At a time of exponential innovations, you might hear that regulations are hindering the adaptation of technologies. But of course, there is a good reason for that. The implications of AI and machine learning on society can be detrimental, so industries must tread lightly and act ethically when applying new technologies. This is where public and private regulators come into play, and Ligia Catherine Arias-Barrera, Ph.D. in Law at the University of Warwick, reviews their impact on this industry’s technological evolution.
Law is impersonal and should not be tailored to an individual’s specific interests or needs. Law is not automatically self-enforcing, and its effectiveness is directly linked to available enforcement tools. These two legal benchmarks guide our considerations on how the multiple actors involved in the regulatory process influence rule making and compliance in the context of FinTech. The central query is to argue that although regulatory sandboxes are an interesting exercise to facilitate the dialogue between start-ups and regulatory agencies, the participation of industry bodies is central to ensure and construct a comprehensive model of regulation that will determine how technology unfolds[1]. In particular, we refer to the role of the International Swaps and Derivatives Association (ISDA) in the adoption of FinTech applications in the derivatives market. The best-suited strategy of regulation to accomplish such objective is judgement-led approach.
‘A tale of two cities’: Regulation and Supervision
Regulation and supervision are two concepts usually assumed to have similar meanings. However, the distinction must be considered in order to understand how authorities perform their mandates. One primary approach could propose regulation and supervision as two complementary stages of regulators’ work. On the one hand, regulation[2] as the setting of standards based on the expectations regulators have about regulatees’ conduct is the behaviour regulatees are expected to maintain in complying with the rules issued by the authorities. On the other hand, supervision[3] alludes to the assessment of compliance by the regulated firms. Therefore, regulation and supervision appear to be extremely interconnected, since the process of understanding how it operates in practice requires the concurrence of both stages. Thus, the success of a regulation and supervision system requires the coherent understanding and inevitable linkage between the two terms.
Moreover, the path of building a regulatory model is inextricably intertwined due to the role multiple actors have in the rule-making process. The derivatives market is regarded as one example of the active interaction of national and transnational[4] or ‘private’ regulators with a strong emphasis on recognising[5] ‘ISDA’s regulatory capacities[6].
ISDA might help to better direct the way in which tech-innovations can serve the growth and development of the derivatives market.
Traditionally, the core discussion is centered on the increasing influence of private regulators in derivatives market regimes worldwide. Notwithstanding the critiques during recent global financial crises, there is what seems to be an unstoppable growth of what could be identified as a self-regulation phenomenon[7]. In order to draw a distinction among all private actors (i.e., informal or private regulators), we consider the role of private stakeholders participating in the market, among others FinTech innovators and ISDA, exerting influence in the regulatory process.
The importance of tackling the role of ISDA in the regulatory process lies on the self-regulatory trend marked during the latter 20th century within the derivatives market[8]. Arguably, the influence of ISDA is undoubtedly a key factor in the public deregulation of the OTC derivatives trading[9], which continues to support the regulatory process.
Notwithstanding, the so-called dealers must be considered within the category of informal or private regulators but to identify their influence on the regulatory process is a more difficult task. Whilst ISDA is a legitimate and visible actor, dealers’ influence could be reduced to a political and economic perspective. Within this category are included the end users, the ‘buy and sell side’ participants[10], not necessarily represented by ISDA. They ‘make the market’[11], developing products and acting as intermediaries in trades.
A regulatory sandbox ‘allows early-stage FinTech start-ups to test out their offerings in a limited market environment, under regulatory supervision, but without having to be fully licensed’
In the era of Blockchain, DLT and Smart Contracts, ISDA has remained as the leading voice of derivatives industry. Recently, ISDA published a series of papers intended to ‘provide high-level guidance on the legal documentation and framework that currently governs derivatives trading, and to point out certain issues that may need to be considered by technology developers when introducing technology into that framework’[12]. Therefore, the role of ISDA in this regard is to assist and guide FinTech developers to address the most prominent issues associated with contract performance and the type of obligations that could be automatised. In this sense, ISDA might help to better direct the way in which tech-innovations can serve the growth and development of the derivatives market.
