The Importance of Regulation in Financial Innovation Essay (Critical Writing)

Introduction

In the last couple of years, there has been increased innovation in different aspects of the financial service sector and ways not previously conceived. While many seasoned financial analysts and experts would argue that financial innovation has been around for a long time, the pace of evolution in this sector has been the greatest cause of concern for policymakers and regulators.¹ The reason for this worry is the introduction of new players in the financial sector who are more technologically oriented as opposed to financially focused. This development has had a significant impact on how financial products and services are delivered to people.²

The powerful force that is changing how people conduct business in the financial sector has been synonymously associated with new and revolutionary terms and concepts, such as, cryptocurrency, virtual currencies, and blockchain technologies (among others).³ Innovation is at the center of the evolution of these concepts.

Although many factors have led to the growth and spread of financial innovation, a key ingredient to its acceptance is regulation. Indeed, there has been a new push for regulators to adapt to these changing market dynamics by formulating new laws that would moderate the use of new financial instruments. Complicating the ability of the same players to regulate the sector effectively is a rule-based culture that has traditionally defined how financial regulators perform their roles and duties. Consequently, there has been a disconnect between financial regulation and innovation because authorities are unable to keep up with technology changes that break the norm or override conventional regulatory procedures.

There are numerous areas where financial innovation and regulation collide. This conflict has led to the growth of the term “disruptive innovation.” The emergence of Bitcoin in 2009 highlighted this technological revolution, but it is not the ultimate event in the evolution of financial innovation in the 21^st century. The Bitcoin protocol, which has demonstrated how blockchain technology could influence the financial industry has been deployed in different cases and consequently influenced how digital currencies are issued.

It has also been applied in asset tracking and financial recording.⁴ Formulating contractual agreements and managing complex data sets are also other ways that the technology has been employed with relative success. Notably, these different areas of financial innovation have different regulatory implications. More importantly, they have attracted the attention of different regulatory bodies and players.

This paper is an argumentative essay that discusses whether emerging financial technologies need robust regulatory frameworks to enjoy public trust and acceptance, or not. The arguments cited in this study are analyzed in the context of financial innovation through digital currency development as a core area of FinTech. The essay is divided into four sections. The first one examines the arguments made in support of financial regulation in FinTech and the second part investigates contrary views. The third section of the paper discusses both sides of the argument with the view of finding a common ground, while the last section of the essay summarises the main findings.

Support for a Robust Regulatory Framework

Unlike traditional currencies, which are backed by central banks, digital currencies (such as Bitcoins) do not have a robust legal framework underpinning their use. Critics of digital currencies argue that it would be difficult for such currencies to gain acceptance because they are not legal tenders.⁵ Their arguments stem from the understanding that generally accepted currencies need to be legal tenders before users can accept them as units of exchange. Digital currencies have also been criticized for their inability to be used as units of debt. In other words, people may find it difficult to accept them as instruments of debt payment because they lack the legitimacy required for creditors to use them.⁶

Therefore, unlike the dollar, which is a legal tender, digital currencies cannot be used to pay public or private debts. Critics of digital currencies also say such financial instruments lack government endorsement, which makes users hesitant to use or retain them.⁷ Consequently, they lack the demand that other currencies, such as the dollar or Euro, enjoy. Some researchers have used detailed explanations to explain this fact by saying that digital currencies lack the “comfort” people need to retain currencies. This “comfort” stems from government backing.

The above view supports the findings of some researchers who suggest that people will find it difficult to rely on digital currencies as an attractive vehicle for holding wealth because they are not backed by well-known legal instruments, are unregulated, and use complex computer algorithms, which many people do not understand.⁸

The lack of regulation in digital currency use has also prompted critics to argue that they cannot be used as acceptable currencies because people are afraid of losing all their investments based on the unprotected nature of the trade instruments.⁹ This view is partly highlighted by extreme price volatilities, which have characterized digital currencies since 2009. Bitcoin is known to suffer from this problem because an excess demand for digital currency has led to price surges. The same cannot happen for conventional currencies because there is a regulatory framework that provides governments with instruments to prevent such an occurrence.¹⁰

For example, governments are free to exercise fiscal and monetary policies, such as varying interest rates and money supply to stabilize currencies. Bitcoin and other digital currencies lack such regulatory instruments. Some critics say there is no central authority, like the Federal Reserve in America, to regulate the currency’s performance.¹¹ This issue highlights the lack of accountability that critics of digital currencies have also used to undermine them.

