Regulation must favor financial innovation that fosters general prosperity
Post Date – 12:45 AM, Wednesday – 4/19/23
Regulation must favor financial innovation that fosters general prosperity
by B Sambamurthy
Hyderabad: Hundreds of millions of underserved and underserved people have access to the formal financial system thanks to fintech and indigenous innovations from big tech companies. Over 260 million users on the UPI platform, over 400 million Jan Dhan accounts and over 110 million demat users are some of the outstanding achievements we have made in our digital journey in the financial sector. We’re just jumping.
This exponential growth is backed by exceptional customer experience and customer empowerment. Super convenience, speed, low cost, and easy access are the hallmarks of customer experience.
Technology is driving financial democratization and decentralization and inclusive growth at an unprecedented rate. We are now in the era of Banking as a Service. You can access a range of financial services with just one app. Fintech in India has produced a number of unicorns/decacorns and attracted a lot of FDI.
why regulation
This begs the question: “Why regulate fintech and big tech companies in financial services?” Financial stability is a top concern for regulators. It is also important to remember that a direct or indirect result of a fintech innovation is a financial service/product, and no amount of fintech cleansing will remove this fundamental feature and the need for similar regulation.
Professor Knut Blind, Chair of Innovation Economics at the University of Berlin, and several other professors provide evidence of how technological innovations have economic, social and institutional impacts and argue that regulation will affect innovation.
reduce monopoly
The UPI ecosystem has a centralization problem. The top three players control more than 90% of UPI’s market share, crowding out smaller but nimble players. It’s worth noting that the UPI software was actually built by a small company rather than any large tech company. More new players with new innovations are needed so that the active user base can increase from the current 300 million to at least 800 million.
Winner-take-all is a techno-economic phenomenon that leads to monopoly. This needs to be alleviated. Network effects are a double-edged sword—helping blitzscaling and creating monopoly. We need new monopoly laws for the digital world.
social and institutional impact
In terms of social impact, there are issues causing harm to consumers such as lack of transparency, coercive practices, debt traps, increased fraud (more than 200,000 frauds per month in payments alone), inappropriate products and services sales, as well as data theft, which makes a strong regulatory case. Buyer beware, this will not work in a world where digital and financial illiteracy rates are high, especially among disadvantaged groups. Regulators need to identify vulnerable drivers and protect them from harm. Another challenge is regulating the impact of AI/ML tools to ensure they are free from bias and data poisoning.
Innovation also affects institutional structures. Rabi Shanker, deputy governor of the Reserve Bank of India, pointed out the problem: “We cannot allow financial institutions to use DeFi technology with little understanding of how the unbanked system works.”
Bank runs, digital finance
The collapse of Silicon Valley Bank and several others showed that digital finance and deregulation are a deadly cocktail. Thanks to digital channels, SVB depositors withdrew nearly 40% of their deposits in a matter of hours, causing the bank to fail at top speed. Globally, digital banking/finance is being severely revalued.
Given these differences, what options do regulators and governments have, without limiting purposeful, responsible, and beneficial innovation, if not competing demands on regulation? Let’s look at various regulatory models for achieving these goals.
* FEDAI/IBA: Self-regulation, co-regulation and statutory regulatory frameworks evolve and coexist. Self-regulation and co-regulation help promote good behavior among participants and complement statutory regulation. Common regulation promotes competition. FEDAI (Foreign Exchange Dealers Association of India), a self-regulatory/co-regulatory body, worked closely with the RBI and played a major role in the design and implementation of reforms in the forex market during the 1990’s. It’s also a great sounding board for regulators. IBA (Association of Indian Banks) also plays a similar role. In fact, these self-regulatory organization (SRO) guidelines are as good as statutory rules. These provide useful lessons. NPCI, while an operating body, offers an alternative model for self-regulation and co-regulation.
* Rules and principles: Regulations cannot evolve at the speed of technology, so highly prescriptive rules hinder innovation. Principles-based regulation provides room for innovation, especially for early-stage start-ups, and helps regulators stay on top of a rapidly evolving system. Working closely with the SRO and providing regular feedback/guidance can help. It will be more outcome-based than activity-based.
*Ratio adjustment: Given that the 2,000+ fintech companies vary in size, stage, size and scope, appropriate regulation could address this issue and help ease the regulatory and compliance burden on early-stage and smaller fintech companies. The financial technology field can be divided into three or four categories for differentiated regulation. Another debate is entity versus activity-based regulation. It requires a combination of both. Capturing macroprudential risks such as governance and operational resilience is critical.
In this rapidly evolving technological advancement, it is not easy for regulators to always make timely and correct decisions. They shouldn’t be afraid to experiment with enough guardrails, especially in uncharted spaces. Maybe RBI and other regulators have to reassess their (combined) resources to navigate the digital economy for faster growth and general prosperity.
data economy
The enactment of the Data Privacy and Protection Act will support a sound regulatory environment. We need a data economy and data markets policy that facilitates innovation, large and small. Policies cannot be defensive and inward looking. UPI’s enormous success is as important as the principles of interoperability, public interest, and governance of the technology. The ecosystem is curated by the not-for-profit NPCI. This is unique to India. Europe and the UK are now discussing international interoperability.
There is currently no global consensus on technical regulations. Laissez-faire in the US, a sound (restrictive?) framework in Europe, and capricious government in China. In all three jurisdictions, digital financial services are booming. Each country must develop a regulatory system according to its own objectives.
fence social media
Social media platforms sometimes pose social, cultural and political stability risks. These platforms are now active in the financial services sector. Financial and social stability risks will only be magnified. Regulators need a playbook to guard against and mitigate these risks. Locally created industry-specific subsidiaries can mitigate these risks. Regulation and development are two aspects of an innovative coin. Regulation must favor innovation and provide buffers for open-ended experimentation.
Digital players need to recognize that regulation can enhance much-needed civic trust and give businesses legitimacy. This avoids surprises for investors and consumers. Our digital financial services are at an inflection point. Regulatory and development policies must aim to create a new digital financial architecture. Technological innovations have created utopian and dystopian narratives, and ChatGPT is the latest example. Smart regulators sit in between by influencing innovation.
Regulation must, to say the least, facilitate and influence innovation for general prosperity.
We are well positioned to advance the Bali Fintech Agenda 2018 and come up with the Digital Financial Architecture for India 2023. This could be India’s contribution to the G20 presidency.
