Regulating innovation or innovating regulation?
What it takes to make digital finance a success
Speech at the Bitkom Digital Finance Conference 2022
02.06.2022 | Berlin | Joachim Wuermeling
1 Introduction
2 Innovation and regulation - a happy relationship?
3 Technology-driven innovation in the financial sector
4 Regulating digital finance
5 Conclusion
1 Introduction
Ladies and gentlemen,
Innovation drives us forward. Without innovation, we would still be living in caves,
hunting with wooden spears - maybe not even that - and dying of "old age" in our
30s. So overall, innovation is a good thing.
But sometimes, it can go awry. Has anyone ever heard of Thomas Midgley? Thomas
Midgley is often described as the most disastrous human who ever lived. Alas, he
was not a mad dictator, a crazy warlord or a terrible tyrant; he was an engineer at
General Motors.
What made him so dangerous was his drive to innovate. In 1921, he invented
tetraethyl lead. This particular kind of lead could be added to petrol in order to
improve car engine performance. What looked like a good thing in 1921, though,
contaminated the soil, poisoned the water and polluted the air. It led to countless
premature deaths and harmed the development of just as many children. It wasn't
until the 1970s that policymakers began to phase out leaded petrol.
But Thomas Midgley had more ideas up his sleeve. In 1928, he came up with
chlorofluorocarbons, or CFCs for short. CFCs could help cool refrigerators, for
instance. You might have guessed it: this is the very same stuff that put a hole in the
earth's ozone layer. According to historian J. R. McNeill, Midgley "had more impact
on the atmosphere than any other single organism in earth's history" - and it was
not a positive impact.
Midgley had some help, though. Even back in 1921, people knew that leaded petrol
was not very healthy, to put it mildly. At least five workers at the original factory had
died; others had fallen ill. Still, light-touch regulators approved Midgley's invention
and thus paved the way for much more harm to be done.
This brings us to the often unloved but inevitable twin of innovation: regulation.
Let's take a closer look at their relationship.
2 Innovation and regulation - a happy relationship?
Innovators tend to focus on the benefits of their ideas and inventions; and who can
blame them? Also, the benefits are often immediate and easy to see, while risks
might take years to build up and affect the innovators themselves less than others.
Thus, risks are easy to ignore - at first.
Meanwhile, it is the job of regulators to take the long-term view, to focus on risks
and potential side effects. They are supposed to try to put in place a set of rules
which mitigate relevant risks right from the start. This is easier said than done,
though. First, innovation goes hand in hand with uncertainty, and long-term risks
are hard to gauge. Second, it requires a certain boldness to point out risks and
impose rules while everyone else is still marvelling at the beauty of an innovation.
And third, regulators run the risk of inadvertently stifling progress. These are the
challenges, but none of them should serve as an excuse for doing nothing.
Regulators have to act, of course; they must act decisively and carefully at the same
time. Their ultimate goal should be to strike a balance between enabling innovation
and protecting society from potential risks.
With a view to digital innovation in the financial sector, this is exactly what we try to
do. And we try to do it as carefully and comprehensively as possible. For us, the core
principle is "same business, same risks, same rules". We take a close look at all the
technologies as they evolve, and we work on rules to mitigate any risks without
putting a brake on innovation. In other words, we are risk-oriented and
technologyneutral.
Let's take a tour through the engine room of digital innovation and see what is
going on before we talk about risks and rules.
3 Technology-driven innovation in the financial sector
To cut a long story short: there is a lot going on. Digital innovation is moving very
fast, and it spits out a number of tools that quickly find their way into finance. To
my mind, the four most important things are:
cloud computing, which allows banks to outsource data and processes in order to
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reduce costs;
artificial intelligence, or AI for short, which helps banks to improve
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decisionmaking in general and risk management in particular;
blockchains, which can improve the speed and efficiency of finance - and,
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according to some, may open the doors to an entirely new financial system;
and quantum computing, which still seems to be a bit further down the road but
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could prove to be a game changer for any process that needs computing power.
