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The Role of Regulation in Financial Innovation: Does Fintech Need Regulation to Flourish?

5 min read

Over the course of the past decade, we have seen the rapid expansion of the fintech sector in areas not previously considered or conceived. While most financial industry observers will note that fintech has been around for decades and forms the lifeblood of all financial institutions, large and small, it is the rapid evolution of fintech over the past decade that has been transformational for the financial sector. The main reason for this is the introduction of new players in the industry—who are generally more "tech" than "fin"—that are having a profound impact on new ways to deliver financial products and services, mostly in the retail space. Fintech and a number of other newly minted concepts and references, including blockchain, distributed ledger technology (DLT), cryptocurrency, virtual currency, regtech, artificial intelligence or "AI," and various other terms, have come to define a powerful force transmuting the financial sector.

Certainly, chief among the buzzwords defining the new fintech sector is innovation or, more precisely, financial innovation, which has spawned the portmanteau, "finovation." While various elements have helped incubate the growth of financial innovation, a critical factor to its continued growth, development and acceptance is regulation and the ability of financial regulation and financial regulators to evolve and adapt to new and continually rapidly developing financial innovations that often challenge traditional regulatory norms, concepts and approaches. Complicating the fintech picture is the ability—or perhaps, inability—of some regulators and regulatory systems, steeped in a very different compliance culture based on a rules-based model, to keep up with the rapid rate of change of a fintech culture that is often motivated to break norms and override traditional regulatory approaches in the name of financial innovation.

There are numerous areas in which fintech and traditional regulatory models and systems are colliding; coining another fintech-inspired term, "disruptive innovation." The emergence of Bitcoin a few years ago was one of the seminal events of the emerging fintech culture, but by no means the defining event. Since 2008, the Bitcoin protocol, the "blockchain," has been deployed in numerous use cases that have redefined or are redefining our notion of how we do everything from issuing new digital currencies to tracking assets and recording transactions, making payments, entering into contractual agreements, and managing complex data sets in a wide range of business applications. Notably, all of these areas have significant legal and regulatory implications and, as such, often have attracted heightened regulatory scrutiny and review.

What this means is that regulations and regulators are being forced by a wave of disruptive innovation and finovation to try to keep up with the rapid pace of change. And this is happening on a global basis with regulation serving as a proxy to legitimise various fintech market segments as well as to differentiate markets, countries and economies that are moving at different speeds to update their legal and regulatory apparatus to deal with the rate of change.

One area in which this is playing out on a large scale involves the development of the legal framework surrounding the use of virtual currency and blockchain by the financial services industry. Across the globe, numerous developments have advanced these efforts, helping to further nurture innovation and legitimise these particular areas and fintech generally.  Not surprisingly, these regulator efforts have also produced a spate of blockchain-based applications for their own regulatory technology or "regtech" processes. As a consequence, a regulatory framework is steadily coalescing; as it does, the uncertainty surrounding the use of novel financial technology will continue to fade. However, challenges remain.

A particularly keen area of regulatory focus is and will continue to be tracking and weeding out money laundering and terrorist-financing activities. While fintech has been an active tool for many years in this space, new financial technologies are posing new risks and challenges in the anti-money laundering/anti-terrorist financing space, and cybersecurity concerns continue to be front and centre for most financial regulators. The growth of virtual currencies and the recent wave in initial coin offerings (ICOs) have done little to quell regulatory concerns about these issues.

Beyond the proliferation of virtual currencies and blockchain, regulators have started to embrace the notion that DLT has wider applications, including the potential to provide greater transparency, innovative ways to solve problems, increased access for citizens, and improve consumer-facing products and services. Particular areas of regulatory focus include developing new ways to manage and track physical and digital assets, record internal transactions, verify identities, reconcile internal databases and increase interoperability.

Perhaps most compelling about the exploration of these new technologies and fintech advances is the borderless nature of many of the opportunities that are being explored and developed. The rapid growth of fintech, regtech, blockchain, DLT and AI solutions, and other advances is an international phenomenon. These areas are becoming an important component of the global financial system. As a result, the various technologies undergirding the fintech wave are steadily gaining legitimacy as regulators focus efforts on building a regulatory framework to support these new products, services and processes. Across the globe, national regulators and international standards-setting bodies have focused efforts on fintech, regtech and similar initiatives.

As a result, financial institutions, investors and other players—which have been hesitant to promote and invest in various fintech innovations in which the regulatory landscape has been uncertain—are taking note and seeing encouraging signs for future growth and opportunity. However, cautionary notes remain, including the imperative that all governments, financial regulators and standard-setting bodies continue to stay engaged, to keep up with the accelerating pace of financial innovation and change or risk getting leap-frogged by countries that understand and act on the opportunities presented by the many varieties and variations in the proliferation of financial innovations.



This content first appeared in Chambers Professional Advisers: FinTech.