Regulators and Innovation: A Reconsideration

In 2016, the Office of the Comptroller of the Currency opened an Office of Innovation. Banking capital and profits were riding high, due in part to reforms enforced after the 2008 financial crisis by agencies like the OCC. They in turn began to recognize and even encourage a new wave of technologies – commonly known as fintech – that had been gaining momentum for about as long as the post-crisis recovery was underway.

The OCC, the U.S. Treasury bureau that supervises a majority of the country’s banking activity, was not the first regulator to put an imprimatur on “responsible innovation” – words carefully chosen to underline the importance of progress and adaptation while signaling that traditional and statutory oversight functions would not be compromised. The trail was blazed by the U.K. Financial Conduct Authority, whose pioneering regulatory sandboxes and hackathon-like tech sprints are still going strong; and the Monetary Authority of Singapore, which in 2015 hired a former Citigroup executive, Sopnendu Mohanty, as chief fintech officer. His role was and remains instrumental in promoting the city-state as a leading fintech development hub and in pulling other central banks onto the bandwagon.

The FCA and MAS were also early movers in the now four-year-old Global Financial Innovation Network. It consists of more than 70 “financial regulators and related organizations committed to supporting financial innovation in the best interests of consumers,” according to the GFIN website. And with central banks, the Bank for International Settlements’ BIS Innovation Hub since mid-2019 has been orchestrating a growing number of projects through hub centers in locations including Hong Kong, London and, in New York, a strategic partnership with that city’s Federal Reserve Bank.

The trend appears unabated. In Canada this year, the Ontario Securities Commission announced seven technology business’ participation in its TestLab, described by OSC innovation office director Pat Chaukos as “a unique opportunity to effect change and support innovation in our capital markets.” The European Commission launched the EU Digital Finance Platform to “overcome fragmentation and support the scaling up of digital financial services across the single market.”

Cecilia Skingsley, Head of the BIS Innovation Hub

While the scope of such projects reflects current marketplace priorities and relevant technological advances – ranging from regulatory reporting to cybersecurity to digital assets – there are indications of attitude adjustments or course corrections in regulators’ relationship with innovation.

Central Bank Efforts

Multiple announcements in November by the BIS-Fed New York Innovation Center, including one with Singapore’s MAS to explore wholesale central bank digital currencies (wCBDCs) for cross-border payments, suggest that these authorities remain squarely on mission and on message.

Announcing completion of a CBDC pilot with the central banks of China, Hong Kong, Thailand and United Arab Emirates in October, Cecilia Skingsley, the former Swedish central banker who had just succeeded Benoît Coeuré of France as head of the BIS Innovation Hub, said that “financial exclusion” affects not only individuals, but also economies: “This project makes important strides towards developing a platform that has the potential to foster more inclusive and efficient payments systems that will benefit those making and receiving payments in different currencies and jurisdictions as well as the overall functioning of the global financial system.”

At the same time, it is not lost on financial industry overseers that macroeconomic developments, corporate profits and performance, operational risks and other factors that they monitor can be volatile or unpredictable, and technology is no exception. A reckoning is now taking place with cryptocurrencies, a phenomenon that coincided with the fintech boom, beginning with the 2008 publication of the Satoshi Nakamoto white paper introducing bitcoin and blockchain.

Despite their struggles to fit crypto assets into existing legal frameworks – and legislative proposals that were too slow-moving to offer much assistance – regulators were alert to potential contagion and systemic risks, and regulated institutions were minimally exposed.

Comptroller’s Reset

Some changes in tone vis-à-vis financial technology predated the sudden and scandalous downfall of the FTX exchange and interconnected counterparts like crypto lender BlockFi. Although there is no retreat from innovation commitments in principle, the messaging is refined and more nuanced.

The OCC is a case in point.

Beth Knickerbocker, OCC Chief Innovation Officer

In the absence of a confirmed Biden administration nominee, Michael J. Hsu has been acting Comptroller of the Currency since May 2021. He inherited the Office of Innovation that was established under Thomas Curry, who was comptroller under President Barack Obama and was succeeded by Joseph Otting from 2017 to 2020. Beth Knickerbocker has been chief innovation officer since inception, making the former staff attorney and onetime bank chief risk officer the longest-serving innovation chief among peer financial regulatory agencies.

Hsu has regularly been speaking out on such issues as bank merger policy, cybersecurity and climate risks, and advising caution on crypto.

“The line between well-adapted regulation and unduly accommodative regulation can be a blurry one,” he said at an October Harvard Law School roundtable. “Just as winning an auction can be a sign that the bidder has overpaid, attracting crypto licensees and activities can be a sign that a regulator may have over-accommodated the industry.”

At a mid-November financial literacy event, amid the FTX insolvency headlines, Hsu observed, “A year ago, the idea of getting rich slowly-but-surely would have sounded ludicrous. Today, it sounds wise. That’s because it is . . . As a backdrop to all of this, I should highlight the quiet trustworthiness of banks throughout this year’s crypto drama.

