advances that drive AI and blockchain, Grennan explains, decentralized finance – also known as DeFi – also reduces the cost of removing intermediaries or executives traditionally involved in financial transactions. Rather, DeFi transactions allow parties to make complex financial transactions that are performed without the need for an intermediary and are then securely recorded in the blockchain. This opens up for “headless” financial organizations that are more transparent and more generative for the parties’ trust, a structure that Grennan says produces more customized and complex services for individual consumers.

Defi’s cost savings do not overcome the fact that it is not a perfect replacement for traditional financial intermediation, Grennan notes, citing a number of DeFi problems, including lack of deposit insurance, volatile rates, cyber risk and coding problems.

Due to the new methods and risks posed by FinTech, Grennan urges that these services “do not fit well within existing regulatory frameworks.”

Grennan explains such a challenge that can arise when the authorities try to regulate AI applications. In the early days of AI, the United States focused on sector-specific regulation. Self-driving cars, for example, were regulated by the Department of Transportation, while the Food and Drug Administration oversaw health-related AI, leading to demands for a more comprehensive approach. Since then, broad AI regulation has developed, but has largely been referred to defense departments, and financial applications have not been a priority. In finance, the US Securities and Exchange Commission (SEC) has implemented enforcement measures to clean up and clarify the use of customer data in AI. In addition to these enforcement actions, Grennan describes general disclosure provisions and encouraging approaches to self-government, such as internal assessments of how an algorithm affects consumers, as alternative regulatory tools for bias and harm reduction.

In contrast to the way AI has been regulated, Grennan describes blockchain and DeFi regulation as “targeted and specific” as regulators seek to target bad actors, but encourage innovation. Consequently, the SEC has used the “Howey test” to determine whether a digital asset is a security within the SEC’s regulatory area, bringing many digital assets under the agency’s enforcement power.

But many DeFi platforms can avoid SEC oversight by showing adequate decentralization, Grennan explains, which can lead to regulatory uncertainty. Grennan discusses a safe harbor plan that will allow new issuers of cryptocurrencies for three years to build a platform that is sufficiently decentralized to avoid security classification and regulatory oversight in the early stages, and encourage growth in the industry while enabling oversight under the right circumstances.

However, legal disputes between those who enter into smart contracts on blockchain platforms present very traditional contractual and legal challenges for consumer protection, as consumers try to legalize unfulfilled user expectations, according to Grennan. But complications arise when courts and regulators have to decide whether the creators of decentralized protocols are responsible when problems arise between users on their platforms. Grennan further outlines the difficulties inherent in holding developers accountable, and offers further regulatory challenges.

Grennan concludes by discussing potential avenues for FinTech regulation, such as advocating for safe harbor regulations, regulatory sandboxes that allow experimentation with new technology in collaboration with regulators, and selective enforcement actions such as ways to punish bad actors while encouraging financial growth.

However, regulators cannot stand alone. Grennan encourages developers and fintech industry players to do their part to achieve regulatory balance, encourage industry associations and increased lobbying to make their interests known.