The risk of theft, hacking, or loss is also more profound in the digital currency platform than in other areas of financial operations. Since virtual currencies operate in the technology space, it is possible for hackers to “steal” the currencies, thereby causing significant financial losses to investors. For example, there was an incident in 2015 where hackers stole $400 million worth of Bitcoins from Initial Coin Offerings (ICOs) within three years.¹²

The funds were meant to finance different projects. The general observation is that about 10% of the money raised through this platform has been lost through hacking.¹³ This problem gives the perception that digital currencies and similar forms of financial innovation are prone to theft and pilferage. People who hold digital wallets have the greatest fear because unlike physical money, which they could hold and protect, virtual currencies are intangible. These fears further highlight the need to have proper regulation of the system to make sure that such incidences are minimized. However, there is a core constituent of researchers and observers who hold contrary views as explained in the section below.

Why It Is Possible To Operate Without a Regulatory Framework

As highlighted in earlier sections of this paper, FinTech is supported by innovation in the financial sector. Most of these technologies are gaining support around the world for their credibility and reliability. In other words, people are starting to realize that some of the technologies supporting today’s financial innovation can be trusted and relied on.¹⁴ Indeed, most of them are starting to realize that such technologies could be used in promoting transparency within the financial sector and increasing people’s access to financial services.¹⁵

Based on these developments, some financial experts suggest that, instead of opposing financial innovation, regulatory improvements should focus on using new technology in the emerging areas of financial development such as digital asset tracking and identity verification.¹⁶ Although these views are expansionary in the sense that they identify new areas of technology use, they do not explain how they would help instill market confidence in the financial system.

Proponents of deregulation also argue that the limited scope of digital currency use within the virtual space provides an opportunity for the currency to operate without a need for control, subject to the low volumes of money currently in circulation. This view has been made in comparison to the dollar and other major currencies because any sizeable effect on the monetary system is predicated on the small size of virtual currency transactions in circulation.¹⁷

For example, the issuance of physical currencies needs to be done by a central regulatory body (the government) because the volume of transactions made using the same mode of payment is high. Comparatively, there is no such need for a central authority in digital currency issuance because few transactions made using this mode of payment, relative to the volume of global business.¹⁸ This argument appears to have merit for now because the volume of digital currency transactions is low. However, it is faulty because it represents a short-term view of the power of digital currencies. Stated differently, their use is expanding and they may fail to retain their small stature in the long term when more vendors start to accept them as conventional modes of payment.

People who support deregulation also argue that financial innovation could operate without the need for a regulatory framework because some digital currencies have an inbuilt regulatory system that serves the same function as a government would do through a central bank.¹⁹

The use of blockchain technology is an example of such a framework because it acts as a regulatory agency on its own. Some observers say it offers a platform for players in the financial sector to operate more freely and efficiently than they would do in the conventional space.²⁰ However, these proposed alternative financial stabilization systems have not been tested on a large scale.

Another argument touted for the need to have a liberal regulatory framework for innovative financial products is the global nature of financial innovation. Indeed, in modern society, financial innovation is borderless and the quest by one jurisdiction to introduce new regulations may be undermined by the unwillingness of another one to implement the same laws.²¹ Legal clashes and policy conflicts may undermine such efforts in the same way as the lack of coordination between different jurisdictions would make it difficult to enforce the financial regulations of one country in another.²²

Therefore, it is difficult to conceive a situation where financial regulation applies to technology that is jurisdictionally unbound. For example, proponents of deregulation say that digital currencies could be used in exchange for goods and services all around the world. Therefore, it would not make any sense for one country to formulate a law governing the same transaction when another country cannot enforce it, or subscribes to a different set of rules. Although their views are rooted in current practice, they fail to account for ongoing legal changes in regulation where countries are collaborating in the enforcement of financial laws or support common regulatory principles.

The apparent transparency of different forms of financial innovation also adds to the voices of deregulation because FinTech promotes transparency and efficiency in the financial market. Proponents of deregulation argue that the lack of these two elements of instrumentation in the mainstream financial industry has typically necessitated financial regulation because the government has had to come in as a third party (between buyers and sellers) and guarantee their transactions or provide legitimacy to them.

Consequently, they say that FinTech has eliminated the lack of trust that characterizes traditional financial transactions because it is inherently transparent.²³ However, as will be discussed in the next section of this paper, increased transparency in financial transactions does not necessarily mean there should be no regulation.

Discussion

Although most aspects of the financial revolution in digital currency development seem not to be backed by existing regulatory and legal frameworks, there are several instances where contemporary laws have been used to govern different aspects of financial innovation. For example, the American government has applied Federal laws and statutes in digital currency management to regulate the currency. In fact, because of their broad coverage, some of these statutes could be used to govern digital currency management, especially when they touch on issues relating to money laundering and terrorism financing.²⁴

For example, under Article 1 of the US constitution, the Federal government has the power to coin money and regulate the value thereof.²⁵ Although these roles are explicitly explained in the country’s laws, there appears to be no conception of the government’s power to do the same for currencies that are not issued by it.