“Last year, the OCC adopted a ‘careful and cautious’ approach to crypto activities by national banks. This helped mitigate the risk of contagion from crypto to the banking system. Years of reform and rebuilding after the 2008 financial crisis have strengthened the banking system, making it more resilient, more fair and more trustworthy. While continued improvements need to be made, this has proven valuable with the rapid rise and fall of crypto this past year.”

Acting Comptroller Michael J. Hsu

A few weeks earlier, Hsu had set in motion a new direction for the Office of Innovation. Its work is to be subsumed early next year within an Office of Financial Technology, led by a chief financial technology officer with the rank of deputy comptroller.

“Financial technology is changing rapidly, and bank-fintech partnerships are likely to continue growing in number and complexity,” Hsu said in a statement. “To ensure that the federal banking system is safe, sound and fair today and well into the future, we need to have a deep understanding of financial technology and the financial technology landscape. The establishment of this office will enable us to be more agile and to promote responsible innovation, consistent with our mission.”

The acting comptroller put it this way in congressional testimony: “By expanding our aperture, engaging more substantively with nonbank technology firms, and mapping out bank-fintech relationships and risks, we can help ensure that banking remains trusted and safe, sound and fair as the system evolves.”

CFPB and CFTC

At least two other U.S. financial regulators have restructured or rebranded their innovation departments.

The Consumer Financial Protection Bureau, which was created by the Dodd-Frank Act of 2010, was the first U.S. agency to join the Global Financial Innovation Network and is one of 10 members of the GFIN Coordination Group. It also participates with the OCC and state regulators in the American Consumer Financial Innovation Network.

Under its Biden-appointed director, Rohit Chopra, the CFPB deemed its four-year-old Office of Innovation to be ineffective and has replaced it with an Office of Competition and Innovation. The former “application-based process to confer special regulatory treatment on individual companies” has yielded to “a broader initiative . . . to analyze obstacles to open markets, better understand how big players are squeezing out smaller players, host incubation events and, in general, make it easier for people to switch financial providers,” according to a May announcement.

“We will be looking at ways to clear obstacles and pave the path to help people have more options and more easily make choices that are best for their needs,” Chopra said.

CFTC Chairman Rostin Behnam

At the Commodity Futures Trading Commission, the outreach- and experimentation-promoting LabCFTC, formed under then-chairman J. Christopher Giancarlo in 2017, is now the Office of Technology Innovation (OTI). What current chief Rostin Behnam terms “an updated operating model” is aimed at improved flexibility and utilization of resources.

“We are past the incubator stage, and digital assets and decentralized financial technologies have outgrown their sandboxes,” Behnam, a commissioner since 2017 who was sworn in as permanent chairman last January, said in a July speech. “The issues are at the front and center of our thinking at the commission, and with a greater acceptance of the role of regulators, innovators need no invitation to office hours to engage directly with our operating divisions and senior leadership.”

Jorge Herrada, who had been an adviser to LabCFTC and to the Federal Reserve Board TechLab, was appointed OTI director, reporting to Behnam. Jason Somensatto, acting LabCFTC director after Melissa Netram departed in 2021, joined the chairman’s office as fintech policy specialist.

On the Policy Agenda

No longer is it a novelty for regulation and innovation to be on policymakers’ agendas and subject to dialogue, debate and revision.

At a December 1 hearing of the Senate Agriculture Committee on the FTX collapse, Behnam denied that CFTC is a “light touch” agency, defended its enforcement record and said legislation is required to close regulatory gaps. Notwithstanding debates over the utility of technologies and responsible innovation, he testified, “Our highest priorities must be the protection of customer property and promotion of fair, stable and resilient markets.”

Securities and Exchange Commission Chair Gary Gensler, under fire from regulated firms for putting dozens of rulemakings out for public comment, has identified and formalized in strategic plans the broad policy goals of “continuing to drive efficiency in our capital markets, and modernizing our rules for today’s economy and technologies.” Commissioner Hester Peirce, a frequent Gensler critic who has been particularly outspoken about his hard line on crypto assets, has been supportive of the agency’s FinHub and the fact that its director, Valerie Szczepanik, reports to Gensler.

Speaking in July to the Peterson Institute for International Economics, Financial Conduct Authority Chief Executive Nikhil Rathi called attention to his agency’s investments in its own technology and analytics as well as market-facing initiatives such as “cryptosprints.”

FCA Chief Executive Nikhil Rathi

“We are embarking on a new approach to digital regulation in the U.K. through our Digital Regulation Cooperation Forum, bringing us together with our communications, privacy and competition regulators,” Rathi stated. He said it is “an exciting and crucial time to be a regulator because of the challenges and opportunities we face. And given the scale and nature of those challenges and opportunities, international collaboration has never been so vital,” as in the case of a U.S.-U.K. Financial Innovation Partnership.

