How Regulation is Shaping the Technological Revolution in Finance

We hear a lot nowadays about how Artificial Intelligence (AI), algorithmic trading, robo-advisors, blockchain and other technologies are shaping how investment services firms operate and even how investments are structured. There is no doubt that technology has had a considerable effect on virtually every industry and that new technologies will continue to develop and cause change and disruption to the “old way of doing things”. When it come to the financial services industry however, which is a highly-regulated industry for obvious reasons, one must keep in mind how the regulations will directly or (sometimes more importantly) indirectly allow the technology to operate.

You can have the best technology in the world, capable of reducing costs drastically, of improving productivity to new heights and capable of presenting the best returns for clients consistently – but you must never underestimate the restraints of regulation. Unfortunately, as more and more regulation is developed we see the concept of proportionality always decreasing and in some instances non-existent. Thus, if a start-up has managed to develop the best investment idea using the best technologically advanced method, but fails to get the regulatory approval to operate – it is essentially useless.

Getting Licensed

Some countries like the UK, the USA, Switzerland, Dubai and Australia have tried to bridge this gap by offering what is known as a “regulatory sandbox”. These initiatives aim to give a space where financial firms or more specifically Fintech firms can test their innovations in a less restrictive regulatory environment for a limited period. Although the initiatives a very good step, one should keep in mind the fact that once such companies would like to fully open-up for business they would still need to abide by the regulations just as other companies would. The initiative helps on the front of getting licensed and developing in a way that will get the entity compliant in a more efficient manner, however getting licensed is not the end of the process, but the beginning. Financial companies are subject to capital requirements, on-going monitoring, risk-management, internal audit requirements and must also abide by other regulations besides the ones directly applying to finance.

Beyond the Initial License

From a capital requirement perspective, the current situation is that a 3-person start-up has to abide by the same capital requirements of a multinational firm that holds the same type of license. There has been an initiative from the EU front to try to make a distinction between the systemically important entities and the smaller firms that pose a much lower market risk, however there have been no conclusive results yet and it could take years to ever get to a workable solution. An important feature of the capital requirements of such firms which is particularly punitive on Fintech and other technologically centred firms is the fact that intangible assets are deducted from the capital base of a company. For capital requirement purposes, the fact that firm has a highly valuable asset in the software and goodwill it has created through its technological advancement is actually penalised. This is a clear example of how regulation is going against the technological advancement of the financial sector.

Another factor to consider is that financial regulation is just one piece of the puzzle. Entities and individuals operating in the industry must also abide by other regulations. One source that continues to grow in importance is the tax regulation. Pressure is always growing for more substance, more tax reporting, more client details – these all add up to more costs. If a start-up fails to factor in these costs it could become insolvent due to the higher ‘un-exepected’ costs.

The Bottom Line

In conclusion, it is safe to say that regulation is having an effect on how the financial services industry can develop. Although certain technological advances are here to stay and will continue to develop as the years go by, their disruption to the more traditional way of doing things is severely hampered by the initial and ongoing regulatory requirements. Thus, the regulatory environment is a very important area to focus on for countries that would like to see the development of their financial industry embrace the technological advancements and take advantage of them. Only once this is done will we ever see the true potential of the Fintech revolution. This is not to say that regulation needs to be lax and more self-regulation is needed, however a more adaptive system is definitely a requirement. The system needs to still incorporate the basic overriding aim of safeguarding stakeholders, most importantly the clients. However, it must be adaptive enough to regulate different entities differently on a risk-based approach and in a proportional manner.