Innovation vs Regulation: a Balancing Act

By Polina Evstifeeva, Head of Regulatory Strategy, New Ventures, Corporate Bank, Deutsche Bank

The flourishing data economy, the emergence of fintech (financial technology) and bigtech (major technology) firms in the traditional-banking space and the growth of the crypto-assets market all promise the financial industry a new era of fresh competition, improved client service and innovative financial products. More fundamentally, these trends could also alter incumbent players’ business models and even financial-market structures.

Regulation will play a key role in shaping the face of this emerging landscape, defining the trajectory of change.

Managing competing data demands

A continuing trend we assess in Deutsche Bank’s recent white paper, “Regulation driving banking transformation”, is the growing “data economy”—a digital ecosystem in which data is collected, analysed and exchanged between governments, companies or other parties to create value for businesses and individuals. Here, big data is the basis upon which advanced analytics operate, which in turn can drive insights and improve client experience, uplifting the provision of financial services.

The data economy in the European Union (EU) was valued at €300 billion in 2016, equivalent to around 2 percent of the region’s gross domestic product (GDP)—which the European Commission (EC) predicts could rise to almost €750 billion next year, if backed by favourable policy and technology investment.^[i]

The winners in this emerging data economy will be those that can best bring such benefits to clients, improving their businesses and saving them money. Given the prize at stake—and also the costs of falling behind—the importance of data collection, storage and analysis can only increase.

In this respect, regulatory-driven data-localisation requirements are a clear hindrance to consolidating rich pools of data. They significantly limit the depth of datasets for analysis and paint an incomplete picture of clients’ needs, which makes crafting bespoke financial products more difficult.

With the matter of data-localisation rules being a complex issue that involves different requirements from various jurisdictions, it will likely remain a barrier at the global level in the meantime. In this environment, financial institutions will seek to address the issue by seeking technological solutions that allow them to make the most of the data they store across the globe while maintaining compliance with requirements across jurisdictions.

The absence of holistic data-sharing regulatory requirements is another challenge that affects the ability to consolidate data that would provide a full picture of clients’ needs. While Open Banking initiatives have helped greater data sharing in the financial industry, they have their limitations. A major one is that they omit from scope any data that is stored with other private companies—such as companies in other industries or platform businesses of bigtech companies—which could otherwise enrich the analytics and, ultimately, the provision of banking services.

As the data-sharing issue becomes more prominent, regulators will likely face demands to lift such barriers—while still maintaining the protection of clients’ rights and the security of their data. Marrying the competing demands for the further opening up of data with those for data privacy will require a delicate approach—and the creation of a regulatory environment that builds trust in data sharing and usage.

The rise of the fintechs

Arguably, some of the most advanced innovation for consolidating, analysing and using clients’ data has emerged from other industries: bigtech companies. The impact of bigtechs, as well as fintechs, on the financial industry is most visible in the area of collaboration with incumbent financial-services providers. Special licencing regimes are just one of the tools that regulators have at their disposal to promote fintech innovation. Others include innovation hubs and regulatory sandboxes, which create an environment in which firms can test innovative financial products, services or business models.

Cooperation also takes place with respect to data storage (such as cloud). While unleashing the upside of such innovation, regulators will also have the potential downside firmly on their radars. Given the increasing concern that the supply of cloud services could be concentrated with just a few large cloud providers, issues surrounding concentration risks, financial stability and the potential development of a new single point of failure will lead the discussion in the near future.

While collaboration is one storyline, another is competition. Many fintechs and bigtechs have established strong footholds in niche markets by “unbundling” traditional financial services—relying on regulatory frameworks that allow the provision of certain banking services without the need for a full banking licence (such as payments or lending).

While bigtechs still provide financial services only as an add-on to their more traditional product offerings, they continue to grow their financial-services propositions, using deep pools of customer data to craft bespoke solutions. The industry, therefore, faces a potential gamechanger.

An emerging concern of regulators arises from the uniqueness of business models of bigtech platforms, which are underpinned by data analytics, network externalities and interwoven activities {termed DNA by the Bank for International Settlements (BIS)^[ii]}. Within this, each of the elements reinforce each other: a user’s benefit from participating on one side of a platform (for example, as a seller on an e-commerce platform) increases with the number of users on the other side (buyers); this then generates more data, which can be analysed to enhance existing services and attract further users. By offering financial services, bigtechs can further reinforce the loop.

While recognising the benefits that the new entrants bring to the financial industry, regulators’ vigilance has increased with attention focused on the impact that these developments have had on financial stability, competition, clients’ protection and data handling.

What constitutes a crypto-asset?

A further transformative trend for the financial industry (which we also assess in our recent white paper) is the evolution of the crypto-assets market. Although the volumes of initial coin offerings (ICOs) or payments in crypto-assets are still dwarfed by traditional methods of capital-raising or payments facilitation, forward-thinking regulators have already moved to provide much-sought-after regulatory clarity to set the path for the market’s development. However, it appears unlikely that we will see a widespread uptake of crypto-assets any time soon without a marked change in regulatory direction on a global basis.

This is a particularly pressing issue for the types of crypto-assets that are attempting to become alternative global payment methods. The key barrier remains the lack of alignment across jurisdictions: while in one region, a crypto-asset could be treated as a payment token, or electronic money, in another, the same asset would be prohibited from circulation.

Yet, this is not to downplay the potential impact that crypto-assets (representing financial instruments) might bring to securities markets. In Europe, for instance, there has already been major regulatory progress to clarify in which instances a crypto-asset should be treated as a financial instrument—defining the applicable rules when it comes to its issuance and circulation, including the protections that those investing in such crypto-assets can enjoy. Such certainty brings comfort to investors and financial institutions that might want to purchase or otherwise deal with crypto-assets representing financial instruments. And while the ability to list and trade such crypto-assets in numerous countries is similarly undermined by regulatory asymmetries between various jurisdictions, this issue is not too dissimilar to that faced when dealing with traditional securities.

The long-term benefits of crypto-assets remain compelling. Yet, although some jurisdictions are moving in the right direction, the regulatory certainty enjoyed by traditional assets is still not established for all types of crypto-assets in all jurisdictions. This makes dealing in them subject to uncertain risks. More clarity needs to be provided by not only the regulators but the industry itself. We are, therefore, only at the beginning of the journey.

The extent to which all of these trends shape the financial industry will depend on how regulators seek to balance the obvious opportunities against the potential risks. The financial industry should not wait for regulators to show their hand; it will need to adapt to these new realities immediately by leveraging innovative technologies to create bespoke solutions and bring additional value to clients. With high levels of client trust and years of financial-services experience, banks are well-placed to take on this challenge.

References:

[i] “Final results of the European Data Market study measuring the size and trends of the EU data economy”, European Commission, 2 May 2017, see https://ec.europa.eu/digital-single-market/en/news/final-results-european-data-market-study-measuring-size-and-trends-eu-data-economy

[ii] “Big tech in finance: opportunities and risks”, BIS, 30 June 2019, see https://www.bis.org/publ/arpdf/ar2019e3.pdf

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