Prof. Beinhocker has recently published an essay on a “new economics” research program, which he chairs at the University of Oxford. This essay contains a number of interesting hypotheses and it is worth reading the whole essay to understand how the approach of Prof. Beinhocker and his team differ from the classic economic thinking.
At the core of this thinking is a view which I tried to outline in my previous research on G8 Financial Markets Regulation: the idea that there will never be an optimal financial market regulation as proposed by classic economic thinking.
Beinhocker writes:
Regulators take an action to address a perceived problem, that changes the perceptions and actions of market participants, which in turn creates a new set of problems triggering further regulator actions, and so on. Over time this infinite chase between fallible regulators and equally fallible market participants leaves a trail of rules, structures, and institutions that has a major effect on shaping the evolution of the economy.
He argues that this traps the economy in suboptimal states:
The predator–prey dynamics between regulators and participants mean there is a never-ending battle between regulators trying to draw rules as tightly and specifically as possible, taking into account all possible contingencies, and armies of lawyers and accountants trying to find ways around them. This often leads to very rigid regulatory structures overlaid on highly dynamic markets.
We can see the evidence of this in many parts of the emerging alternative finance system. In the past years, each European country developed its own set of regulation towards alternative finance, Crowdfunding and particular equity-based Crowdfunding (Crowdinvesting) and lending-based Crowdfunding (Crowdlending).
The result is a patchwork of often contradictory approaches and very limited transnational financial streams. In particular in Germany, the alternative finance market has been driven to use financial incentives which are both marked sub-optimal by market players, science and regulators themselves.
The emerging problem is that financial market regulation of digital services is highly susceptible to path dependencies.
Beinhocker proposes a more flexible approach to financial market regulation:
[P]olicies and institutions should be made as adaptable as possible. […] A better approach is to create rules that provide general frameworks, but then adapt to specific circumstances.
In my testimony before the German Bundestag on Financial Market Regulation, I introduced two ideas which might create such a general framework of adaptable regulation:
- Sandbox-Regulation
- Adaptive Regulation
Sandbox
The idea of a Sandbox Regulation emerged in the UK. The Financial Conduct Authority created the first Regulatory Sandbox in 2015, currently they are searching for their second batch of Fintech Startups.
The successful applicants often create services which are heavily regulated or need to obtain costly licenses. However, in order to prove that the service has a viable business model, it might make sense to relax some aspects of regulation – at least for some time. The FCA allows a Fintech Startup to operate without having to fully comply with regulation.
But the Sandbox provides something more interesting: Fintechs can interact with the supervisor and receive opinions on business models and legal frameworks:
The sandbox may be useful for authorised firms looking for clarity around applicable rules before testing an idea that does not easily fit into the existing regulatory framework.
We can help in the following ways:
Individual guidance
Setting out how we interpret relevant rules in the context of the test. This creates a safe space because, if you act in accordance with this guidance, we will proceed on the basis that you have complied with the aspects of our rules that the guidance relates to.
Waivers or modifications to our rules
If your test might breach one of our rules we may be able to waive or modify it where it is unduly burdensome or not achieving its purpose, and waiver or modification would not adversely affect the advancement of any of our objectives. We are not able to waive national or international law.
No enforcement action letters
This letter would give firms some comfort that as long as they dealt with us openly, kept to the agreed testing parameters and treated customers fairly, we accept that unexpected issues may arise and we would not expect to take disciplinary action.
The Sandbox is “smart” because it allows the relaxation of certain parts of regulation without comprimising the whole regulatory framework. It allows the supervising authority to learn from startups and their digital innovation.
Adaptive Regulation
A second approach, which is not fully implemented yet, is called Adaptive Regulation and Smart Regulation.
The idea is currently debated by the Dutch Financial Markets Authority (AFM), but as far as I know not implemented yet. The general mechanism would be to allow financial innovations and regulation of these services grow alongside each other.
For instance, a new service in the banking sector could be offered publicly without a banking license by a startup. As soon as the service reaches certain thresholds, then full license requirement kicks in. Thresholds could be:
- Number of users
- Volume of financial transaction
- Systemic relevance of the service – market share in the emerging market
- Systemic relevance of the service – market share in the total financial market
- Number of competing companies offering the same service
I will try to outline the pros and cons of the each threshold in a separate post, but the overall approach would help to reduce the licensing requirements for Fintech startups without reducing the protection of consumers.
The adaptive regulation is “smart” because it allows a gradual tightening of rules without restraining initial innovation. The regulatory framework can adapt to the necessities of markets.
Conclusion
As Terry Pratchett says in “Making Money”, “An economist is like an alchemist, but less messy“. Certainly there is quite some mess in the thinking of how to create smart regulation, but I hope to elaborate further on some of the issues above.
Nevertheless, smart regulation seems to be a way of enabling a more dynamic and more flexible regulatory approach.