Fintech, embrace your inner regulator!

2017 is shaping to be the year of “#regtech“, aka new technology startups setting up digital shop to help the financial services sector cope with its heavy “regulatory burden”. But what is “regulation”? Why is it a burden and how does it relate to real risks and risk management?

The narratives around financial regulation have been, for some time, completely dominated by the so-called compliance perspective. Compliance prescribes procedures, tools, operating boundaries that a financial firm must have in place in order to be have an operating license. Compliance is a powerful motivator (Which implies – in passing – that efficient provision of “compliance” is indeed a nice little business opportunity). Yet for the fledgling disruptors of the financial industry the incumbent state of affairs regarding compliance is hardly a solid basis on which to build their new business models.

The simple reason is that, whether real or nominal, the hyper-compliance culture of today is the outcome of serial and serious failures of the financial industry to self-regulate. It is the absence of demonstrably effective self-regulation that shifted the focus (and onus) on the massively expanded role of external regulation. Yet this is not a particularly robust or efficient state and is thus unlikely to persist.

In well functioning systems, the primary mode of regulation is internal and not external (imposed). All biological systems maintain their balance homeostatically. Maintaining internal balance ensures sustainability as it helps steer away from the risks that lurk at the extremes. It is true we can stay on the road even if our car has a malfunctioning steering wheel. We can do this by bumping left and right onto regulatory “barriers”. But our car will not be in good shape after the end of the journey…

It is actually hard to find scenarios in which an internally driven balancing act would not be the optimal way to complete any journey. But how do we achieve this middle of the road nirvana? How do we detect drift from balance and how do we restore? Well, giants before us told us how, and we simply need to stand on their shoulders: They invented the regulator:

The regulator is a small, efficient and super-smart device which creates a natural feedback loop. How does it work? Using only imperceptible amounts of energy, if the engine goes too fast the internal regulator spins even faster and uses this extra spin to choke the fuel supply which slows the engine down, upon which the regulator calms down as well. Without the regulator our steam engine blows and we need to mop up the pieces in the aftermath (assuming we survived the explosion).

So this is the true task for a disruptive take on regulation, which in turn is a disruptive take on the entire financial services sector: Devising effective internal regulatory mechanisms. Technology has a great role to play, because regulation is all about leveraging signals, digital signals.