Lessons on crypto, fintech and regulation

The explosion of interest in new financial technology - including blockchain and distributed ledgers - poses a dilemma for regulators: how do you protect individuals and the financial system without stifling innovation or economic growth? 

"Lessons can be learned from the regulation of other parts of the financial services industry, such as trade finance.”

The question will likely persist as fintech and non-bank alternatives proliferate. While commentators debate how this brave new world should be regulated, there are lessons to be learned from the regulation of other parts of the financial services industry, such as trade finance.

The gap

Global trade is currently experiencing a ‘trade-finance gap’, where a portion of demand is not being met by the banking sector.

As non-bank alternatives begin to fill the void we all need to ensure regulation upholds the stability of the financial system; we effectively combat financial crime; and finance ultimately flows to those who need it to ensure the global economy keeps growing.

A balance needs to be struck between effective regulation on the one hand and the conduct of inclusive, value-creating and legitimate business activity on the other.

This requires a collaborative approach. Whether it is regulating trade finance or the latest trends in financial technology, it is everyone’s responsibility – regulator and regulated – to ensure the accountability is in the right place.

So let’s look at some of the lessons learned from trade-finance regulation.

1. Commercial realities cannot be ignored

As lenders, banks have a key role to play in keeping the wheels of the economy turning. However, they are value-driven institutions and will not continue certain types of business if it no longer makes sense from a commercial point of view.

Regulations which have been introduced over the past decade or so, such as higher capital requirements, tighter anti-money (AML) and know your customer (KYC) rules have changed the risk-return equation for banks. For example, KYC requirements have materially increased the cost of compliance for banks by an estimated factor of five.

Of course, this kind of regulation is necessary but the extent of it has created a burden which has had some unintended consequences.  

As a result of this wave of regulation since the global financial crisis, banks looked at their correspondent banking relationships – the network which facilitates lending for global trade – and cut back the number of banks they deal with.

Ultimately policymakers want banks to continue lending and supporting the economy but the new regulatory environment means this isn’t always possible.

When regulating trade finance, as well as fintech, cryptocurrencies and the like, regulators need to take an approach of regulating in a way which does not unnecessarily impede commerce.

2. Regulation can unintentionally impact financial inclusion

The increased KYC and AML requirements prompted a wave of ‘de-risking’ where banks substantially reduced the number of correspondent banks in their international network. In some cases, this had serious consequences for financial inclusion.

With international payments, some economies were cut off entirely from receiving remittances – which comprise a substantial portion of their gross domestic product – because they no longer had an international correspondent bank willing to receive payments into their country.

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From a trade finance perspective, the reduction in correspondent banking relationships meant certain segments – particularly small and micro businesses in emerging markets – were unable to get financing.

This has had unintended consequences for financial inclusion, as well as potentially creating more risk in the financial system.

As banks cut their correspondent relationships, other players stepped into the void, absorbing the risk banks were no longer prepared to take. This pushed potentially suspicious transactions out of the banking system – where they could be more easily monitored and detected – and onto more unstable, unregulated channels.

A similar principle extends to cryptocurrencies and the like. Although bitcoin has often been characterised as a facilitator of crime, its digital properties are a tool by which illicit transactions can be traced.

Bitcoin has also given the unbanked and underbanked access to payment systems where banking channels have been too expensive, inconvenient, or inaccessible. In regulating bitcoin and other cryptocurrencies, the impact on financial inclusion also needs to be considered.

3. The industry-regulator dialogue needs to improve

Bankers have been vocal about the unintended consequences of trade finance regulation for a number of years. However, the dialogue around regulation still needs to evolve, and the quality of deliberations needs to be raised.

There needs to be more open discussion so regulators can be better informed about the industries they are regulating, and be more open to feedback, and vice versa. 

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There have been some encouraging developments with regulatory sandboxes, where fintechs and banks can innovate in a test-and-learn environment supported by regulators.

Unfortunately any kind of engagement between regulator and regulated can get misunderstood as lobbying or regulatory capture. Obviously this is not what we are proposing but rather creating a more-open avenue for information exchange, without lobbying, which raises awareness for both parties.

This does not have to be a zero-sum negotiation between the industry and regulator. Banks, as well as fintech companies, must be objective in presenting their issues and concerns. They have a key role to play in shaping regulation, and must not hide from their responsibility of maintaining a robust financial system.

4. Financial crime is everybody’s problem

Bankers agree financial crime should be stopped in its tracks and banks have an obligation to report anything suspicious to the relevant authorities. However, the policing component of complying with regulation in some cases has become overly burdensome.

Take an anecdotal example of a bank having to validate the name of a ship’s captain and check they are not on a list of named terrorists. This check occurs after documents have been prepared by a range of external parties and delays the shipment of goods, thus impacting businesses and trade flows.

Thinking this through further, who would think it reasonable for it to be effectively left to the banks, whose role happens late in the process, to detect this? Particularly when so many other players earlier in the documentation and logistics process would have the opportunity to challenge how a terrorist could suddenly be named a ship’s captain without years of industry experience.

There are other parties involved in global trade well placed to fight financial crime. Shipping companies, insurers, customer agents and freight forwarders, for example, can detect suspicious shipments.

And in the case of buying property, lawyers, estate agents and land title registries can spot if a transaction is suspicious.

Despite efforts already being made by banks there is still much more which can be done via thinking differently about their processes, product development and technology investment – ensuring compliant outcomes are integrated into their solutions from inception and not treated as a burdensome ‘bolt on’ after the fact.

Combatting financial crime should be seen as everybody’s problem so all parties – in addition to banks and fintechs – are working together to the same end.

5. There needs to be consistency in global regulations

The complex regulations introduced since the crisis are further complicated by the differences in regulation between jurisdictions. It is costly for international companies to navigate the differences which may mean a global solution cannot be rolled out across multiple markets.

In some cases money is being spent on accommodating these complexities which could be put to better use elsewhere – like lending, for example.

There can also be discrepancies with national interpretations of global regulations. This can lead to a situation of regulatory arbitrage where a country’s less-strict regulations are advantageous to local players because international companies have to comply with more-stringent regulations in their home market.

International fintech companies face a similar situation, and Bitcoin has been treated very differently by national regulators. Addressing the gaps and creating global consistency will create a stronger regulatory framework for everyone, whether it is banks or fintech groups.

The lessons from regulating trade finance show there are unintended consequences to certain types of regulation.

When it comes to regulating the new world of financial technology, everyone has a role to play in ensuring that the accountability is in the right place and regulation protects individuals and the financial system, and at the same time does not impede economic growth or innovation.

Mark Evans is Managing Director, Transaction Banking at ANZ, and also a member of the International Chamber of Commerce (ICC) Banking Commission’s Executive Committee.  

Alexander Malaket is President of Canadian consultancy OPUS Advisory Services, focusing on international business, trade and investment and a specialist in trade and supply chain finance. He is Deputy Head of the ICC Banking Commission’s Executive Committee.