Alongside ISDA there’s a relatively new level of ‘informal or private regulators’ that comprises of FinTech developers and startups. In sandboxes, they have the opportunity to build in safeguards for consumers, and to provide information to public regulators about the new technologies and products before they are offered to the market[13].
Dialogue between ‘private’ and public regulators
It would be an incomplete regulatory-network that ignores to role of ISDA in promoting and developing more stable, sound and efficient markets.
The question is, therefore, what the role public regulators are expected to have in front of innovation and the adoption of FinTech developments, as well as their interaction with start-ups and industry bodies or associations (e.g., ISDA)? ‘Regulatory sandboxes’ are one of the most proliferated models of cooperation between public and ‘private’ regulators. A regulatory sandbox ‘allows early-stage FinTech start-ups to test out their offerings in a limited market environment, under regulatory supervision, but without having to be fully licensed’[14]. The model promises to provide regulatory authorities with sufficient understanding about new technologies content and associated risks. It also facilitates timely access to information concerning the process of innovation lead by start-ups and technology developers. Then, the question is what regulatory strategy could be adopted to facilitate and improve the current ‘regulatory sandboxes’ model.
Does judgement-led regulation fit?
Judgement-led regulation is the regulatory strategy that best-serves the dynamics of FinTech and public-private regulators. The level of discretion conferred to regulators will be informed by the knowledge of innovative developments. It will also be guided by the proactive and forward-looking nature of the approach. The rationale of this strategy is to allow certain level of discretion to regulated firms within the frame and control of regulators[15]. Thereby, the adoption of judgement-led regulation will be translated into regulators’ powers of intervention and the expectation that regulatory authorities will be more intrusive in order to pre-empt the materialisation of future risks[16].
In this context, firms will ‘be granted freedom’ to manage their affairs according to the expected outcomes set by regulators[17]. Along with the leading role of regulators, it calls for the active involvement of regulated firms that in the FinTech-derivatives market environment comprise dealers, end-users, FinTech developers and startups, as well as experienced industry organisations as ISDA.
There is a need to align private regulators’ behaviour and rules with public regulation objectives
To restrict the composition of sandboxes to startups and public regulators means to leave behind an important component of the functioning of the derivatives market. It would be an incomplete regulatory-network that ignores to role of ISDA in promoting and developing more stable, sound and efficient markets. Thus, the traditional impediments affecting the use of judgement-led regulation can only be overcome when ‘regulatory sandboxes’ include all ‘private regulators’, that is FinTech developers, start-ups and industry bodies (e.g., ISDA). Such conformation will reduce the issues associated to access to information, as regulatory sandboxes create the perfect forum for private actors to submit all the relevant data related to certain modes of action and the foreseeable risks brought by innovation[18].
Once data is collected, the next step is to clarify the way information will be analysed and linked to regulatory actions and supervisory priorities[19]. The challenge is to connect collected information to the design and implementation of adequate supervisory powers and tools. Professor Lastra asserts that to be able to supervise ‘regulators must have knowledge and exercise judgement’[20]. Therefore, knowledge is intimately connected to access adequate information, along with the familiarity with market dynamics and evolution[21].
In this context, regulatory sandboxes are only effective when the objectives inspiring its adoption are clear from the outset, and involve both private and public regulators. In other words, there is a need to align private regulators’ behaviour and rules with public regulation objectives. We propose going one step forward. Not only to adjust regulation and compliance, but to ensure observance of rules by means of including private regulators in the design of new regimes governing FinTech environment.
[1]Michèle Finck, Blockchain Regulation and Governance in Europe (Cambridge University Press, Dec 20, 2018).
[2]‘Regulation refers to the sustained and focused attempt to alter the behaviour of others in order to address a collective issue or attain an identified end’. Julia Black, ‘Constructing and Contesting’. See also Rosa Lastra, ‘The governance structure for financial regulation and supervision’: ‘In financial law regulation is ‘the establishment of rules, and the processes and instruments of rule-making’. Pg.99
[3]Rosa Lastra, ‘The governance structure for financial regulation and supervision’. Supervision to activities of licensing, supervision strictu sensu (ie. Monitoring) sanctioning and crisis management(…) The future of the internal Market in financial services will be directly affected by the institutional design of supervision and by the extent to which the legislative process ensures the principles of transparency, Market discipline, consultation and flexibility’.
