The fusion of technology and finance presents an entirely new regulatory challenge. Indeed, today’s financial technology (fintech) ecosystem finds itself in a bind. The realm of artificial intelligence, blockchain, and decentralized finance (DeFi) is seemingly caught between regulatory inaction on one hand and micro-management on the other.
Advancements in fintech are providing greater access to financial services for more people, from the non-finance savvy to those trading or paying digitally for the first time. This expansion is especially relevant when it comes to investing and transaction services. The underlying story here is an innovative one that can potentially revolutionize key components of economic activity for the better.
For example, blockchain could be shaped to bring structural efficiencies to the economy. By leveraging decentralized ledger technology (DLT), many advantages are evident: higher security for participants, lower costs, and the complete traceability of “things” both digital and real. This transparency is perhaps DLT’s greatest asset. This might sound Orwellian to some, but if structured properly, it does not have to be.
Cross-border transfers, now slow and expensive, could also become rapid and nearly cost-free. As investors have pointed outabout XRP, the peer-to-peer powered cryptocurrency, it “has real-world utility in the form of payments, allowing cross-border payments in as little as 3-5 seconds.”
If nations embrace digital currencies (e.g., Central Bank Digital Currencies, or CBDCs), it will open the door to mass adoption and profound savings in cost and capital. Federal Reserve Chairman Jerome Powell seems to support this. Visa, the global payments juggernaut, just announced its start on this path by accepting stablecoin USD Coin to settle transactions. The company notes that this paves the way for its preparation to one day support CBDCs.
Recent regulatory actions, however, illustrate the pickle hindering fintech’s evolution. Back in December, the Securities and Exchange Commission (SEC) filed a lawsuit against Ripple. The suit claims that XRP, the token the company uses on its cross-border payments network, is a security. As a real-time gross settlement system, currency exchange, and remittance network, Ripple has produced innovations that frankly surpass the government’s dated definitions.
This case has been assailed by securities law experts as deeply flawed. Perhaps more importantly, others have rightfully observed that the lawsuit is a byproduct of the lack of a clear set of rules. This feels like the right diagnosis. After billions of XRP coins were sold over the past seven years during a period of little clarity, it appears that Ripple is having the rug pulled out from under it by the SEC. Unexpected rule changes are never encouraging to innovators, nor investors.
The swing to sudden new regulations can quash innovation, too. The U.S. Treasury Department’s Financial Crimes Enforcement Network (FinCEN) recently proposed stark rules imposing a set of know your customer (KYC) requirements on cryptocurrency exchanges. While FinCEN’s intended goals here are surely important, the specifics of the proposal have led exchanges like Coinbase to sound the alarm. Simply put, these proposed rules would be so burdensome that they would threaten the exchange’s existence. That would be a lose-lose for everyone.
One of the lessons I learned as a risk officer at J.P. Morgan was that the essence of having authority over the way transactions take place is the responsibility to enable virtuous risk-taking as efficiently as possible. Good overseers want to encourage good risk-taking at the foundation of any enterprise or market under their scope. It is far better to encourage market participants to do the right thing themselves than the heavy-handed alternative. Unleashing creativity in this way – whereby increasing the size of the economic good for everyone – makes regulators’ other crucial mandate of preventing and controlling bad behaviors that much easier.
Finding the way to govern the digital markets of the future cannot rely on translating older methods into new forms. The GameStop trading controversy was an exemplary case. We quickly discovered that traditional equity and next generation fintech markets alike are not keeping pace sufficiently with the way markets of the future are likely to work. This new world, embodied by WallStreetBets and a host of other participants, has startled some into realizing they need to learn more. It is also apparent that government officials are now taking much more interest, as evidenced by the recentCongressional hearing on Robinhood, GameStop, and the meme trading fervor.
To me, one of the most interesting things about the GameStop frenzy was that it was a triumph of “game theory” – the power positioning of trading interests – over “reality.” Traditionally, one point of regulating markets is to allow the tension between buyers and sellers to externalize a debate about the correct value of the thing being traded, in this case GameStop’s stock. As a society, we should want market participants focusing on what GameStop is worth. Looking from the outside, few were really asking that question. It is the regulators’ job, like the eponymous method made famous by Socrates, to keep the marketplace focused on asking the right questions.
The future of the finance ecosystem can truly be an exciting one as we rethink the best ways for markets to function and capital to be deployed. As I have highlighted before, capital is the real key risk factor. We cannot regulate well without this appreciation. As such, we must build the right guardrails to protect from fraud, money laundering, and market manipulation. But we must also step out, and this begins by steering into transparency, access to data, and workable uniform rules. Cryptocurrencies, online trading and payments, and countless new digitally inclined market participants will all be better for it.