The regulators are doing a fine job of scaring firms into compliance ahead of innovation in financial instruments—just when ingenuity is needed to put a fragile recovery into first gear. No one wants the self-destructiveness that caused the Great Recession. But firms shouldn’t be making trade-offs between compliance and real advances in financial services and technology.
A case in point is the regulators’ push to reform over-the-counter (OTC) derivatives long after they have done their damage.
The vendors trying to stay on top of the OTC situation tell me that the main concern of most firms is compliance—they are sidestepping innovation in either instruments or technology. One official at a financial technology vendor tells me that most firms recognize that many OTC instruments will move to the exchange-traded realm and that there will a contract standardization process similar to the path for credit default swaps. These are important steps but not exactly the “wow” factor that attracts customers and jumpstarts progress. “I think there will always be the need for some large segment to have bilateral agreements,” the source adds. “I don’t think the complexity is going away.”
As of this writing, it’s unclear if the rulemaking bodies enlisted by the Dodd-Frank Act to reform the industry will have the foresight to create a framework for dealing with the inevitable complexity to come. It’s sadly naïve to expect the regulators will become proactive even though that’s exactly what the industry needs. It’s also foolhardy to think the regulators will meet their deadlines or stand up to idiot politicians that make matters worse. As the process drags on, financial and IT innovations are likely to be stuck in limbo. Essentially, the regulators fail to see that it’s better to know the rules of the game as soon as possible.
In another telling example, regulators were caught off guard by the emergence of social media networking.
A wonderfully disruptive technology, social networks began life as a wide-open, grass roots movement, not as a deep, dark conspiracy. In addition, social networks can actually help financial enterprises with their sales and marketing efforts, customer service and even investor relations, if harnessed and managed correctly; the regulators must think so too because many of them have joined social networks.
But, in a kneejerk reaction, regulators have come down hard on firms via intimidating audits and threats of fines. It’s reasonable to ask if the regulators’ actions are warranted given that most of the violations are due to human error and most firms have timidly embraced social media. Some have banned it altogether out of fear and ignorance.
“It feels like compliance and the regulators are always about 10 steps behind what’s happening,” says Cathy Vasilev, vice president at Red Oak Compliance Solutions, an Austin, Texas-based compliance consulting firm for broker/dealers, registered investment advisers, and hybrids thereof. “I think they need to be more in tune with what’s going on instead of keeping their heads in the sand,” Vasilev says.
In retrospect, it would have made great sense for the regulators to have shepherded social media into the financial markets. Instead, “they try to make it fit in their box when it was never created to fit in their box,” Vasilev says.
The bottom line is that regulators have put a chill on innovation, which has been in a lull since the Great Recession. A CEO of a major supplier to the industry put it succinctly: “In the 28 years that I’ve been in this industry, I have never seen so little financial innovation. And that is very concerning to me because at the end of the day financial innovation is what drives upticks in volumes in the markets as people need to lay off the risk from the new instruments. It also bothers me that financial innovation is seen as inherently evil and to be avoided, which is just silly.”
Yet human ingenuity is unstoppable. For instance, the vendors helping financial services firms monitor their employees’ social networking activities will steadily improve their offerings, predict Vasilev and others.
“As technology progresses and as the human mind continues to create these fantastic ideas … I think the regulators need to get motivated or create a task force to try to stay ahead of the technology,” says Vasilev.
I could not agree more.
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