13 KiB
Driverless Finance Notes
Allen, Hilary. 2022. Driverless Finance. Oxford University Press.
Reading notes on the new textbook about regulation of fintech.
Chapter 1 - The Cause for Precaution
Dealing with Uncertainty
Precaution about fintech is warranted and requires a value judgement about costs and benefits ahead of time.
Instead—unavoidably—regulatory approaches to new financial technologies will have to be informed, at least to some degree, by assumptions and value judgments about the likely costs and benefits of these new technologies. This chapter explains why, in the face of the uncertainty associated with new financial technologies, we should take a precautionary approach.
Fintech policy is inherently about predicting events about unknown futures and managing tail risks.
Knightian uncertainty” therefore describes a world of “unknown unknowns” where we may not even know the types of risks we face, let alone their probability of occurring. Knightian uncertainty is an apt description of our financial future. [...] We could throw our hands up in the face of this Knightian uncertainty, leaving new financial technologies unregulated and simply letting the free markets shape their development instead
Financial stability as a public-goods-problem.
financial stability is a classic “public good,” in the sense that everyone benefits from it, but the public can’t be forced to pay for it.
Government's role in process:
It is precisely the province of good government to make guesses as to what laws are likely to be worth their costs ... there is no reason to assume that in the absence of conclusive information no government action is better than some action ... in uncertainty increase the chances of correcting an error.
The Cost of Doing Nothing
Definition of capital formation.
The financial system also exists to move money from those who have it and wish to invest it, to those who need it to grow. This is often referred to as the “capital intermediation” function of our financial system,
Many in the financial industry genuinely believed that this securitization process had made mortgage lending safer by moving mortgage risk out of the banking system; others simply didn’t care because it was profitable in the short-term.
The human costs of market manias and bubbles.
Even among people who were able to keep their jobs and some sense of financial security during the recession, many experienced a pervading sense of uncertainty and precariousness that may have caused them to delay life events like marriage, home purchases and retirement.
The rise of financial populism as a result of the 2008 financial crisis and government bailouts.
Not only are emergency responses to financial crises unlikely to be completely successful, they are also likely to be a very bitter pill for most of society to swallow. Many people heard about funds being pumped into the very financial institutions that had caused the 2008 crisis, saw little relief being provided to everyday people suffering as a result of the crisis, and concluded that there was “a pattern of winners and losers that could not be defended on any principle of desert.” This sense of economic injustice was exacerbated in countries that chose to, or were forced to, implement austerity measures
What exactly do we mean by precuation?
How regulatory capture occurs organically out of expertise asymmetries.
When the technology is complex, this can be a very challenging thing to ask of financial regulators, who may lack the necessary technical expertise to look critically at the innovation. Regulators may end up deferring to and internalizing the rosy perspective of the regulated industry—at the expense of the public interest. This phenomenon is known as cognitive capture.
The public knowledge of financial crises fades with time.
While all members of the public have a continuing vested interest in promoting financial stability, it becomes increasingly difficult to marshal their attention as memories of previous crises fade.
Precaution in other contexts
Financial catastrophes are abstract and hard for the public to understand, as compared to threats to health or bodily harm.
If viewed collectively, the widespread economic, psychological, and political costs of a financial crisis should be more than enough justification for precautionary intervention. And yet, many new financial technologies are being developed without any regulatory oversight
The FDA has more of a mandate and is more proactive about regulation because the public intuits the nature of health problems more than financial health problems.
The costs of precuationary regulation
However, it is very difficult to quantify the benefits of financial stability regulation—what numbers should we use? Methodologies for estimating the cost of the 2008 crisis vary enormously, and the cost of that crisis probably won’t be predictive of the cost of a future crisis.
Financial regulation may therefore, at least in some respects, help facilitate innovation in financial products and services—so we should think long and hard about the type of innovation that regulation should seek to promote.
Innovation isn't always good
Innovation can be bad. Financial engineering can cause more harm than good in many cases.
At the heart of debates about regulation and innovation, there is often an implicit assumption that innovation is a good thing. But it is important to acknowledge that this is not always the case—at the very least, we should accept that innovation is not always unqualifiedly good.
It is possible to have non-economic innovation.
However, not all financial innovation is disruptive, and not all financial innovation propels economic growth.
The predatory inclusion of payday loans are financial innovation that is worse than banks.
When banks are not available to serve consumer needs, fringe providers fill the void. The financial services provided by these fringe providers (including check cashing services and payday loans), “cost more, take longer, risk more, and do less to build their financial futures” than equivalent services provided by mainstream financial institutions
Some fintechs are bad actors.
