A regulatory approach to fintech
Guarding against emerging risks without stifling innovation
by Christine Lagarde in Washington
Thu 20 Sep 2018
In 1876, when Alexander Graham Bell was awarded a patent for the telephone, the only way to communicate rapidly over long distances was by telegraph. The dominant company in that market dismissed Bell's invention as a useless toy and rejected an opportunity to buy his patent. The rest, as they say, is history.
This anecdote illustrates the unpredictable nature of technological innovation. Today, some enthusiasts say crypto assets may represent the beginning of a similar breakthrough. Others condemn crypto assets as little more than a fad or a fraud. We should not dismiss them so lightly.
Crypto assets are just one example of how new technologies are being used to deliver financial services. Advances in artificial intelligence promise to extract more value from ever more abundant and ubiquitous data. Its applications in financial services include enhancing fraud protection and regulatory compliance, potentially expanding access to services and deepening financial inclusion.
Financial technology offers considerable promise, but it also poses risks. Consider distributed ledger technology, which underpins crypto assets. It can enable faster and cheaper transactions, store records securely and execute so-called smart contracts automatically. But the technology has also been used for illicit purposes.
Regulators face a difficult task. On the one hand, they must protect consumers and investors against fraud and combat tax evasion, money laundering and the financing of terrorism. They must also protect the integrity and stability of the financial system. On the other, they must beware of stifling innovation that benefits the public. By engaging with market participants at the centre of financial innovation, regulators can stay abreast of the benefits of new technologies and identify risks. Developing a forward-looking regulatory framework calls for creativity, flexibility, and new expertise.
The experience of the 2008 financial crisis and its aftermath yielded three important lessons. First, trust is the foundation of the financial system, but it is fragile and can be shaken easily. Second, risk accumulates in unexpected places. In the years before the crisis, financial instruments emerged that were poorly understood by investors, such as collateralised debt obligations. It is unclear whether a decentralised financial system will be more stable or less. There is a chance that emerging risks will go undetected as the role of traditional intermediaries diminishes. Third, in a globalised world, financial shocks quickly reverberate across borders. Responding to a crisis requires concerted action. And a global financial system may transmit shocks more quickly.
So far, national authorities have reacted with varying degrees of regulatory stringency. If this uncoordinated response continues, activity will simply migrate towards more lightly regulated jurisdictions in a race to the bottom. Because crypto assets know no borders, a global approach is vital.
Such an approach is taking shape. The Financial Action Task Force has given guidance to its members on addressing money-laundering and terrorist-financing risks associated with crypto assets. The Financial Stability Board, which coordinates financial regulation for the G20 economies, is studying ways to monitor crypto assets.
The G20 agrees with the FSB's assessment that crypto assets do not pose a threat to stability, though they could pose a threat in the future. The G20 asked the FSB and other standard-setting bodies to continue their work on crypto assets and report on progress.
The International Monetary Fund can serve as a forum for the exchange of ideas and forging consensus. It is the job of the Fund to monitor the economies of its 189 members. That gives the IMF a unique global perspective.
We must understand innovative technologies, learn from them, and perhaps even adopt some of them to improve regulation, supervision and surveillance. In some cases, it will be enough to apply existing regulations. In others, new approaches may be required as risks emerge and as distinctions between entities and activities break down. One thing seems certain: we should not put off action until the answers become clear. Instead, we must begin to consider the regulatory framework of the future.
We must do so in a manner attuned to the rapid pace of change, and with the awareness that unexpected new opportunities and risks may emerge. One approach, undertaken in Hong Kong, Abu Dhabi and elsewhere, is to establish regulatory sandboxes where new financial technologies can be tested in a closely supervised environment.
Above all, we must keep an open mind about crypto assets and fintech, not only because of the risks they pose, but also because of their potential to improve our lives. When in doubt, think of Bell and his telephone.
Christine Lagarde is Managing Director of the International Monetary Fund. This is an edited version of an article that first appeared in Finance & Development magazine.
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