FinTech Regulation in the United States: Past, Present, and Future 

For the last year, participants in the growing financial technology (FinTech) sector have been anticipating new regulation for digital assets. On March 9, 2022, President Biden signed an executive order to begin the process of developing a new supervisory regime that will help the United States be a leader in the space and resolve the challenges associated with regulatory uncertainty. Because existing regulatory frameworks have not kept pace with the innovation of these technologies, they pose a threat to continued innovation, efficiency, and competition in financial services. The solution seems clear: legacy regulation should be modernized. How exactly to modernize, however, is a more challenging question, which my new manuscript, “FinTech Regulation in the United States: Past, Present, and Future,” helps to address.   

In the manuscript, I purposefully take a broad, high-level perspective on potential regulatory solutions in the critical FinTech services of artificial intelligence (AI), blockchain, and decentralized finance (DeFi).   By covering the breadth of FinTech applications rather than an in-depth analysis of any single application, I help to highlight the risks and benefits across the space. Across this spectrum of use cases, I characterize the potential legal risks of existing laws for both developers and users of these technologies. I then describe the best available tools for regulators to mitigate the associated market failures. I differentiate my study from other important work on these issues by considering the economic purpose and incentives of the emergent FinTech as a backdrop to my analysis. 

The study ultimately advocates for a combination of self-regulation, adopting safe harbors with sunset provisions for developers, and policing against mischaracterization of the emergent technologies. In doing so, I also remind stakeholders—both incumbents and new entrants—that there is time and space to influence the modernization of FinTech regulation, emphasizing the importance of doing so for the benefit of developers and consumers alike. To that extent, stakeholders that wish to influence and shape this looming regulatory regime have options. For example, the former presidential candidate, Andrew Yang, founded a decentralized autonomous organization (DAO) – Lobby3 – to fund effective policy advocacy for the FinTech community. 

Below I summarize some of the key parts of the paper and the regulatory responses.

Characterizing the Challenge

Emerging FinTech has powerful potential to transform financial services by creating customized financial services cheaply rather than through more costly human advice or through similarly priced one-size-fits-all options. How is this possible? AI decreases the cost of prediction and exploration. Blockchain reduces the cost of state verification. Smart contracts, which are software programs with potential AI capabilities stored on a blockchain that can receive external data and execute when certain conditions are met, enable DeFi. The primary benefit of DeFi is that it reduces the cost of building and/or coordinating complex financial and managerial services, with the potential to enable completely customized services. As with all transformative solutions though, the potential for efficiency gains intertwines with potential legal risks and market failures. An outdated regulatory framework that does not effectively police harm resulting from market failures in this space is a real danger; however, a misguided regulatory approach that deters further innovation and advancements is similarly perilous.  

Economics of FinTech

This section characterizes the economic purpose and incentives associated with AI, blockchain, digital assets, smart contracts, DeFi, DAOs, and areas of financial services resistant to technological change. I discuss each in a parallel structure highlighting the potential benefits, costs, and dynamic changes still unfolding. For example, advances in blockchain are helping to decrease the price of state verification, which presents cost reductions in multiple ways. First, with smart contracts, it is possible to exchange a certain amount of currency for another between two counterparties through a self-executing mechanism, thus eliminating the need for third parties to facilitate the transaction. This encourages those who need to engage in a transaction to adopt blockchains as a substitute for more costly forms of intermediation that are typically necessary to verify that certain conditions are met (e.g., required currency or authenticity of an image). This suggests that industries with high degrees of centralization, such as finance or publishing, may benefit the most from this cost reduction. 

Further, cost savings can be passed along to the customer, which is especially important for customers who face extraordinarily high fees (e.g., cross-border payments, where the average transaction fee hovers around 10%). In these instances, the reduction in cost could be what brings these participants into the financial system. By dissolving the financial barriers and offering a low-cost alternative, blockchains have the potential to bring financial services to billions of people who would otherwise be left behind. Yet emerging technologies may have unintended consequences associated with the decrease in the cost of state verification. These include environmental externalities and a destabilizing substitution effect associated with stablecoins at a jurisdictional level. It is important, however, not to overemphasize the risks associated with the first iteration of these technologies. As well-intentioned developers are demonstrating, they can and will iterate toward more environmentally friendly and financially stable products and services. 

