Challenges in Regulating Digital Innovation

Fintech continues to dominate headlines and the attention of global policymakers.

After the price of Bitcoin skyrocketed by 300 percent last year, Citigroup declared that digital currency is “optimally positioned to become the preferred currency of global trade,” putting its growth directly in conflict with the U.S. dollar. Walmart announced a partnership with fintech investment firm Ribbit Capital, throwing down the gauntlet to consumer banks as the giant retailer prepares to offer financial services to millions of customers worldwide.

At the same time, capital market analysts and investors spent the first months of 2021 confounded by the meteoric rise of “meme-stocks,” powered by chatter on social media and by retail-orientated, app-based brokerages, such as Robinhood.

And, in a striking regulatory intervention, Chinese authorities flexed their muscles by pulling Ant Financial’s blockbuster public offering. China also ordered this fintech payments behemoth to restructure its operations and seek out authorization as a regulated financial firm.

These illustrations are telling. Novel financial products highlight the blurring of boundaries between fintech and mainstream finance—whether it be in the realm of currency, banking services, payments, or trading. These fintech products bring consumers into more direct contact with the financial system through digital technologies and interactions with new categories of financial service providers.

As the financial system absorbs these innovations into its bloodstream, their emergence raises urgent questions for both domestic and global regulators, such as:

• Do fintech products pose new kinds of risks for market integrity, or simply repackage existing and well-known dangers into digital form?
• How can regulators encourage innovation without compromising the safety of consumers in the marketplace?
• Should new categories of entrants in financial markets—such as Robinhood, Walmart, and Ant Financial—be regulated within existing paradigms or by new rules specifically designed for less traditional or non-financial firms?

In a recent law review article, Chris Brummer of Georgetown University Law Center and I offer an analytical prism through which to understand the tradeoffs faced by financial regulators seeking to balance the goals of innovation, market integrity, and rules clarity and simplicity.

In our article, we suggest that trying to achieve these three objectives creates a trilemma. Regulators can—at best—achieve only two of the three goals. Encouraging innovation through clear regulation—for example, by granting expansive permissions—risks undermining market integrity. Promoting market integrity using clear regulation—such as by banning certain activities—can jeopardize innovation. Prioritizing innovation and market integrity pushes regulators toward a complex rulebook.

The rise of fintech exacerbates the challenge that regulators face when making these tradeoffs. Brummer and I suggest that fintech possesses three defining characteristics that amplify the intensity of the tradeoffs and create distinctive difficulties for regulators.

First, digital financial products and services rely heavily on sophisticated, artificially intelligent algorithms that are designed to process large quantities of data and update their programming in response to feedback from ongoing operations. For example, online lending firms and robo-advisors depend on automated programs that ascribe values to incoming data and allocate capital in accordance with programming that can adapt in response to successes and failures. Algorithms offer many powerful efficiencies. But they also tend to create high information demands on regulators to understand the underlying programming. They also create potential future risks as fintech products evolve.

Second, fintech firms harness new and historically untested forms of data to power the delivery of products and services. For example, online lenders can score borrowers on a range of alternative data points, including social media use, geolocation, exam scores, and hobbies. These emerging categories of input can provide a holistic, enriched picture of a borrower. They perhaps can offer a corrective tool to remedy the discriminatory lending caused by reliance solely on FICO scores and income statements. Vast quantities of digital data, however, do not necessarily help cure the information gaps. They introduce their own uncertainties—most fundamentally about whether they provide effective and accurate information that can be used to determine, for example, how likely a borrower is to default.

Third, fintech firms present a tricky proposition for financial market regulators long used to overseeing resourced and experienced banks and investment firms. Comprising start-ups, Main Street retailers, decentralized networks, tech behemoths, as well as the more conventional financial firms, the fintech ecosystem showcases heterogeneity in firm structure, organizational culture, and compliance expertise. Regulators are called to find strategies for rulemaking that are robust and protective of the financial system, while also encouraging of the innovation offered by emerging fintechs.

In other words, fintech firms can lack the resources, capital reserves, experience, and expertise of conventional financial firms. So policymakers must be especially creative when developing compliance requirements that harness fintechs to provide valuable services without threatening the integrity of the financial system. In the wake of Ant Financial, for example, Chinese regulators have called for tighter rules on fintech lenders, including requirements that fintechs maintain stronger capital buffers. This move would shore up lender balance sheets, but commentators suggest that the volume of fintech loans could “significantly contract” in response.

Seen through the prism of the trilemma, the international regulation of fintech faces an even more complex set of tradeoffs. Curing information asymmetries requires that regulators share intelligence and data across borders. Information sharing is a tall order because regulators might be reluctant to provide foreign governments with trade secrets about domestic fintech companies and consumers. These barriers make it even harder to negotiate and develop clear international standards that governments can incorporate into their domestic legal and administrative systems.

In addition, attitudes toward fintech vary across jurisdictions and are shaped by how effectively fintech services are meeting the economic needs of local populations. Unsurprisingly, fintech products and services have proven especially popular in countries such as India and China where home markets have historically lacked an inclusive and comprehensive system to deliver core financial services and products. Distributive concerns further complicate the political economy of international standard-setting where countries that gain economically from certain innovations may seek to adopt home-grown or light-touch approaches to how they oversee these technologies.

And international standard-setters must also legislate for a more bustling and heterogeneous financial system, populated by new categories of firms—including start-ups and technology behemoths such as Facebook or WeChat—along with banks and other traditional financial institutions.

The emergence of fintech sets a novel and special challenge for policymakers. Despite the mainstreaming of fintech products, such as online lending, robo-advising, and cryptocurrencies, regulators still struggle to develop a domestic and international roadmap for overseeing digital innovation.

Solutions depend on the creation of structural mechanisms for coordination, public-private partnerships in intelligence sharing and surveillance, and robust mechanisms for reviewing and updating policies to respond to new challenges. Although regulators have long dealt with challenges from innovation, fintech poses a distinct conundrum that calls for administrative and legislative creativity.

Yesha Yadav is a Professor of Law at Vanderbilt Law School.