Market Structure Impediments May Limit Regtech Potential

The use of technology to create process efficiencies and enhanced user experiences has been fully entrenched in the financial services sector for some time.  In recent years, the pace of change has quickened with the introduction of a kaleidoscope of new technologies such as data analytics, cloud computing, blockchain, machine learning and biometrics that can be applied to solve friction points within the financial services sector while meeting the needs of an ever-demanding digital savvy consumer.

Derivatives of fintech have emerged to define specialized areas of technology innovation.  One such branch is Regtech which applies technologies to solve regulatory and compliance requirements more effectively and efficiently. It is meant to permit better compliance solutions and lower the cost of ownership to comply to new regulation. Supporters of Regtech view it as an enabler not a threat to the industry; however, the complexities of implementing a successful Regtech solution should not be underestimated.  Although technology is enabling better Regtech solutions, there are several market structure impediments that may prevent solutions from reaching their full potential.

Traditionally market service providers have provided regulatory solutions to financial institutions (“FI’s”) under the umbrella of a commercial agreement; however, once you introduce a regulator or government agency into the equation, it opens the door for a rethink of the most suitable operating model and it vastly increases the areas where consensus is required.  Since many of these technologies are new, governance models and standards need to be developed. Furthermore, significant time and effort are needed upfront to assess how these new technologies can be applied to improve operational efficiencies within the context of the current business and market structure environment to ensure the solution does not create unintended consequences or complexity.

Gaining Consensus Among Stakeholders with Varied Interests

Over the past decades, financial institutions have invested in several tactical regulatory compliance-related IT solutions. Traditionally FI’s have addressed regulatory compliance by either implementing in-house proprietary systems or by using vendor solutions.  These solutions were often developed to solve a specific regulatory problem for an institution and are often inflexible in design, configuration and scalability.  Third party services providers, driven by commercial interests have taken on the role of ‘problem solver’ for financial institutions resulting in a patchwork of disintegrated technologies, increased costs and an over-reliance by financial institutions on service providers.

The suitability of this convention is now being questioned as financial institutions and regulators seek to find efficiencies by embracing new technologies. One area where regulators and financial institutions see potential efficiencies is the use of blockchain and cloud computing technology for data/transaction reporting since both parties’ interests are aligned and there is an efficiency advantage in using the same technical solution.  Yet, technology is only one aspect of product design. Gaining consensus on business and data requirements, deciding on the appropriate funding model and addressing market structure issues are all part of building a good product and can take considerable time and effort.

A good case study where financial institutions collaborated to address a new regulatory obligation, was BOAT, an industry initiative driven by a consortium of European banks that joined efforts to create a platform to satisfy trade reporting requirements introduced by the Markets in Financial Instrument Directive (MiFID).[1] Part of the trade reporting obligation was that trade reports needed to be disseminated to the public at ‘reasonable commercial terms’.  Although efficiencies were gained by the participating banks by using the same technology and data standards, the resulting platform was a commercial model which met the needs of financial institutions, but the infrastructure required by the regulator to receive, analyse and store the data still needed to be developed. There was also a direct conflict between the regulatory requirement to make the trade reporting data inexpensive for retail investors and the commercial interests of the service provider who invested heavily in infrastructure and wanted to get a return on their investment. One might argue that a utility model might have been a better operating model for BOAT however, at that time, the regulators did not have a seat at the table.  Now as regulators become increasingly interested in improving their operational processes, the coordination effort increases as does the effort to gain consensus from multiple parties with varied interests.

Data/transaction reporting is often cited as a dominant user case for blockchain technology. The use of distributed ledger-technology (DLT) or blockchain has the potential to take away several pressure points for financial institutions and regulators. Since blockchain is immutable by design, regulators would not have to collect, store, reconcile and aggregate the information themselves. All transactions are documented on the distributed ledger providing a comprehensive, secure, precise, irreversible and permanent audit trail.  Having one permeant ledger would alleviate the need for both regulators and financial institutions to keep their own records which would be a tremendous cost saving for the entire industry.

There is no denying that many of the features of blockchain are attractive and would support better more efficient reporting but is it feasible from a cost an operational point-of-view to re-do what is already in place? And who would pay for it? Furthermore, many regulatory risks have cross border issues and require global coordination which takes time to solve.