A few months later, in a speech at London’s Mansion House, Rathi said, “We will continue to embed competitiveness throughout our regulatory approach, but it is vital that there is no compromise on consumer protection or market integrity. Those globally high standards are why the U.K. can be open to innovation.”

The FCA had just issued a discussion paper on Big Tech that “examines the innovation the tech giants could bring to financial services but also explores the risk of their potential dominance which can harm consumer outcomes,” Rathi noted.

He reviewed the FCA’s openness “to simplifying regulation whilst delivering the same outcomes and streamlining our processes without undermining rigor,” as well as its agility in reacting to “COVID, Russia, the rising cost of living and unprecedented market turbulence . . . This last year has been a sobering experience, has left all of us a bit older and hopefully most of us a bit wiser.”

Facilitators and Their Risks

The International Organization of Securities Commissions (IOSCO) in July published a report on innovation facilitators – innovation hubs, regulatory sandboxes and accelerators – with a focus on emerging-market jurisdictions.

Without coming to “decisive conclusions,” the report called for a balanced approach to weighing opportunities and risks. Benefits could arise from “a structured environment for engagement and exchange of knowledge between regulators and innovative companies,” better understanding of emerging technologies, regulatory certainty, and “a safe space for testing innovative products, services or business models in a controlled environment, while preserving investor protection and the integrity of the market.”

Risks include “potential regulatory arbitrage” when a jurisdiction relaxes regulatory and supervisory expectations, inconsistent or opaque rules and selection criteria, legal risks for program participants and diminished investor protections.

“Innovation facilitators provide an environment for firms to test their innovative products and to better comprehend the regulatory and supervisory expectations, in a manner that serves the public interest and does not bypass any legal and regulatory requirements, while ensuring investor protection, market integrity and the stability of the financial system,” said Mohammed Omran, chairman of Egypt’s Financial Regulatory Authority and of IOSCO’s Growth and Emerging Markets Committee. The report “sheds light on some of these regulatory and supervisory expectations and provides the ecosystem for establishing an innovation facilitator within the proper regulatory ambit.”

Sultan Meghji, formerly of the FDIC

Parting Shot

FDITECH, the Federal Deposit Insurance Corp. innovation lab, which has sponsored tech sprint and rapid prototyping programs since 2019, was harshly evaluated by Sultan Meghji. A fintech entrepreneur, Meghji served only a year as the FDIC’s first chief innovation officer, asserting in a February 2022 Bloomberg Opinion article: “The federal bureaucracy is both hesitant and hostile to technological change. America’s global financial leadership is in jeopardy.”

He blamed bureaucracy, apathy and “widespread doubt about technology itself – call it ‘tech hesitancy.’” His prescriptions: civil service hiring reforms, education and training, and “more collaboration with companies and universities outside the Beltway” and with international partners.

“While I successfully pushed the government to mimic some of the U.K.’s progress,” Meghji wrote, “working directly with foreign counterparts would be more useful. Learning from our friends is as essential to staying ahead of our enemies . . . The alternative is to let China build a more advanced financial system, while letting it and other hostile regimes increasingly undermine our own.”

Finding the Balance

Acting FDIC Chairman Martin J. Gruenberg – a board member since 2005 who was nominated by President Biden to officially succeed ex-chair Jelena McWilliams – took a long view of innovation in an October Brookings Institution appearance. Automated teller machines, mobile and online payments were transformative as technology addressed specific social, financial or economic needs, he said.

Acting FDIC Chairman Martin Gruenberg

“As we know, innovation can be a double-edged sword,” Gruenberg went on. “Subprime mortgages, subprime mortgage-backed securities, collateralized debt obligations and credit default swaps were all considered financial innovations that would serve the interests of both consumers and banks in the early 2000s. Yet they ended up being at the center of the global financial crisis of 2008 . . . Their risks were too often poorly understood by consumers and industry participants, frequently downplayed and even intentionally ignored, in the market’s eagerness to participate in these products.

“The risks associated with these products are clear today, and would have been clearer then, had we stepped back and taken the time to thoroughly analyze them. Indeed, history and hindsight show that the better approach is often caution when confronted with conditions such as these.”

A newer member of the top regulatory echelon, Federal Reserve Vice Chair for Supervision Michael S. Barr, similarly referred to how emerging risks were masked in the run-up to the 2008 crisis. “Excitement over innovative financial products can lead to a pace of adoption that overwhelms our ability to assess and manage underlying vulnerabilities,” he remarked in a D.C Fintech Week speech.

Michael Barr of the Federal Reserve Board

Barr acknowledged the difficulty of “striking the right balance between creating an enabling environment that supports innovation and managing related risks to businesses, households and the stability of the financial system.”

Being too prescriptive or cautious can “run the risk of stifling innovation and locking in the market power of dominant participants in ways that can raise costs and limit access,” Barr added. “When regulation is lax or behind the curve, it can facilitate risk taking and a race to the bottom that puts consumers, businesses and the economy in danger and discredits new products and services with consumers and investors. I believe everyone has a stake in getting the regulatory balance right.”