Regulating the future

What happens when a complex legal and regulatory system tries to address fast-paced innovation? Todd Beauchamp, Stephen Wink, Yvette Valdez, Alan Avery, Loyal Horsley and Deric Behar of Latham & Watkins discuss the challenges facing US regulators

The US has always been at the forefront of technological innovation but recent drastic advances have truly revolutionised certain sectors of the average American's life. Financial services have been and continue to be reshaped by technology. Fintech aims to introduce new products, services and efficiencies – or to disintermediate traditional access points – to the way people bank, transfer money, borrow and invest. But where entrepreneurs see opportunity, regulators often see risk.

Financial services is one of the more heavily regulated industries, in the US and globally and regulation has not kept pace with the changes imposed by fintech. The US financial regulatory system is complex and a bit unwieldy: there are multiple regulators at the federal level and then each state may have applicable laws or regulations. The US regulatory system is well-suited to dealing with discrete sectors and well-defined market participants but not quite able to manage when the sector walls break down and market participants take on wholly new personas.

Over the last year we have seen retailers enter the banking and credit space, social media platforms innovate new methods of cross-border payments and banks doing everything in their power to fend off the assaults on their bailiwicks with their own offerings, or by entering strategic partnerships with the innovators.

Markets are quickly evolving but federal regulators seem stuck, viewing innovation through the well-worn lens of years past. Some state regulators have been more forward-thinking in their approaches to fintech regulation but the innovator's challenge compounds when contending with laws that differ from state to state. Forward-thinking federal regulators do not have it easy either, as they face political and legal challenges from sceptical politicians, state authorities and partisan advocacy groups.

Federal regulators have all recognised the need to refine their approach to regulating new technology and new products and services, balancing the desire to encourage innovation with the need to protect American consumers. Some of the most innovative and high-profile fintech developments of the past few years have involved blockchain ledgers, cryptocurrencies, security tokens, utility tokens and stablecoins (collectively, cryptoassets).

So far, federal regulators have moved to address certain specific questions or issues, while leaving many other questions unanswered and the industry unclear on legal and regulatory requirements or expectations. FinCEN, which imposes the US's primary anti-money laundering and counter-terrorism finance law and its implementing regulations, introduced guidance in 2013 to ensure that virtual currency activity was captured under the Bank Secrecy Act. The SEC, guided by 1946 Supreme Court precedent, has treated most tokens sold in initial coin offerings (ICOs) as securities and regulates the space via non-binding guidance, enforcement action and no-action letters.

The SEC has become increasingly active in enforcing federal securities laws in the cryptoasset space, leading 20 enforcement actions in 2018. The Office of the Comptroller of the Currency (OCC), SEC, Commodity Futures Trading Commission (CFTC), and Consumer Financial Protection Bureau (CFPB) have all created offices of innovation to attempt to engage with and understand the fintech industry in their respective regulatory purviews.

Compound regulatory uncertainty with enforcement activity that has not abated, and the threat to American innovation becomes apparent. There is less risk-taking by the undercapitalised, capital outflow to regulation-friendly jurisdictions and increased market dominance by the established players that have the deep pockets to easily mobilise talent and systems, absorb defence costs and pivot development to alternate geographies as needed.

Despite the risks and regulatory uncertainty, fintech innovation in the US continues to flourish. At midyear 2019, there are over 40 venture capital-backed fintech unicorns – privately held start-ups valued at over $1 billion – in the US worth over $150 billion in aggregate. In 2019, US investment in fintech reached new highs in deal volume and funding, while the number of investors participating in fintech funding rounds has doubled since 2014.

Lawmakers in the US have reacted aggressively to fintech developments where they see heightened privacy, cybersecurity and trading risks, and even national security concerns. However, they also want to foster innovation and expansion. For example, the newly-formed House Task Force on Financial Technology, created to examine the current legal framework for fintech, held its inaugural hearing in June 2019 to focus on what it sees as the SEC's piecemeal regulatory regime; the SEC, for its part, denied that its approach was piecemeal or unclear. The House also created a Task Force on Artificial Intelligence, which will focus on the issues raised by the growing use of artificial intelligence in financial services. In an attempt to provide more statutory certainty to the growing cryptoasset industry, the House is also considering several bills, such as the Token Taxonomy Act and the Blockchain Regulatory Certainty Act, which would clarify the regulatory posture of certain products and services.

To the extent that regulatory uncertainty and political pressure stymies fintech in the US, or legislatures and regulators collaborate to craft a coherent and supportive framework, 2019 may prove to be a watershed year for the future of American innovation.