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A transition in thinking: risk-based approach to regulating the disruptive role of FinTech

Ahead of QuantMinds Americas, we asked Ligia Catherine Arias-Barrera, Associate Professor at Externado de Colombia University  to introduce her topic for the conference in Boston this September. 

2016 can be identified as the year in which FinTech (2) occupied the debate in financial regulation. Regulators around the world have been especially focused on identifying the potential revolutionary effects it might have for financial markets’ functioning and structure. The other post-GFC regulatory reforms are not embedded with innovations, and so it is the Dodd Frank Act (DFA) which has brought FinTech to the forefront recently.

I will examine the roles that FinTech and DLT, in particular, play in central clearing services, and discover that the DFA is insufficient to tackle such innovative developments. We shall see that although there have been few regulatory developments in some states (e.g., the incorporation of blockchain rules in Delaware’s company law), the US regime needs to implement a risk-based approach to regulation based on principles to design an effective FinTech regime. The central query of this is to argue how the adoption of risk-based regulation can contribute to efficiently manage the ‘innovation risk’ –as a type of manufactured risk- triggered by the adoption of digital developments in central clearing services.

The implementation of FinTech is heavily reliant on enhanced operational risk and continuous assessment of security risks.

I argue that a risk-based approach to regulation is central to the effective adoption of FinTech (e.g., DLT and smart contracts) in the OTCDM, especially in central clearing services. The implementation of FinTech is heavily reliant on enhanced operational risk and continuous assessment of security risks. Hence, a strategy such as the risk-based regulation, that features the early identification and mitigation of risks, is central to the management of the unknown risks and uncertainties brought by FinTech innovations. The sound functioning of these technologies would benefit both market participants and regulators and supervisors. On the one hand, market participants would benefit from a common set of data and process standards that could operate across firms, platforms and markets. The high level standardisation of process would reduce post-trade costs (3) and would be time efficient. On the other hand, standardisation might assist the achieving of regulatory objectives, because it enhances transparency and access to timely information, and is likely to incentivise compliance. If regulated firms find the use of FinTech and the concomitant standardisation as a simplification of trading and post-trading processes, they are motivated to comply with the respective regulation.

The emphasis on the rule of law is particularly relevant in a time when traditional norms and financial market structures are under strain.

John Locke’s famous maxim, ‘Where there is no Law, there is no Freedom" (4) helps to explain the role that risk-based approach to regulation based on principles can have in solving the issues triggered by FinTech innovations in the OTCDM and its clearing services. In this context, the strategy of risk-based regulation would act as an enabler (5) of further technological developments. By that process, it will also incentivise regulated firms to voluntarily comply with the new regulation, as they will see that such rules are facilitating the adoption of technologies that ease their trade. Moreover, as market participants are the ones developing new technologies, regulators would be compelled to have a fluent dialogue with regulated firms, and to understand their perceptions of risk (mainly operational and security risks).

The emphasis on the rule of law is particularly relevant in a time when traditional norms and financial market structures are under strain. Regulators are expected to move towards understanding FinTech developments, and to decide the role which regulation will have. This discussion puts in the forefront classic arguments about the meaning of freedom. In the context of FinTech’s momentum, Hayek’s definition seems to fit perfectly, freedom being: ‘a state in which each can use his knowledge for his purposes’(6). Indeed, current technology developments in financial services are focused on streamlining trading and post-trading process, and on improving transparency and access to information. FinTech innovators are using their knowledge to enhance their market activities. Therefore, financial regulators are expected to support and guide such processes, to enable innovation whilst protecting the stability of the market. Risk-based approach to regulation is sufficiently broad do so.

QuantMinds Americas

  1.  Ligia Catherine Arias-Barrera, ‘Regulation and Supervision of the OTC Derivatives Market’ (Routledge Research in Finance and Banking Law, 2018) 231. Book prizes: "One of the best Banking Law books of all time" and "One of the best new Banking Law books to read in 2018" of BookAuthority. The book is available for purchase on Amazon.
  2. ‘Financial technology, commonly called “fintech”, is now a highly used buzzword. Startups competing with traditional financial services, offering customer-centric services capable of combining speed and flexibility, are spreading throughout the world.’ Bernardo Nicoletti, ‘The Future of Fintech: Integrating Finance and Technology in Financial Services’ (Palgrave Studies in Financial Services Technology 2017) 
  3. ‘Post-trade costs now make up a large slug in investment bank expenditure between 15% and 20% according to Boston Consulting Group’ Scott D O’Malia, Welcoming Remarks, ISDA Conference ‘Technology & Standards: Unlocking Value in Derivatives Markets’ London (30 November 2017). 
  4. John Locke, Two Treatises of Government (Awnsham Churchill 1689) 234.
  5. Joseph Singer, No Freedom Without Regulation: The Hidden Lesson of the Subprime Crisis (Yale University Press 2015).
  6. Friedrich Hayek, Law, Legislation and Liberty (University of Chicago 1973) 142.

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