How will all this change finance? Well, that is anyone's guess, including mine. So I
will not make any specific predictions, which would only turn out to be wrong
anyway. Instead, let's consider a few scenarios. And to stake out the territory, I will
lay out two extreme scenarios. Scenario one: nothing will change. Scenario two: the
financial system as we know it will cease to exist. Instead, we will have an entirely
new one, built on blockchains and run by artificial intelligence and extremely
powerful computers.
I think it is already obvious that the first scenario is not going to happen. Things
have already started to change and will not revert back. Likewise, I would rule out
the second scenario - at least for as far as I dare look into the future. There are still
too many hurdles to be cleared before decentralised finance could become
mainstream.
Thus, the future lies somewhere in between these two extreme scenarios. I admit
that this does not help very much because there is indeed a lot of space between
them. There is a lot of space, and it is by no means certain that every country or
even every part of a country's financial system will end up in the same spot.
First, the impact of new technologies depends on how developed the financial
sector is. Take Africa as an example. Over there, financial infrastructure was still a bit
patchy when digitalisation hit. The result: many African countries still lag behind
when it comes to the number of bank branches or ATMs. But when it comes to
electronic money, they are far ahead of the curve. New technologies arrived in time
to fill gaps and thus quickly took hold. Here in Germany, we do have a
welldeveloped financial sector; thus, there is less room to leapfrog ahead, and there are
more well-established structures that innovation needs to clear.
The next question is how traditional institutions deal with new technologies. A few
years ago, many observers saw traditional banks as an almost extinct species - the
dinosaurs of finance. They reckoned that new, tech-heavy companies would quickly
replace banks. As of today, banks are still alive and well. Some of them apply new
technologies for their own benefit; others happily work together with fintech firms.
As long as traditional banks manage to adapt, they apparently do have a future.
Third, the impact of digitalisation depends on how policymakers react to it. If they
are too lenient when it comes to regulating things, we might see an explosion of
new business before it all blows up in a crisis. If they are too strict, innovation might
cease and we will stay where we are forever.
To sum up: it is very hard to gauge what the financial sector might look like in the
future - that is, two or three decades from now. Nevertheless, I will venture to make
three predictions.
First, the value chain of banking will disintegrate further but not entirely. From a
technical point of view, it might be possible to atomise it completely. But there is
also the economic angle. Bundling activities within a single entity does offer
benefits; and while digitalisation might shift the boundaries, it does not render
bundling completely irrelevant.
Second, finance will become more efficient. New technologies will help to speed up
transactions and lower their costs. They will help to streamline processes and
improve how banks interact with their customers. And they might lessen the burden
of regulation. We could, for instance, turn regulation into code that computers
could read. Banks could integrate this code into their own systems, automate
compliance and save quite a bit of money.
Third, the financial system will become more resilient. Just think of how AI can help
banks to improve their risk management. At the same time, supervisors can use the
very same technologies to spot risks early and mitigate them effectively. At the
Bundesbank, we are making intense efforts to integrate these new technologies into
our work.
To sum up: I do believe that digital finance can be a success story. But real success is
determined over the long run. What looks good today might prove a disaster
tomorrow - think of Thomas Midgley's botched inventions. It is the job of regulators
to look out for disaster, set up safeguards and thus stop the disaster from
happening. So how should we approach this task?
4 Regulating digital finance
First of all, it is quite hard to pin down digitalisation; it's not a single new financial
instrument, for instance, or a single new business model we are talking about.
We're talking about many new technologies that enable many new business models
that push many new players into the market, breaking up the value chain and
shifting the boundaries of finance. It's a very broad and diffuse development we are
looking at - a development that spans countries and sectors and makes it hard to
see the forest for all the trees.
Thus, we might need to adapt the rulebook in some places to cater for all the
dimensions of digitalisation. Towards this end, the principle of "same risks, same
rules" helps a lot. Any entity that starts to take deposits or grant credit automatically
counts as a credit institution and has to follow the relevant rules. It does not matter
whether it is a fintech or a bigtech firm or any other new player. And it does not
matter which technology is used. Thus, existing rules should be flexible enough to
cover at least part of the digital finance landscape.
