A FinTech and RegTech Overview:

Where We Have Come From and Where We Are Going

By Douglas W. Arner1, Ross P. Buckley2 and Janos Barberis3

1Kerry Holdings Professor in Law, Co-Founder, Asian Institute of International Financial Law, and Faculty Director, LLM in Compliance and Regulation, University of Hong Kong

2KPMG Law - King & Wood Mallesons Chair of Innovative Disruption and Law, Scientia Professor, and Member, Centre for Law, Markets and Regulation, UNSW Sydney

3Senior Research Fellow, Asian Institute of International Financial Law, Faculty of Law, University of Hong Kong, and Founder, SuperCharger FinTech Accelerator and FinTech HK

Introduction

In this overview, we seek to set the scene for all that is to come by providing a brief history of FinTech and RegTech, and by giving our particular view on the truly transformative potential of RegTech. In doing so, we draw upon some of our major works in the field.1

Regulatory and technological developments are changing the nature of financial markets, services and institutions. Financial technology, or FinTech, refers to the use of technology to deliver financial solutions, and regulatory technology, or RegTech, describes the use of technology in the context of regulatory monitoring, reporting and compliance. We argue that the true potential of RegTech lies in its ability to effect a profound transition from a Know Your Customer (KYC) to a Know Your Data (KYD) approach - one underpinned by efficient processes for the collection, formatting and analysis of reported data.

FinTech

The Evolution of FinTech

FinTech is not a new concept. The term 'FinTech' can be traced to the early 1990s,2 and now refers to a rapidly developing evolutionary process across financial services.3 The evolution of FinTech has unfolded in three stages, which we characterize as FinTech 1.0, 2.0 and 3.0.4

FinTech 1.0 (1866-1967)

Finance and technology have had a long history of mutual reinforcement, from early calculation technologies like the abacus, to the emergence of double entry accounting in the late Middle Ages and Renaissance. The late 1600s saw a European financial revolution featuring the rise of joint stock companies, insurance, and banking - all based on double entry accounting - which was essential to the Industrial Revolution.5

In the late 19th century, technologies such as the telegraph helped to forge cross-border financial connections.6 This was followed by rapid post-World War II technological developments. By the end of this period, a global telex network had been implemented.7

FinTech 2.0 (1967-2008)

The late 1960s and 1970s saw rapid advances in electronic payment systems, including the establishment of the Inter-Bank Computer Bureau in the UK in 1968 and the US Clearing House Interbank Payments System in 1970. Reflecting the need to link domestic payments systems, the Society of Worldwide Interbank Financial Telecommunications (SWIFT) was established in 1973, followed shortly after by the 1974 collapse of Herstatt Bank - a crisis which served as the catalyst for the first major regulatory initiative, the establishment of the Basel Committee on Banking Supervision of the Bank for International Settlements in 1975.8

1987's 'Black Monday' saw stock markets crash globally; another reminder that global markets were technologically interlinked.9 Advances in the mid-1990s underscored the initial risks with complex computerized risk management systems, with the collapse of Long-term Capital Management after the Asian and Russian financial crises of 1997-98.10 However, the emergence of the internet in the 1990s provided the foundational change that made FinTech 3.0 possible.

FinTech 3.0 (2008 - present)

A confluence of factors emerged between 2007 to 2008, which provided the impetus for FinTech 3.0 in developed countries. The brand image of banks was severely shaken. A 2015 survey reported that Americans trusted technology firms far more than banks.11

The GFC damaged bank profitability and the regulation that ensued drove compliance costs to record highs. The timing of the GFC also played a critical role in FinTech's development. This phase has required high levels of smartphone penetration and sophisticated application programming interfaces (APIs), which would not have existed had the GFC occurred five years earlier.12

The key differentiating factors of FinTech 3.0 have been the rapid rate of development and the changing identity of those who are providing financial services. Start-ups and technology firms have challenged established financial institutions by offering specific, niche services to consumers, businesses and incumbent financial institutions.

FinTech 3.0 has also been characterized by the rapid growth of companies from 'too-small-to-care' to 'too-large-to-ignore' and finally 'too-big-to-fail'. This landscape raises the important question for regulators of precisely when they should begin to focus on certain industry participants. This highlights why the evolution of FinTech requires similar developments in RegTech. A flexible, multi-level approach is necessary to impose regulatory requirements with differing intensity based on the size and risk of firms.

FinTech in developed and developing economies

Today, FinTech impacts every area of the financial system globally, with the most dramatic impact perhaps in China, where technology firms such as Alibaba have transformed finance. China's inefficient banking infrastructure and high technology penetration make it a fertile ground for FinTech. Emerging markets, particularly in Asia and Africa, have begun to experience what we characterize as Fintech 3.5 - an era of strong FinTech development supported by deliberate government policy choices in pursuit of economic development.

FinTech development in Africa has been led by telecommunications companies on the back of the rapid uptake of mobile telephones and the underdeveloped nature of banking services. Mobile money - the provision of basic transaction and savings services through e-money recorded on a mobile phone - has been particularly successful in Kenya and Tanzania.13 Mobile money has significantly spurred economic development by enabling customers to securely save and transfer funds, pay bills and receive government payments. M-Pesa remains Africa's best-known success story.14

RegTech

RegTech refers to technological solutions that streamline and improve regulatory processes. In contrast to FinTech's inherently financial focus, RegTech has the potential to be applied in many regulatory contexts, both financial and otherwise. Further, while FinTech growth has been fueled by start-ups, RegTech has emerged in response to top-down institutional demand arising from the exponential growth of compliance costs.15

The Evolution of RegTech

RegTech 1.0

In the 1990s and 2000s, institutions encountered increasing regulatory challenges as they became more global, catalyzing the development of large compliance and risk management departments. By the 1980s, financial technology was being employed to facilitate risk management as finance itself became increasingly reliant on IT systems. Financial engineering and Value at Risk (VaR) systems became embedded in major financial institutions,16 and would ultimately prove to be among the major contributing factors to the GFC.17

By the beginning of the 21st century, the financial industry as well as regulators suffered from overconfidence in their ability to apply a quantitative IT framework to manage and control risks.18 Regulator overconfidence manifested in the unduly heavy reliance of the Basel II Capital Accord on internal quantitative risk management systems of financial institutions.19 This false sense of security was brutally exposed by the GFC, which ended the first iteration of RegTech, RegTech 1.0.

Another illustration of RegTech 1.0 is the monitoring of public securities markets. Regulators rely upon trade reporting systems maintained by securities exchanges to detect unusual behavior.20 The GFC exposed the limitations of these systems - they cannot shed light on transactions that occur off the exchange.21 Regulators around the world reacted by mandating the reporting of all transactions in listed securities, regardless of where they took place. Such reporting requirements will have to be met with enhanced regulator IT systems to analyse the reported information - an enhancement which is part of the next stage of RegTech's development.

Ultimately, RegTech 2.0 has emerged in response to post-GFC regulatory requirements. These waves of complex regulation have drastically increased compliance costs,22 and regulatory fines and settlements have increased 45-fold.23 Adding to rising costs is the increasing fragmentation of the regulatory landscape. Despite attempts to establish similar post-crisis reforms, regulatory overlaps and contradictions between markets are not uncommon and financial institutions have...