Regulatory compliance is time consuming and expensive for both financial institutions and regulators—and the complexity and cost is increasing. According to Federal Financial Analytics, a policy analysis firm, the six largest U.S. banks spent $70.2 billion on compliance in 2013, twice the $34.7 billion spent in 2007.

As we explain in our recent report “Regtech rising: Automating regulation for financial institutions,” regulatory technology—regtech—has emerged to address these and other challenges.

An outgrowth of fintech, regtech uses digital technologies—including big data analytics, cloud computing and machine learning—to facilitate regulatory compliance. Regtech applications automate risk management and compliance processes, enable companies to stay abreast of regulatory changes around the world, facilitate regulatory reporting, and support strategic planning.

For now, the vast majority of regtech solutions are focused on helping financial institutions manage compliance. There are numerous startups already providing regtech solutions, but long-established players are getting into the game as well. For example, IBM just announced that it is acquiring Promontory Financial Group, which advises banks on regulatory matters. IBM says Promontory will help train Watson, IBM’s artificial intelligence platform, to build regtech solutions.

At this early stage, most regtech activity is focused on three broad areas:

• Modeling and forecasting. Applications that run scenarios and other analyses to evaluate the possible effects of adverse events on businesses, often focusing on banks that must comply with rules that require capital and liquidity reporting, recovery and resolution planning and stress testing.

• Identity validation. Applications that aggregate and analyze public and private sources of information to verify the identities of customers and business partners, often to ensure compliance with anti-money laundering, anti-terrorist financing, and know your customer regulations.

• Real-time monitoring and behavioral analytics. Applications that continuously evaluate business activities, particularly related to financial transactions and trading, to identify violations and flag behaviors patterns that may be indicative of existing or potential problems.

Regtech offers many of the same benefits to regulators as it does to financial institutions, although it appears that fewer regtech providers have emerged to serve the significant needs of regulators. Eventually, smart contracts may provide regulators with real-time oversight of an array of automated financial transactions.

Organizations must be vigilant about managing the risks of implementing regtech solutions. The space is evolving rapidly, and regtech could bring significant change to the financial services sector in relatively short order, potentially transforming how regulators and financial institutions operate and interact.

All players in the space should develop clear perspectives about how to manage five broad categories of risk to minimize their exposure and maximize the potential benefits of their regtech endeavors:

• Uncertain development paths. It is too early to know which technologies will prevail and how standards will emerge and evolve as the regtech space matures.

• Provider reliability. The integrity and security of partners and their systems is crucial to financial institutions that use solutions from third-parties.

• Increased regulatory scrutiny. As financial institutions gather and analyze more data, authorities may require more detailed or extensive reporting, which could open new avenues for regulation.

• Limited judgment. Algorithms continue to require significant human oversight, particularly when success depends on making complex judgments or accounting for nuance.

• Privacy. Any time an organization collects data about individuals, it must take steps to ensure it does not violate privacy rules.

Although the regtech era is just getting started, financial institutions and regulators are already reaping tangible benefits from implementing regtech solutions. As the space matures, regtech will become prevalent throughout the financial services industry and an increasingly important aspect of the regulatory process.

This post comes to us from White & Case LLP. It is based on the firm’s report, “Regtech rising: Automating regulation for financial institutions,” dated September 26, 2016, and available here.