[4] We refer to transnational regulators to include the role of Basel Committee on Banking Supervision (BCSC); the Financial Stability Board (FSB); and the International Organisation of Securities Commissions (IOSCO). They have been charged by the G20 with overseeing the OTC derivatives regulatory reform process across Jurisdictions.
[5]‘The incorporation of ISDA contractual norms into national legislation indicates that ISDA standards are very strong’. Frank Partnoy, ‘Second Order Benefits from Standards’ (2007), 48 Boston College Law Review 169
[6] John Biggins and Collin Scott, ‘Public-Private Relations in a Transnational Private Regulatory Regime: ISDA, the state and OTC derivatives market reform’ (2011). University College Dublin Working Papers in Law, Criminology & Socio-Legal Studies. Research Paper Nº.51.
[7] Notwithstanding a degree of scepticism expressed about private and self-regulation in the wake of the global financial crisis (GFC), the phenomenon continues to develop its significance for the setting and application of private rules and standards. E. Helleiner and S. Pagliari. The End of Self-Regulation? Hedge Funds and Derivatives in Global Financial Governance in E. Helleiner, S. Paglairi and H. Zimmermann, eds., Global Finance in Crisis: The Politics of International Regulatory Change (London, Routledge, 2009) Cited by John Biggins and Collin Scott, ibid 3
[8]See Arias-Barrera, Ligia Catherine, The Traditional Role of ISDA ‘Co-Regulating’ OTC Derivatives Contracts (May 8, 2014). Warwick School of Law Research Paper No. 2014/07. Available at SSRN: https://ssrn.com/abstract=2434662
[9] Sean Flanagan, ‘The Rise of a Trade Association: Group Interactions within the International Swaps and Derivatives Association’ (2001) 6 Harv. Negotiation L. Rev. 211
[10] John Biggins and Collin Scott, ‘Public-Private Relations in a Transnational Private Regulatory Regime: ISDA, the State and OTC derivatives market reform’ ibid (n 46) 20
[11] The Group of the largest dealers are G16: Bank of America-Merrill Lynch; Barclays; BNP Paribas; Citigroup; Credit Agricole; Credit Suisse: Deutsche Bank; Goldman Sachs; HSBC; JP Morgan Chase; Morgan Standley; Nomura Group; Royal Bank of Scotland; Sociéte Générale; Union Bank of Switzerland (UBS) and Wells Fargo.
[12] ISDA, ‘Legal Guidelines for Smart Derivatives Contracts Introduction’ January, 2019. Available at https://www.isda.org/2019/01/30/legal-guidelines-for-smart-derivatives-contracts-introduction/
[13]Jemima Kelly. ‘FinTech Sandbox’ might sound like a harmless idea. It’s not’ FT. 4 December, 2018.
[14]Jemima Kelly. ‘FinTech Sandbox’ might sound like a harmless idea. It’s not’ FT. 4 December, 2018.
[15]Ligia Catherine Arias-Barrera, Regulation and Supervision of the OTC Derivatives Market (Routledge, 2018).
[16]Ibid.
[17] Rosa Lastra, ‘Defining forward looking, judgement-based supervision’. Journal of Banking Regulation. Vol 14 Num. 3/ 4 July-Nov 2013
[18] Oleg Boyko, Chairman of Finstar Financial Group said“The most progressive regions – such as the UK or Singapore – put a lot of emphasis on supporting Fintech and the startup community in general. I think finding an equilibrium will take some time. However, early initiatives – such as PSD2 in Europe – clearly show the direction regulators across the globe will eventually be taking. This creates exciting opportunities for newcomers who can look five or 10 years ahead and visualise the new business models that will transform the financial services industry”. Interview available at http://www.fstech.co.uk/fst/Interview_FinStar_Financial_Group.php .
[19] Joanna Gray and Peter Christian Metzing, ‘Defining and delivering judgement-based supervision: The interface with the legal system’. Journal of Banking Regulation Vol.14 Number 3/4 July/Nov 2013.
[20] Rosa Lastra, ‘Defining forward looking, judgement-based supervision’ ibid (n 155)
[21]Ligia Catherine Arias-Barrera, Regulation and Supervision of the OTC Derivatives Market (Routledge, 2018).