What makes things a bit tricky, though, is the fact that the value chain of banking is
breaking up. As a result, some of its parts might move out of the regulatory
perimeter. Think of cloud computing. Cloud providers certainly do not count as
credit institutions. Yet, they now are a key part of the value chain and might be a
source of risk for banks. Thus, here in Europe, we came up with the Digital
Operational Resilience Act, or DORA for short. It is meant to improve banks'
resilience vis-à-vis third-party providers. Likewise, here in Germany, we have also
strengthened the supervision of outsourcing arrangements.
And then there are entirely new things such as blockchains and crypto assets. As
such, they require new rules, which are being written as I speak. At the global level,
for instance, we are working on standards for handling crypto assets on banks'
balance sheets. At the European level, we are drafting rules to govern providers of
crypto-related services and issuers of stablecoins. In Germany, new rules on crypto
custody services have already entered into force.
But while we deal with crypto assets, we do not deal with the world they are
helping to create: decentralised finance, or DeFi (Decentralised Finance) for short.
The basic idea of DeFi (Decentralised Finance) is to build a financial system based on
blockchains and crypto assets, which would render intermediaries such as banks
redundant. So far, DeFi is a small and mostly self-referential world. To me, DeFi
seems more like a casino for tech-savvy speculators, to be honest. Yet it is growing
quickly and so might its ties to the rest of finance and the economy. Thus, we need
to be discussing regulatory options now. But then again, whom should we regulate?
DeFi is supposed to be decentralised by design. Thus it is not straightforward to
determine who should be regulated in the first place. When it comes to DeFi, this
question is the elephant in the room.
Yet, there are even bigger elephants in the room that we still need to take care of:
bigtech firms. These companies are poised to enter finance big time. They control
vast platforms, which allow them to embed finance into commerce, collect huge
amounts of data and turn them into money. Bigtech players are the one example
where the boundaries of finance are most obviously shifting and no longer overlap
with the regulatory perimeter. Thus, we have to better understand what bigtech
firms mean for finance and how we can regulate them. So far, it is clear that we
need to cooperate across sectors and engage with competition authorities, for
instance. Otherwise, we might end up with a patchwork of rules where no two
parts fit together properly.
To sum up: regulators are adapting the rulebook to account for digitalisation. We
have to be quick, though. Writing new rules takes time, while innovation happens
fast. Thus, there is the risk that everything will have changed again by the time we
are done. There are two potential fixes to this problem. First, we could take an even
more principles-based approach, which would make it easier to cover new products
and business models. Second, we can review and potentially adapt our regulation
on a regular basis to account for new developments.
5 Conclusion
Let us return to Thomas Midgley. In 1940, he fell ill with polio, which left him
severely disabled. Just 10 years later, the first vaccines for polio were developed, and
today most of us do not have to worry too much about contracting polio. Thomas
Midgley and innovation - a tragic couple in every respect.
This is the power of innovation; it can make the world a better place. The financial
world is no exception: digitalisation can make the financial system more efficient
and more stable. Still, we regulators have to look out for potential new risks and
rein them in. This is our job, and we do it in the interest of society and innovators
alike.
Digitalisation knows no borders. That is why we have to coordinate across national
borders when we design regulation. Personally, I could imagine having a global
forum akin to the Basel Committee on Banking Supervision, the
BCBS (Basel Committee on Banking Supervision) for short, that could set global
ground rules for digital innovation - a "digital
BCBS (Basel Committee on Banking Supervision)".
To sum up: innovation without regulation is not what we should aspire to. After all,
most innovators are not keen on seeing their ideas harm other people, and this is
exactly what regulators try to prevent. By doing so, they help to increase trust in
innovations. So yes, the relationship between innovators and regulators can indeed
be a happy one, and it should start early. Regulators should accompany the process
of innovation from an early stage instead of trying to catch up with the outcome;
they should take a precautionary approach. In finance, this is what we do.
Thank you.