If fintech business models try to exploit groups of consumers with little financial sophistication or experience, then fintech’s promise to expand access to financial services could be seen as a little sinister.
If innovation is driven entirely by a financial institution’s desire to generate fees by repeatedly introducing updated versions of existing products and services, and if the new versions don’t achieve anything significantly different to the older versions, they will increase the complexity of the financial system without providing any real improvement to the user
Or, if the innovator is a start-up firm, their innovations may be designed more to attract the interest of venture capital investors than to satisfy genuine needs for their users
Some innovation is driven by artificial demand or incoherent narratives about "innovation" and novelty instead of utility.
It might seem counterintuitive that there could ever be a market for a product that does not meet genuine market needs, but in fact, there are many ways in which this can happen. Demand can be generated by fads and trends, rather than a reasoned evaluation of the product or service,with users primarily enticed by the story that has been spun by the innovator.
Regulatory arbitrage is not innovation.
We also have little to fear from limiting innovation that primarily exists to evade or “arbitrage” regulation (in the sense that a product or service achieves the same economic function as a regulated product or service, but does so in a way that manages to avoid the regulation).
This is not productive for regulators.
Innovations designed to arbitrage existing regulations often spur the creation of more regulations, and then new innovations are created to innovate around the new regulations in an unending cycle of increasing complexity. A precautionary approach can help stop this cat and mouse game by shifting the burden to the innovator to demonstrate that the innovation meets a need beyond exploiting regulatory loopholes.
Imagine if credit default swaps had been cryptoassets
Using smart contracts to automate the handling of derivatives products.
In the future, it may be technologically possible to create a contract so that some of its terms are programmed into a smart contract, while other terms remain in their more traditional paper format to allow for more flexibility.
We still need human-in-the-loop.
However, interactions and feedback loops between the automated and non-automated provisions of the contract will create lots of potential for unanticipated outcomes.
Precautionary regulation is process-oriented
The financial system becomes more fragile as it becomes faster, more complex, more interconnected, and more correlated, and so regulators need to be particularly alert to any new innovation that contributes to these forces. If regulators don’t focus on the development process, then it is easy to be fooled into thinking that a new product (like a smart contract CDS) that achieves roughly the same result as an existing product (like a paper CDS), should be regulated in the same way as the existing product.
Regulation needs to follow from understanding on both sides.
Merely by virtue of knowing that they will struggle to explain an exceedingly complex innovation to a regulator, innovators may be encouraged to eliminate superfluously complex features before seeking regulatory approval.
Products that can't be explained simply to regulators are a red flag.
A regulator has a job to try to understand innovation and regulate it, but it doesn’t mean that the innovator has the right to introduce the innovation in the market ... if I can’t understand it I won’t permit it until you make me understand, or until you redesign it in a way that we can understand.
Complete bans are sometimes necessary to deal with Knightian uncertainty and extreme risk.
Banning an innovation before it even reaches the market will certainly deprive society of its potential benefits. This loss of benefits may ultimately be a harm that even outweighs the risks associated with the product. However, in an environment of Knightian uncertainty, difficult trade-offs will have to be made on the basis of imperfect information
The problem of moral hazard.
Maintaining the current practice of waiting until a problem has occurred before taking regulatory action is not a neutral approach. Instead, it stacks the deck in favor of the innovators who get to profit by generating risks that, if they come to fruition, will be borne primarily by the rest of society.
Time is of the Essence
The time to act on crypto regulation is now.
The financial applications of smart contract and distributed ledger technologies (as well as machine learning and cloud computing technologies) are still in their early stages. [...] That window of time will close soon, though, and we don’t yet have a precautionary regulatory framework in place for financial innovation
Incremental regulation is often ineffective since it an be routed around.
If that policy bends too far in favor of the industry and too far away from precaution, the financial stability risks of cryptoassets will go largely unregulated—at least until something goes wrong. Once something does go wrong, there may be political support for regulation that targets the specific problem that occurred. However, regulation that is implemented incrementally as problems unfold will spur the industry to innovate around that regulation, inviting more incremental regulation. Layering regulation over cryptoassets over regulation over cryptoassets, unintentionally but inevitably, makes the financial system more fragile by increasing its complexity.
Precaution is warranted and now is the time to act because of the political environment.
We should therefore approach the latest generation of financial innovations, which are likely to exacerbate the already significant levels of complexity, speed, and correlation associated with our financial system, with precaution. In this venture, time is of the essence: the growing public skepticism about the benefits of big tech provides an excellent political opportunity to implement a precautionary approach to new financial technologies, and it should not be wasted.