RegTech: creating value, not disruption

In 2016, at JPMorgan alone, the compliance and regulatory headcount grew to 43,000 compared with 23,000 in 2011. All of these costs end up being passed on to the customers. The trend will continue.

Meanwhile, the financial industry has been threatened by a flurry of innovation and increased competition from new fintech firms applying technology to provide new innovative products and services for an ever more demanding, digital savvy customer base.

From both perspectives, financial firms must drive down costs and improve the efficiency and effectiveness of their operational processes. That’s also true for regulators and governments.

One glance at the gig economy such as Uber and AirBnB and it is clear governments are unable to catch up with disruptive implications until long after new services are established. How government and regulators function needs to change in order to be aligned with and responsive to new technologies and businesses.

In contrast, current compliance systems are rife with manual, repetitive and tedious tasks. Some of these processes are a result of laws which demand a certain technology - or even paper - be used. Other inefficiencies are simply a result of a failure by lawyers and compliance professionals to innovate.

In Australia, the Financial System Inquiry outlined the need to weigh the costs and benefits of new regulation adequately, the need to look for other solutions before applying regulation, or the possibility, because these processes are not being applied adequately, Australia is potentially over regulated.

At the intersection of regulation and technology lies a phenomenon accelerating the pace of change and reshaping the fintech industry’s status quo – RegTech, the use of new technologies to solve regulatory and compliance requirements more effectively and efficiently.

The same technologies being used to disrupt the financial services industry can be used to add value – including, for example, being able to get a customer up and running more quickly or having more accurate Anti-Money Laundering screening to improve efficiency and customer satisfaction.

Here are the most promising trends:

Artificial intelligence (AI)

Consider Anti-Money Laundering (AML). Current systems flag transactions of certain amounts or currencies or block transactions with certain countries. The system is labour intensive as human intervention is required to resolve false positives.

AI is trained to learn from transactions, cross check a wide array of channels and data sources, analysing when and where the customer attempts to transfer money, while comparing results with other social data to detect unusual behavior far more efficiently and cost effectively.

Open data

Australia is leading the way in open data for tax compliance, publishing a list of total income, taxable income and tax payable for Australian public, private and foreign private entities for the 2013-14 income year.

Yet it is missing a great opportunity in opening further data points such as registry. NZ has paved the way with a great initiative on open data which has created a more transparent and efficient system which not only gives insights into companies but can also add a layer of analytics to understand and predict trends.

Distributed ledger technologies (DLT)

A distributed ledger is an asset database shared across a network of multiple sites, geographies and institutions.

One key feature of such blockchain technology is a distributed database only allows users to ‘append’ operations not ‘amend’ or ‘delete’.

All participants within the network can be guaranteed to have an identical copy of the ledger.  The primary objective of blockchain based applications is to establish a shared source of truth for all actors on the network even if they have conflicting agendas.

One powerful consequence of this is disintermediation – by removing the entity in the middle, faster delivery, enhanced trust, a lower cost per transaction, a better customer experience and improved bottom line is achievable.

Gaining efficiency in regulatory reporting

DLT or blockchain also has the potential to take away several pain points for financial institutions and regulators. Since blockchain data is shared by design, regulators would not have to collect, store, reconcile and aggregate the information themselves. 

All transactions are documented immutably on the distributed ledger providing a comprehensive, secure, precise, irreversible, and permanent financial audit trail.

Having one shared permanent record would alleviate the need for both regulators and financial firms to keep their own replicated records which would be a tremendous cost saving to the entire industry.

It would also vastly improve the speed and quality of regulatory review process since there would no longer be a need for reconciliation. 

Financial firms would benefit from a more efficient regulatory reporting process since the distributed ledger would act as both an execution platform and a mechanism to store transactional information.

The use of blockchain would significantly improve an organization’s ability to resolve compliance issues, react to new regulatory and compliance obligations and address internal audit requirements.

Faster identity checks using blockchain

Another regulatory field where blockchain will play an important role is in the know your client (KYC) process and for anti-money laundering (AML) compliance. 

Having the ability to quickly and inexpensively verify an individual’s identity would vastly improve the KYC process.

The immutability, immediacy and transparency of information captured within a blockchain means all necessary data can be recorded in shared ledgers and made available in near real time.

Many of the steps required to verify and confirm identity could be eliminated if the information existed already in a secure, tamper-resistant database.

Any changes to customer data will be distributed to participants in the blockchain immediately including the individual whose identity is being verified which will keep the process honest.

It would also mean KYC performed by one bank (Bank A) can be leveraged by another bank (Bank B) operating in the same jurisdiction. This model requires consensus among participating banks on the validation process to maintain the trust and integrity of the system.

Using blockchain will also allow the regulators to oversee the process since all the steps are easily traceable on the blockchain.

One important pre-requisite for any digital identity or automated KYC utility is personal information must be protected according to the laws on the use of personal information within the jurisdiction.

Embedding rules into smart contracts

Streamlining the onboarding process would be a positive first step towards better AML compliance. But blockchain technology also has the potential to improve monitoring through increased automation and the implementation of real-time alerts.

AML compliance monitoring involves continuous screening of clients’ personal and transaction information.

With ‘smart contracts’ (software embedded in blockchain) rules can be ‘hard-coded’ into a smart contract producing a trigger or alert.  For example, stopping a transaction by generating an alert during a trade transaction where there is sanctions risk on the counterparty.

The use cases for this technology are still in a nascent stage however the technology has huge potential due to its ability to modify or prevent actions if certain pre-defined conditions are met.

Managing pre-described limits such as capital and liquidity limits or restrictions on the re-hypothecation of assets are other potential user cases worth exploring. 

Although there is enormous efficiency to be gained in using smart contracts, a strong governance and operational structure would need to be in place to manage the ‘unlocking of hard-coding in response to regulatory changes. Regulators or other trusted parties could potentially be given this responsibility.

Chami Akmeemana is executive director of Regulatory solutions at ConsenSys Inc. Chami is the former Fintech advisor to the Ontario Securities Commission. He was also the Managing Director Global markets at the Global Risk Institute (a Mark Carney initiative).