Based on the insights highlighted in this paper, it is difficult to conceptualize a situation where financial innovation, which does not have legal or regulatory backing, could be holistically accepted or trusted. Money is a sensitive issue for many people because it carries their hopes, aspirations, and sometimes all their life’s work. It would be difficult to conceive a situation where the same people would entrust this resource in a system that does not have the guarantees that conventional currencies provide.

More importantly, it is difficult to picture a scenario where all the “chaos” that is associated with the conventional financial system would be addressed in a framework that has no accountability. Stated differently, the current global financial system is still vulnerable to shocks and volatilities that have ravaged economies and affected people’s livelihoods, even with government regulation in place. A system that does not have any regulatory framework is more vulnerable and cannot be trusted.

Although some people or companies would take the risk of using such a system, it is unrealistic to conceive a situation where it would compete with the existing one that has been perfected for more than a century. Here, it is important to also point out that no system is perfect, but current financial innovations that are changing how people use money and operate in the markets should not be viewed in isolation. Instead, they should be deemed a complementary framework that needs to improve what is already there, as opposed to fundamentally changing how the world’s global financial system works. In other words, such innovations should not be seen as an attempt to “reinvent the wheel,” but an improvement of the existing financial model.

Since national borders do not define digital currencies, solving legal and regulatory issues may require a global approach. In other words, countries, such as the US (through Congress) and the UK or Australia (through their legislative organs) cannot effectively formulate legal or regulatory frameworks that would effectively solve the legal issues underpinning the use of these currencies.²⁶ Instead, they need to seek international cooperation from other countries to provide a holistic approach to addressing the outstanding legal issues governing the same.

Conclusion

The findings of this paper show that there is a rapid push for financial regulators to keep up with innovation in the wake of disruptive technology. This push is happening globally and regulation is quickly being used as a proxy to legitimize these innovative processes and create new market segments. Nonetheless, the most consistent force emerging in this analysis is the need for countries and economies to take proactive measures and update their regulatory frameworks to keep up with the rapid change of technological innovation.

Based on the findings derived from this paper, the biggest regulatory issue emerging in this study is how authorities should monitor technological change, as opposed to how fast or far they could regulate financial innovation. Stemming from some of the arguments touted in this study in support of the use of digital currencies, it is important to point out that there is no basis for a generic regulation of financial innovation, such as digital currencies. However, such innovations need to be harmonized with existing financial policies to avoid a clash between the current legislative framework of policies and the operations of the same innovation. Collectively, this view supports the idea that regulation is important in financial innovation.

Bibliography

Secondary Resources

Books

Iain MacNeil and Justin O’Brien (eds), The Future of Financial Regulation (Hart Publishing 2010).

Zavolokina Liudmila, Dolata Mateusz, and Schwabe Gerhard, FinTech – What’s in a Name? In: Thirty Seventh International Conference on Information Systems (University of Zurich, 2016).

Websites

Craig Elwell, Maureen Murphy, and Michael Seitzinger, ‘Bitcoin: Questions, Answers, and Analysis of Legal Issues’ (Digital Library. 2013) Web.

Europa, ‘Directive 2014/65/EU of the European Parliament and of the Council of 15 May 2014 on Markets in Financial Instruments and Amending Directive 2002/92/EC and Directive 2011/61/EU’ (EUR-Lex, 2015). Web.

Europa, ‘Regulation (Eu) No 600/2014 of the European Parliament and of the Council of 15 May 2014’ (EUR-Lex, 2015). Web.

Journals

Anastasia Sotiropoulou and Dominique Gue´gan, ‘Bitcoin and the Challenges for Financial Regulation’ [2017] 12 CMLJ 466.

Douglas Arner, Janos Barberis, and Ross Buckley, ‘The Evolution of FinTech: A New Post-Crisis Paradigm’ [2016] 47 GJIL 1271.

Lucy Frew, Rich Folsom, and Sophie van Wingerden, ‘Legal and Regulatory Issues Relating to Virtual Currencies’ [2015] 7 JIBFL 438.

Nathan Coombs, ‘What Is An Algorithm? Financial Regulation in the Era of High-Frequency Trading’ [2016] 45 ESL 278.

Tarun Chordia, Gideon Saar, Amit Goyal, and Bruce Lehmann, ‘High-Frequency Trading’ [2013] 16 JFM 637.