Regulatory Response 

This section discusses the disjointed regulatory response to the challenge that FinTech poses to the current regulatory framework. I characterize the obstacle that regulatory uncertainty creates for developers by studying the various actions that governments have taken in response to AI, blockchain, smart contracts, and DeFi. In the case of AI, for example, the prominent market failures include: biased algorithms, manipulation of vulnerable populations, and environmental and labor externalities. An important component of the regulatory response has been policing mischaracterizations (e.g., in the intended use of data). While DeFi is not as mature as some of the AI technologies are, the importance of policing mischaracterizations (e.g., the extent of decentralization and/or the timeline to achieve it) also takes on a prominent role. 

For example, in the case of AI, the novel market failure is the mischaracterization of the use of data. The Securities and Exchange Commission (SEC) has brought several recent cases that help clarify the “best practices” with regards to AI and big data. For example, in 2021 the SEC sent a cease-and-desist letter to AppAnnie, a seller of market data on the performance of mobile apps, alleging that AppAnnie violated the antifraud provisions of the federal securities laws by building their AI model with inappropriate data not intended for use in proprietary algorithms. Through this enforcement action, the SEC suggested that AI models or products that are created with illegally used data are legally tainted themselves and will be quashed. Other enforcement actions have clarified additional aspects of the framework regulating AI. 

Next, I characterize the regulatory response with respect to blockchain, smart contracts, and DeFi.  I document anecdotal responses of developers to SEC comments, tests, and enforcement actions taken relating to digital assets. From these responses, it is clear that developers continue to make subtle adjustments to their new digital asset offerings to discourage purchasers of such tokens from expecting profits, thereby avoiding the compliance costs associated with issuing a security. For example, developers are providing documentation that requires purchasers to state their intent of token use.  

Finally, I turn to a key regulatory challenge in the DeFi space: if and how to attribute liability to the creators of decentralized protocols. Here, I examine prior precedent set in the early days of software development, focusing on applications without a legal purpose (e.g., gambling or circumventing encryption technology meant to protect movie copyrights). Ultimately, this analysis leads to recommendations such as safe harbors for well-intentioned developers with sunset provisions, such as automatic termination unless renewed.  

The arguments for sunset provisions parallel prior safe harbors, such as those associated with Section 230 of the Communications Decency Act for platform providers. While these prior safe harbors arguably enabled legitimate digital companies to thrive, they also enabled illicit activities and outlived their usefulness. Assuming a parallel trajectory for this emerging technology, the lesson seems clear that sunset provisions for FinTech technologies could both help the industry to prosper and incentivize the development of protocols that are sustainable in the long-term. Such sustainability will be important given that many DeFi protocols operate in conjunction with each other and with oracles of information. As these other DeFi protocols upgrade and iteratively improve, a community-driven approach to continuously updating or ending the protocol will be needed.    

Call to Action

It will take time for regulators to learn the points of tension in the financial ecosystem brought about by the new use cases of emerging technologies in the industry. Rapid innovation, however, does not allow for static solutions. Dynamic and adaptable policy solutions are critical. Further, there is minimal margin of error in confronting consistently developing technologies. As a result, policymakers need to establish a means to efficiently assess the influence of new regulatory provisions and approaches. For example, securing cooperation from developers that enables access to key metrics on decentralization could help ensure that costs and benefits of the regulatory approach are accurately measured and quickly calibrated accordingly.

To that extent, developers, startups, and incumbents operating in the FinTech space may need to overcome their anarchist/antiauthoritarian roots and join a trade association, lobbying DAO, or work with politicians and policymakers to achieve a regulatory solution that optimally balances all stakeholders’ interests. This study presents a call to action for involvement by industry participants in shaping a modernized regulatory framework. 

Jillian Grennan is an Assistant Professor at Duke University, Fuqua School of Business

This post is adapted from her paper, “FinTech Regulation in the United States: Past, Present, and Future” available on SSRN.

The views expressed in this post are those of the author and do not represent the views of the Global Financial Markets Center or Duke Law.

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