Regulation versus innovation is a double-edged sword

I was intrigued by a new report from the IMF (International Monetary Fund) which states that: “if the use of fintech grows rapidly outside of the regulated sector, it can generate risks to market conduct and integrity”. Shock, horror! And so? “New fintech developments might quickly become systemic due to network effects (for example, when BigTech provides financial services). To manage risks, authorities need to monitor new developments effectively”.

Systemic risks, new developments, regulatory authorities.

It’s that old question of how authorities can keep up with innovations. Answer: a sandbox?

The IMF says no, not really. “Sandboxes are resource-intensive hypothesis-led initiatives that allow firms to test innovative propositions with real consumers in a controlled environment … sandboxes allow authorities to monitor developments closely and can help them to get comfortable with new technologies and business models. Sandboxes, however, are expensive and diverse in design, and require significant resources dedicated to supporting a small number of firms”.

In other words, sandboxes help the wee little start-ups get bigger quicker, at the expense of a lot of time and effort of regulators and banks.

Interesting.

The report is wrapped up in government speak text – as in it is formal and not easy to read – but has a few quotes that made me wake up. For example:

“Given the cross-border nature of fintech, new technologies, business models, and products and services driven by fintech are likely to affect financial markets across borders. The ability to share information and insights and exchange learnings and best practices can help authorities to better monitor new fintech developments, understand emerging risks, and create frameworks to mitigate these risks while harnessing their benefits”.

Loved this quote, as it seems to say that it is: “better to have the son-of-a-bitch inside the tent pissing out than outside the tent pissing in.” (Lyndon B. Johnson)

I kindof appreciated this insight, as it appears to be true of a lot financial market and regulatory attitude towards fintech. The general view is that fintechs are the enemy but, because they are a threat, we should engage with them to defeat them, rather than encourage them to succeed.

It reminds me of a comment made by Philippe Gelis on this blog eight years ago:

“Most banks look to fund fintech start-ups that create products to be added on top of banks products, that will make the user experience better, but they almost never invest in products that directly compete with them, that cannibalize them. Let me explain why I think bankers are completely wrong.”

Why are banks wrong?

90% of bankers say “that a fintech bank was improbable and, if it happens, it would be built by an incumbent.  This creates a fantastic window for fintech entrepreneurs, to build it, and once it’s done, it will be too late for them to react.”

I am not sure, as I can see both sides of this argument. On the one hand, you need to have structure and regulation to constrain market risks; on the other, you need to have vision and innovation to progress market structures.

It is a classic double-edged sword.