Footnotes

1. Craig Elwell, Maureen Murphy, and Michael Seitzinger, ‘Bitcoin: Questions, Answers, and Analysis of Legal Issues’ (Digital Library, 2013). Web.
2. Nathan Coombs, ‘What Is An Algorithm? Financial Regulation in the Era of High-Frequency Trading’ [2016] 45 Economy and Society 278.
3. Anastasia Sotiropoulou and Dominique Gue´gan, ‘Bitcoin and the Challenges for Financial Regulation’ [2017] 12 CMLJ 466.
4. Craig Elwell, Maureen Murphy, and Michael Seitzinger, ‘Bitcoin: Questions, Answers, and Analysis of Legal Issues’ (Digital Library, 2013). Web.
5. Lucy Frew, Rich Folsom, and Sophie van Wingerden, ‘Legal and Regulatory Issues Relating to Virtual Currencies’ [2015] 7 JIBFL 438.
6. Lucy Frew, Rich Folsom, and Sophie van Wingerden, ‘Legal and Regulatory Issues Relating to Virtual Currencies’ [2015] 7 JIBFL 438.
7. Anastasia Sotiropoulou and Dominique Gue´gan, ‘Bitcoin and the Challenges for Financial Regulation’ [2017] 12 CMLJ 466.
8. Anastasia Sotiropoulou and Dominique Gue´gan, ‘Bitcoin and the Challenges for Financial Regulation’ [2017] 12 CMLJ 466.
9. Lucy Frew, Rich Folsom, and Sophie van Wingerden, ‘Legal and Regulatory Issues Relating to Virtual Currencies’ [2015] 7 JIBFL 438.
10. Douglas Arner, Janos Barberis, and Ross Buckley, ‘The Evolution of FinTech: A New Post-Crisis Paradigm’ [2016] 47 GJIL 1271.
11. Craig Elwell, Maureen Murphy, and Michael Seitzinger, ‘Bitcoin: Questions, Answers, and Analysis of Legal Issues’ (Digital Library, 2013). Web.
12. Craig Elwell, Maureen Murphy, and Michael Seitzinger, ‘Bitcoin: Questions, Answers, and Analysis of Legal Issues’ (Digital Library, 2013). Web.
13. Craig Elwell, Maureen Murphy, and Michael Seitzinger, ‘Bitcoin: Questions, Answers, and Analysis of Legal Issues’ (Digital Library, 2013). Web.
14. Craig Elwell, Maureen Murphy, and Michael Seitzinger, ‘Bitcoin: Questions, Answers, and Analysis of Legal Issues’ (Digital Library, 2013). Web.
15. Zavolokina Liudmila, Dolata Mateusz, and Schwabe Gerhard, FinTech – What’s in a Name? In: Thirty-Seventh International Conference on Information Systems (ZORA 2016) 16.
16. Craig Elwell, Maureen Murphy, and Michael Seitzinger, ‘Bitcoin: Questions, Answers, and Analysis of Legal Issues’ (Digital Library, 2013). Web.
17. Craig Elwell, Maureen Murphy, and Michael Seitzinger, ‘Bitcoin: Questions, Answers, and Analysis of Legal Issues’ (Digital Library, 2013). Web.
18. Craig Elwell, Maureen Murphy, and Michael Seitzinger, ‘Bitcoin: Questions, Answers, and Analysis of Legal Issues’ (Digital Library, 2013). Web.
19. Nathan Coombs, ‘What Is An Algorithm? Financial Regulation in the Era of High-Frequency Trading’ [2016] 45 Economy and Society 278.
20. Anastasia Sotiropoulou and Dominique Gue´gan, ‘Bitcoin and the Challenges for Financial Regulation’ [2017] 12 CMLJ 466.
21. Iain MacNeil and Justin O’Brien (eds), The Future of Financial Regulation (Hart Publishing 2010) 56.
22. Europa, ‘Directive 2014/65/EU of the European Parliament and of the Council of 15 May 2014 on markets in financial instruments and amending Directive 2002/92/EC and Directive 2011/61/EU’ (EUR-Lex, 2015). Web.
23. Craig Elwell, Maureen Murphy, and Michael Seitzinger, ‘Bitcoin: Questions, Answers, and Analysis of Legal Issues’ (Digital Library, 2013). Web.
24. Tarun Chordia, Gideon Saar, Amit Goyal, and Bruce Lehmann, ‘High-Frequency Trading’ [2013] 16 JFM 637.
25. Craig Elwell, Maureen Murphy, and Michael Seitzinger, ‘Bitcoin: Questions, Answers, and Analysis of Legal Issues’ (Digital Library, 2013). Web.
26. Europa, ‘Regulation (Eu) No 600/2014 of the European Parliament and of the Council of 15 May 2014’ (EUR-Lex, 2015). Web.