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How to Regulate FinTech, Crypto Assets, DeFi, and Other Financial Innovations

In a new article, I attempt to build a systematic framework for regulating FinTech-driven innovations. In doing so, I clarify and simplify the confusing terminology that makes FinTech appear more complicated than it is.

“FinTech” refers to the use of technology to facilitate financial innovations. FinTech’s innovations can provide valuable and, some argue, revolutionary new economic benefits including increased access to financial markets and products, thereby greatly expanding financial inclusion and helping to democratize the financial system. At the same time, the radical transformational consequences of these innovations are threatening to disrupt traditional finance and even jeopardize the stability of the financial system.

The complexity of blockchains, for example, can reduce transparency and cause programming errors. The anonymity of decentralized finance (“DeFi”) can obscure the identity of counterparties, thereby preventing them from resolving disagreements and increasing counterparty risk. It also can shift financing away from regulated banks to unregulated funding sources. The U.S. Treasury believes that DeFi can even threaten national security by enabling the financing of rogue states and other bad actors.

Furthermore, the unchecked execution of smart contracts, which operate automatically based on programmed steps, can spread panic. The classic Disney movie, “Fantasia,” provides an analogy. A sorcerer orders his apprentice, Mickey Mouse, to fill a cauldron with water. Deciding to nap, Mickey conjures a broom to pour the water. He later wakes in horror, unable to stop the broom from continuing to pour water and creating a flood. A smart contract’s automatic execution can produce similarly unintended and harmful results.

Even those who argue that FinTech-driven innovations represent the same types of risks raised by traditional finance – credit risk, market risk, liquidity risk, and operational risk – admit that FinTech can incrementally change those risks. Consider cryptocurrencies, a commonly known FinTech innovation referring to currencies whose ownership and transfer are electronically recorded by blockchain cryptography.

Even one of the most conservative types of cryptocurrencies, stablecoins, might impair financial stability. Being redeemable for “reference” assets having intrinsic value, such as U.S. dollars or euros, the mere perception that a stablecoin issuer might become unable to redeem the coin for its reference assets could panic stablecoin holders, resembling a classic bank run and reducing the stablecoin’s value. If the stablecoin is widely used as a common store of value – which would be likely in emerging markets and developing economies – even a moderate variation in its value might cause significant fluctuations in holders’ wealth. If that fluctuation is sizeable enough to affect spending decisions and economic activity, it could cause a recession.

FinTech’s riskiness should, nonetheless, be put into perspective. FinTech is not entirely new; its historical roots are exemplified by the advent of computers. Computers made it feasible to transmit and settle payment orders electronically, to facilitate cross-border payments, and to develop online banking. Advances in computing power enabled high-frequency trading by allowing parties to analyze market conditions and execute orders in fractions of a second. Increased computing power also enabled firms to model potential new securities markets and their risks, enabling innovative financing techniques such as securitization.

Although beneficial, these financial innovations brought significant risks. For example, computerized high-frequency trading became so fast, executing thousands of orders per second, that (somewhat like smart contracts) they operated unchecked in real time. As a result, erroneous trades disrupted finance by causing substantial losses before they were able to be discovered.

Similarly, computer-enabled innovations in securitization jeopardized financial stability by causing, or at least greatly contributing to, the 2008 global financial crisis. In connection with that crisis, securities issued in standardized securitization transactions were pooled together and “re-securitized” in highly complex leveraged transactions. The complexity of these transactions reduced transparency and created a risk that relatively small errors in cash-flow projections could disproportionately impair repayment of the re-securitized securities. The unanticipated 2007 decline in housing prices reduced cash flow on the mortgage loans underlying many of those leveraged transactions, significantly impairing repayment. That caused defaults on many re-securitized securities that were rated at the low end of investment grade and prompted credit-rating agencies to downgrade the more highly rated re-securitized securities. These defaults and downgrades panicked investors, reducing confidence in all credit ratings – even the ratings on basic corporate bonds and commercial paper. That destabilized the market for debt securities, severely reducing business credit and exacerbating the crisis.

These tensions between benefits and costs raise a fundamental but not fully answered question: How should the law regulate financial innovation? Although scholars have attempted to answer that question, their approaches have been ad hoc. Furthermore, there is fundamental disagreement over whether FinTech-driven innovations are radically changing the financial system, necessitating completely new forms of regulation, or whether they merely present the same types of risks already associated with electronic banking. My article strives to build a more systematic framework for analyzing how FinTech-driven innovations in particular, and financial innovation in general, should be regulated.

My article begins building its framework by analyzing actual precedents for regulating financial innovation, including the U.S. and EU regulatory responses to computerized innovations in high-frequency securities trading, and then comparing normative regulatory models. Thereafter, it integrates these precedents and models into a regulatory framework, which it applies to FinTech-driven innovations and financial innovation more generally, thereby testing the framework’s ability to cost-effectively control the risks of those innovations. That testing confirms that the article’s framework, or at least a more systematic normative framework for financial regulation than currently exists, should help regulators devise appropriate and cost-effective rules for regulating financial innovation. That, in turn, should improve the prevailing process for regulating financial innovation, which has been compared to “regulating in the dark.”

Although my article seeks to build a substantive regulatory framework, financial regulators should be cautious lest premature regulation restrict innovation and impose transaction costs without effectively controlling harm. Early regulation runs the risk of being underinclusive or overbroad. The latter, for example, can impose unnecessary costs, such as the expenses of preparing and implementing a supervisory program, developing employee expertise, and updating examination and training manuals as well as databases for receiving, analyzing, and storing information. For these reasons, policymakers initially might consider more principles- than rules-based regulation, deferring granular decisions about implementation to the regulators.

Deferring implementation decisions to regulators can be controversial, however. It entrusts unelected officials with choices that could have significant consequences. Accordingly, if possible, policymakers should wait until regulation is truly needed.

This post comes to us from Steven L. Schwarcz, the Stanley A. Star Distinguished Professor of Law & Business at Duke University School of Law. It is based on his recent article, “Regulating Financial Innovation: FinTech, Crypto-assets, DeFi, and Beyond,” available here.

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