RegTech & SupTech: Unintended regulatory arbitrage and technological disruption

Financial institutions refer to entities that deliver a spectrum of financial services to individuals, enterprises, and governmental bodies. This gamut encompasses activities such as banking, lending, investment, and insurance, amongst other financial services. In tandem with technological advancements and consumer needs, the financial landscape has evolved, gaining increased diversity and intricacy. Concurrently, as financial institutions progressively embrace solutions encompassing regulatory technology (RegTech) and supervisory technology (SupTech), the realm witnesses amplified transaction volumes within markets and an elevated necessity for stringent regulatory adherence and reporting. However, this progression poses a dual challenge: The potential for regulatory arbitrage and the prospect of disruptive technological influences.

The term “RegTech” denotes the application of technological solutions to automate and enhance the efficiency of regulatory compliance procedures within the financial sector. This entails harnessing sophisticated data analytics, artificial intelligence (AI), machine learning (ML), and comparable tools to facilitate financial institutions’ adherence to regulatory mandates. Such mandates encompass an array of regulations including anti-money laundering (AML) protocols, know-your-customer (KYC) requisites, data privacy statutes, and cybersecurity guidelines. The primary objectives of RegTech solutions encompass the mitigation of compliance expenditures, amplification of operational efficiency, and elevation of precision and efficacy in compliance operations.

SupTech pertains to the utilisation of technology with the objective of enhancing supervisory procedures within the financial sector. This encompasses the application of data analytics, artificial intelligence (AI), machine learning (ML), and similar technologies to facilitate regulatory bodies in monitoring and overseeing financial institutions. The core functions of SupTech encompass the identification of nascent risks, the enforcement of regulatory conformity, and the enhancement of supervisory efficacy. By doing so, SupTech solutions aim to optimise the efficiency of regulatory surveillance, alleviate the regulatory onus on financial entities, and fortify regulatory agencies’ capacity to discern and address threats to financial stability.

While these technologies have the potential to improve compliance with the regulatory requirements and increase the efficiency of financial services, they may also create new challenges for regulators and industry participants.

Unintended disruptions

Regulatory arbitrage is the practice of taking advantage of differences in regulatory requirements across jurisdictions and nations to achieve a competitive advantage. Regulatory arbitrage can take many forms, such as regulatory shopping, regulatory evasion, or regulatory optimisation. As financial institutions adopt RegTech and SupTech solutions, there is a risk that regulatory requirements may be interpreted and implemented differently across jurisdictions, leading to inconsistencies in regulatory compliance. This could lead to a race-to-destruction, where financial institutions seek to establish operations in jurisdictions with the least stringent regulatory requirements.

Regulatory arbitrage can create significant risks for financial stability. It can lead to a concentration of systemic risks in certain jurisdictions, as well as an uneven playing field that undermines the integrity of financial markets. This can lead to an uneven playing field that undermines the integrity of financial markets and creates risks for financial stability. To address this challenge, regulators need to work together to ensure that regulatory requirements are applied consistently across jurisdictions. This can be achieved through increased cooperation and information sharing, as well as the development of common regulatory standards and frameworks. Regulators also need to be vigilant to emerging risks and market developments that could create opportunities for regulatory arbitrage.

At the same time, the rapid pace of technological advancements is disrupting traditional financial services business models, potentially leading to job losses, market concentration, and systemic risks. For example, the rise of digital currencies and the use of blockchain technology are changing the way payments are made and settled. This could lead to a shift away from traditional financial intermediaries, which could reduce their profitability and create systemic risks if they are unable to adapt to the changing landscape. To address these challenges, regulators need to be proactive in adapting to new technologies and market developments. They need to work closely with industry participants to identify emerging risks and ensure that regulatory frameworks are sufficiently flexible to accommodate new technologies and business models.

Delicate balance between regulation and innovation

While regulatory measures are crucial to ensure stability and consumer protection within evolving financial landscapes, there exists a delicate balance to strike. Overzealous regulations run the risk of stifling the very innovation they intend to govern, potentially inhibiting the true benefits that these technological advancements could bring to consumers. Striking the right equilibrium between robust oversight and fostering an environment conducive to innovation is pivotal. Navigating this path requires a nuanced approach that safeguards consumer interests while allowing the full potential of innovative solutions to flourish, ultimately enhancing the financial experience for all stakeholders involved.

Regulatory arbitrage and technological disruption are not new concepts in the financial industry. However, the speed and complexity of technological advancements, as well as the growing adoption of RegTech and SupTech solutions, have amplified the potential risks and challenges.

New technologies can increase the efficiency and accessibility of financial services, improve compliance with regulatory requirements, and reduce costs. On the other hand, they can also create new risks, such as cyber threats, data privacy concerns, and operational risks. Simultaneously, the rapid evolution of technology is reshaping traditional financial business models, which could lead to job displacement, market concentration, and systemic risks. The shift towards these novel avenues might undermine the profitability of established entities and trigger systemic risks if these institutions fail to adapt.

To navigate these complexities, regulatory bodies must proactively adapt to technological evolution and market dynamics. This necessitates a blend of regulatory ingenuity, collaboration, and adaptability. Engaging with industry stakeholders to comprehend the potential benefits and risks of emerging technologies is paramount. Additionally, regulators must monitor and assess the systemic risks linked to technology adoption and implement suitable measures to counteract these threats. Close collaboration with industry stakeholders is pivotal to recognising emerging risks and establishing flexible regulatory frameworks to accommodate evolving technologies and business models.

The convergence of regulatory arbitrage and technological disruption presents formidable challenges to the financial sector and its regulators. As the financial ecosystem adapts to these advancements, regulators must remain vigilant and proactive in their approach, fostering an environment where innovation is harnessed for the collective betterment while mitigating the risks that can arise from the intricate interplay between technology, regulation, and market dynamics. The journey ahead necessitates a continuous commitment to understanding, embracing, and shaping the evolving financial landscape for the greater good of all stakeholders involved.

Srinath Sridharan is Visiting Fellow at the Observer Research Foundation.