Like many things, the devil is in the detail and although many new technologies provide novel ways to assist with regulatory compliance, the coordination effort may just be too great to truly effect large-scale change and it may be better to embed new technologies into current vendor products or solutions to improve efficiency or use them, at least initially, in a more limited basis to address targeted friction points within an individual financial or regulatory institution.

Governance and Standards – In a Nascent Stage

Even though there is clear recognition in the industry that supporting best practices and strong governance frameworks is an important area to address, standard setting is very much in a nascent stage since in many instances market participants and regulators are still learning and developing user cases on how to apply new technologies.

The topic of blockchain is complicated because blockchain standards can be divided into three interrelated vectors, comprised of technical, business and legal considerations. Standards carry with them several benefits, including some network effects, easier interoperability, shared implementation knowledge, lower costs and less overall risk; however, they are also not easy to implement.

Many of the user cases for blockchain require a network effect – meaning that a group of financial markets participants must come together and accept the application and integrate it into their business workflow. Business standards will need to be agreed and put in place to safeguard their interests before the network effect will take root. For Regtech solutions, any legal or regulatory requirements would need to inserted into the overall solution as well.

Some jurisdictions are exploring the development of standards. The UK announced in a HM Treasury Report[2] that they plan to work on a “pioneering” framework of voluntary standards for consumer protection. The government will work with the British Standards Institution[3] and the digital currency private-sector to create a series of “best practice” standards for consumer protection. The Monetary Authority of Singapore (MAS) proposes to establish a National Payments Council to coordinate key initiatives such as promoting interoperability and adopting common standards.[4]

Although standard-setting will play a key role as new technologies evolve, they are difficult to execute and there is currently very little progress internationally to provide clear direction on how this will take shape.

The Challenge of Unbundling The Status Quo

Increasingly, the regulators and the regulated are embracing the ideology that technology can work for them to ease the pressure, especially in this new data-driven/machine-readable world.  However, RegTech solutions will only be accepted if they are fully compliant with legal requirements, particularly in the fields of data privacy and data protection rules, know-your-customer regulations and IT security requirements. The use of blockchain for AML compliance is compelling but it requires extensive global coordination before it can be truly effective. Even at a jurisdictional level, current privacy and data protection laws may constrain development until legislation is alerted to allow for more open dissemination of personal information.

Additionally, while financial firms have been consumed with compliance since the 2008 financial crisis, the financial industry has been threatened by a flurry of innovation and increased competition from new fintech firms applying technology to finance to provide new innovative products and services. Financial institutions are challenged with how best to use their working capital – protect their turf or make their turf more efficient by using technology.

In the short term, Regtech will likely be applied in a limited way to help firms become more efficient by automating the more mundane compliance tasks or to reduce operational risks in highly resourced compliance functions. Over time, using technology to implement more efficient processes for data driven monitoring and machine readable filings will become more commonplace to control compliance costs.

Slow and Steady Will Win the Race

As regulators and financial institutions explore the opportunities and efficiencies that new technologies can bring it is important that they are mindful of current market structure issues and do not bring further fragmentation and complexity into the financial ecosystem. An open dialogue should be encouraged between the industry and the regulators to ensure market solutions are developed that suitability address regulatory compliance, governance and legal issues while providing a distinct efficiency and cost advantages to the financial ecosystem. It will be Regtech solutions that have taken their time, planned well and collaborated extensively that will affect meaningful change and reach their full potential.

[1] MiFID required equity and equity derivative products to reported to a trade repository

[2] Digital Currencies: response to call of action, March 2015

[3] The British Standards Institute is the UK’s National Standards Body.

[4] Proposed Activity-based Payments Framework and Establishment of a National Payments Council – First Consultation, August 2016

 

Leave a Reply

Your email address will not be published. Required fields are marked *

* Copy this password:

* Type or paste password here:

About The Author

Donna Bales
is a product development professional with a proven track record of managing complex capital market industry initiatives during times of significant market change and market structure reform. Donna is the founder of Balmoral Advisory, a boutique advisory firm that works with exchanges, regulators, technology firms, market participants and market data vendors to identify and evaluate business opportunities, understand and respond to changing industry/market dynamics and develop and implement strategies and solutions that make sense now and in the future. In addition she acts as a strategic advisor to an international consultancy firm, CollegeHill Asia and sits on the Board of 3Q Innovation, a non-profit that focuses on retraining and replacement of older workers following protracted unemployment. Originally from Canada, Donna holds a bachelor degree in Economics from the University of Western Ontario.