Can suptech take DeFi to the next level?
As technology-driven decentralised finance (or DeFi) grows in popularity and market value, it appears that a battle is brewing between DeFi protocols and regulators. But can technological tools in the hands of regulators head this off at the pass? A reasoned, transitional approach to compliance, along with powerful supervisory technology (or suptech) may hold the key to peaceful coexistence in this burgeoning new industry.
Suptech is the application of new technologies to help regulators improve their oversight, supervisory and enforcement activities. DeFi is the application of new technologies to eliminate the need for rent-seeking intermediaries by applying automated business logic to allow market participants to interact with each other seamlessly. Current financial regulatory regimes rely on the licensing and monitoring of financial services providers who function as intermediaries in the financial markets. Many DeFi protocols, as a practical matter, function as unregulated, borderless robo-intermediaries that impose few or no compliance requirements – including, notably, know your customer (KYC) – on participants. This seemingly intractable conundrum lies at the heart of the challenge of harnessing the power and attractiveness of DeFi innovations to responsible consumer protections and market risk mitigation.
Last month, the Financial Stability Board (FSB) published a report on the use of advanced technologies by authorities and regulated institutions to improve oversight and compliance functions. Suptech is increasingly being utilised by regulatory authorities keen on enhancing their ability to monitor and gain insights into a variety of financial market risks and activities.
Regulators have long used technology to improve oversight functions and capacities before the term suptech first emerged in 2017, when Ravi Menon, managing director of the Monetary Authority of Singapore, asked why regulated entities should have a monopoly on the use of technology for compliance purposes, when regulators, themselves, can also harness technology to enhance the efficiency and effectiveness of supervision and surveillance. Since then, a number of regulatory bodies around the world have established strategic frameworks around suptech specifically, or included suptech as part of broader strategic initiatives. Those efforts include launching specialised units within regulatory authorities or conducting limited tests and pilot initiatives to understand how the application of advanced technologies can support and enhance certain regulatory functions.
As the FSB report and prior suptech reports have indicated, regulators are still early on in their assessment of suptech tools and services and the current focus largely revolves around how new technologies can help regulators sift through and generate deeper meaning from the mountain of information reported to the regulator from its regulated entities. Indeed, the most common suptech use cases reported by authorities, as discussed further in the FSB report, include regulatory reporting and data management.
When one considers the volume of materials that must be provided by regulated entities to their respective regulators, it is no wonder that regulators are interested in suptech to more effectively and efficiently monitor the increasing amounts and types of data being reported to them. In 2020 alone, JWG Group – a market intelligence platform providing regulators and industry with independent analysis of regulatory changes taking place around the globe – has already filtered through 700,000 alerts from more than 700 bodies that issue financial services rules across the globe to net 24,000 relevant documents with a total of 380,000 pages. While, as noted, regulatory authorities have largely focused on applying suptech to derive greater efficiencies in regulatory reporting and data dissemination and analysis, financial technology continues to evolve and market participants increasingly seek to unlock greater efficiencies by becoming less reliant on intermediaries through self-executing ‘smart contracts’.
In this environment, current strategies around suptech must move beyond a forensic, reports-driven approach to more proactively identifying and warding off risks by more broadly incorporating artificial intelligence (AI) and other technologies that enhance accountability and auditability of market activities. In the meantime, ongoing developments in the DeFi space and the proliferation of digitalised assets in tokenised form, continues to attract retail, institutional and regulatory attention (both positive and negative). As traditional modes of finance increasingly move to a decentralised environment, where the role of the financial intermediary is reduced or removed entirely from the lifecycle of a financial transaction, these innovations will continue to face the headwinds of current regulatory structures.
As noted by US Securities and Exchange commissioner Hester Peirce, a regulator widely viewed as open-minded in her approach to fintech regulation, during this year’s LA Blockchain Summit:
“There’s some real potential for some pretty major and revolutionary change coming out of the DeFi space. This idea that you can have the users of something be the ones who also govern it in a very direct way will challenge the regulatory structure in a number of ways.” Nonetheless, commissioner Peirce also noted in a recent interview: “[DeFi is] going to challenge the way we regulate. And it’s going to cause us to ask questions about what we think the role of a regulator is in DeFi – and I’m not sure that I’ve answered that for myself yet.”
These challenges will lead to an increased demand by regulators for robust suptech solutions. The regulatory focus on tools and applications capable of enhancing data management and reporting mechanisms will evolve to include requirements for technologies that provide regulators with the ability to audit particular tokens, changes to those tokens, who initiated, and who gave the authority to initiate a transaction or change the governance framework around a particular token under a decentralised financial services ecosystem. Essential to regulatory buy-in for the DeFi space are plain-language tools capable of not only allowing regulators to confirm the compliance of a protocol but that can also provide regulators an audit trail to accurately trace activity and ensure the safety and soundness of markets.
Perhaps more important, though, will be the deployment of AI-driven market surveillance tools that may allow for a methodical evolution away from prescriptive, broad-brush regulation to more proactive analyses that identify developing systemic risks and allow for more enhanced consumer protection. Getting there will require a more cooperative, transitional mindset by market participants, technologists and regulators alike. As a starting point, regulators should adopt a stance from which their regulatory focus remains on the activity, rather than on the entity or the technology. Blockchain-based technologies, for example, provide for significantly more robust surveillance mechanisms when deployed responsibly, and the disintermediation provided by DeFi (among other fintech innovations) can substantially reduce participation costs, thereby expanding consumer access to markets. On the other hand, innovators and market participants should assume a less adversarial posture and recognise that a transitional approach that respects the importance of reasonable, principled oversight and allows regulators to adapt to these powerful innovations will actually lead to more rapid approval and adoption. While many technologists understandably fear that heavy-handed, head-in-the-sand regulatory approaches will stifle innovation, they must also recognise that nothing will kill an industry like an erosion of public confidence and the wild exuberance of an unregulated market more often than not gives way to disillusionment and antipathy. A collaborative approach among industry, policymakers and regulators will produce the trust that allows markets to truly mature and grow.
With these principles in mind, it is clear that suptech is the bridge that will allow for this sort of transitional approach. AI-based surveillance tools require robust machine-learning capabilities and the ingestion of data that occurs over time. Market infrastructure financial technologies that are able to provide a compliance framework that corresponds with current regulatory practices are best-suited to serve as these bridges, as these systems can accelerate market data collection and migrate over time to enabling risk-based oversight models. Moreover, providing ‘two-way panes of glass’ that allow, on the one hand, plain-language auditability of smart contracts and digital financial instruments and, on the other hand, machine-readable regulations that can be easily ingested into compliance oracles, will further enhance this collaboration. In the end, early intervention based on market activity and risk-based assessments will provide the type of ‘light-touch’ oversight that will spur innovation to greater heights.
The evolution of finance and the exhilarating rise of DeFi will drive a corresponding evolution in regulatory demands to maintain, if not enhance, oversight functions. From potent data science capabilities to the adoption of new tools that capture the delegation of authorities that make up and govern a particular digital asset, ongoing changes in the marketplace will generate new demands for technologies capable of providing regulators with deeper insights into an increasingly decentralised space.
As markets evolve, so to must current perceptions and use cases of suptech. Wise innovators will focus on both sides of this issue and build responsible bridges to the future of finance.
This is an extract from The Fintech Times – Edition 35
Authors: Patrick Campos,Chief Strategy Officer,and Jackson Mueller,Director, Policy & GovernmentRelations, at Securrency